gcse business unit 2 chapter 8 finance

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GCSE Business Unit 2 chapter 8 Finance - Teacher presentation


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Slide 1:

Unit 2 Chapter 8 Finance

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Section 8.1 Finance for Large Businesses Learning Objectives At the end of this section you will understand The main sources of finance for large or growing businesses Which methods of finance are appropriate in different cases

Why businesses need finance:

Why businesses need finance Finance is needed for… Business Set-up Day-to-day trading (working capital) Growth Why does a business need finance?

Several factors affect the type and amount of finance required:

Several factors affect the type and amount of finance required What is the finance required for E.g. is it to finance long-term assets like a new factory) or a short-term increase in stocks? The cost of the finance Bank finance incurs interest costs Share capital also has a cost – the dividends (returns) required by shareholders The flexibility of the finance What repayments might be required (and when) The business organisational structure E.g. limited companies normally find it easier to raise finance than sole traders

Some key ways to raise finance in a larger business:

Some key ways to raise finance in a larger business Internal External Retained profits Issue shares Bank overdraft Bank loan Sale of assets

Retained profits – after taxes have been paid to the tax man and dividends to the shareholders the profit that is left is called retained profit:

Retained profits – after taxes have been paid to the tax man and dividends to the shareholders the profit that is left is called retained profit The most important and significant source of finance for an established, profitable business

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Domino’s profits rise Domino’s Pizza, famous for its take-away menu, has announced that its profits for 2008 were £350.8 million. This is a rise of 18.4% of its profit figure for 2007. The company, which has 553 branches in the UK and Ireland, said it believed that consumers were choosing to buy cheaper take-away meals, rather than dining in a restaurant. Domino’s Pizza has a target of having 1,000 branches by 2015. How might Domino’s shareholders react if the company decided to keep a larger proportion of its retained profits for reinvesting in the company? Answers might include: ● they may be unhappy and decide to sell their shares in the company ● they may think that this is a good long-term strategy that will ultimately increase the value of their shares ● they may be pleased with the decision

Sale of assets:

Sale of assets Selling spare or surplus assets is a way to achieve a short-term boost to cash flow Good examples: spare land, surplus equipment Note – not all businesses have spare assets If a business needs its assets it can arrange a sale and leaseback deal For example they could sell a building to a leasing company and then that leasing company would charge them an annual leasing charge (like a rental) This would allow them to get the finance but also carry on using the asset

Sale of assets - example:

Sale of assets - example

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New Share Issue A business can raise finance by selling more shares This is quite easy to do if the firm is already a public limited company If they are not already a plc this will be very costly exercise and will take a long time This is an external source of finance (the business is getting finance from people outside of the business – those that buy the shares)

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Loan This is also an external source of finance (the bank is outside of the business) If a firm takes a loan it will have to pay back the amount it has taken plus interest The payments will be made in agreement with the bank – they are likely to be monthly but could be yearly The loan could be short term e.g. to increase stock for the next 3 months It can also be long term e.g. to buy new equipment and pay over 5 years An overdraft is an example of a loan but it is very expensive and would only be used for very short term uses

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Mortgage This is a long term loan used to buy property such as a factory or office space Usually over 15 to 25 years The interest on this loan is lower because it is secured and so it is less of a risk to the bank The building itself is used as collateral so if the business cannot pay the bank will take over ownership of the property and sell it to get their money back Collateral is an asset that a bank holds as security for the repayment of a loan

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Caffe Nero Caffè Nero operates a chain of coffee shops across the UK. The business started in 1997 and has grown rapidly since then. In 2009 the company had 360 coffee shops. What might be the advantages and disadvantages to Caffè Nero of using mortgages as a source of finance? Answers might include: Advantages ● the company can pay back the loans over a long period of time reducing the payment it has to make each month or year ● the existing shareholders will retain control of the company which may protect the directors’ positions Disadvantages ● this can be an expensive option as if the loans are long term it will mean that Caffè Nero pays a lot of interest ● the company will have to use its properties as collateral and could lose them if it fails to pay its mortgage on time Complete worksheet on best sources of finance (worksheet 10)

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Have a look through table B on P123 I am going to call out a benefit or a disadvantage or when it is most used and you write down the source of finance without looking at the book

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Sources of Finance - recap What are the different sources of finance? Loan Selling Assets Selling shares (share issue) Retained profit What is retained profit? The profit left after tax and dividends have been paid What is an advantage of using retained profit? Don’t lose control of ownership How could you sell assets but still get to use them Sale and leaseback All

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Section 8.2 Profit and Loss Accounts and Balance Sheets Learning Objectives At the end of this section you will understand The purpose of a business’s financial statement The main components of financial statements How to interpret data on financial statements

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Purpose of financial statements Every business has to keep financial records so that they know Whether a profit or loss is being made How much cash is flowing into and out of the business When suppliers must be paid for goods and when tax must be paid to government They will include details of Products sold; the value of them and which customers have not yet paid Goods and services bough by the business; the value of them and which suppliers have not yet been paid Equipment and other assets purchased Wages and other labour costs

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Purpose of financial statements At the end of each financial year important statements will be prepared by the firm’s accountants This chapter explains what these statements are and what they contain They help the stakeholders in a business answer 2 important questions Is the business trading at a profit or loss? How much is the business worth? Without answers to these questions Shareholders or owners will not know whether they have made a good investment and whether to invest more Banks will be uncertain whether to lend more or demand early repayment of loans Government will no know how much to tax Workers will be uncertain about jobs and whether the business can afford to pay their wages

Recap: the importance of profit:

Recap: the importance of profit Profit is the return for taking a risk Profit measures the success of an investment Profit is an important source of finance

The profit formula:

The profit formula PROFIT = TOTAL SALES less TOTAL COSTS

Two ways of measuring profit:

Two ways of measuring profit Profit in absolute terms The £ value of profits earned E.g. £50,000 profit made in the year Profit in relative terms The profit earned as a proportion of sales achieved or investment made E.g. £50,000 profit from £500,000 of sales is a profit margin of 10% E.g. £50,000 profit from an investment of £1 million = a 5% return on investment

The profit and loss account:

The profit and loss account A historical record of the trading of a business over a specific period (normally one year) Shows the profit or loss made by the business – which is the difference between the firm’s total income and its total costs You may also see the profit & loss account referred to as an “ income statement ”. The two terms mean exactly the same thing!

Example profit & loss account:

Example profit & loss account Contains six important pieces of information The sales revenue (goods sold x price) Cost of sales – the cost of the goods plus labour costs Gross Profit : sales revenue minus cost of sales Overheads : expenses of the business that are not part of the production process (e.g. rent and management salaries) Net profit : (also known as operating profit). Profit after all costs. Gross profit minus overheads Complete activity 1 & 2 Page 125

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Interpreting profit and loss accounts To properly understand what the numbers mean on a P&L we need to have something to compare them with This could be numbers from previous years to see if the firm is doing better or worse It could also be compared with the close competitors’ numbers We use ratios to make those comparisons The two most important ratios on the P&L are Gross Profit Margin Net Profit Margin

The gross profit margin (how much profit per £ of sales):

The gross profit margin (how much profit per £ of sales) £'000 2008 2009 2010 Revenue 250 325 400 Cost of Sales 150 186 225 Gross Profit 100 139 175 Gross Profit margin 40.0% 42.8% 43.8% Gross profit = revenue less cost of sales Gross profit margin (%) = gross profit / revenue To increase this margin a business could either increase its price or reduce the cost of sales. Problems? In 2009 for each £ of sales the firm made 42.8% profit

Gross profit margin - formula:

Gross profit margin - formula GP Margin (%) = Gross profit Sales Revenue x 100 Gross profit = £200,000 Revenue = £800,000 Gross Profit margin = £200,000/ £800,000 = 25% Example You don’t need to learn the formulae – they will be given to you in the exam

Net profit and net profit margin:

Net profit and net profit margin Net profit is what is left after all the costs of a business have been taken from its sales revenue Example £’000 Sales 150 Wages (50) Energy costs (25) Marketing (15) Other overheads (30) NET PROFIT 30 Net profit margin 20%

Net profit margin – the formula:

Net profit margin – the formula Net profit margin = Net profit (before tax) Sales X 100 Note: net profit margin is expressed as a percentage

What does net profit margin tell us?:

What does net profit margin tell us? Net profit margin is good to know because it tells us how efficiently a business is being run It takes into consideration all the costs To increase the net profit margin the firm could Increase the price A higher price may send customers to the competitors Reduce the cost of sales This may mean lower quality which will upset customers Reduce overheads e.g. cut advertising This could lead to lower sales What problems would we have with each of these? In the exam you will need to be able to explain the difference between gross and net profit margin

The importance of comparison (1):

The importance of comparison (1) The net profit margin of a business should be compared with other competitors in the same market, and over time Example Company A £’000 Company B £’000 Company C £’000 Sales 150 250 500 Net profit 50 25 125 Net margin 20% 10% 25%

The importance of comparison (2):

The importance of comparison (2) Example Company A £’000 Company B £’000 Company C £’000 Sales 150 250 500 Net profit 50 25 125 Net margin 20% 10% 25% Company C makes the highest net margin of these three & also the highest sales. So it makes the largest net profit too Company A makes a higher net profit than Company B even though its sales are lower – because it has a higher net profit margin

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One of Marks and Spencer’s shops In 2008 Marks and Spencer announced that its profits for the year were £1,000 million. How might you judge if this level of profit means that the company has been successful? Answers might include: by calculating the company’s gross profit margin or even better the company’s net profit margin through a comparison with the amounts of profits earned in previous years by comparison with the profits earned by other retailers such as Debenhams

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Do you think that Susie should be pleased with her company’s profits ratios? The two profit ratios have both increased significantly compared to the previous year — Susie should be pleased with this. Net profit margin of 15.25% is a considerably higher return than Susie would get on her bank account She would need to compare it with her competitors if she had access to that information Complete activities on P125

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Balance Sheets The Balance sheet tells us how much the firm is worth It is like taking a photograph of everything that the firm has at the end of the year – it is only a snapshot in time and can change over the year At GCSE the main reason we look at the Balance sheet is to see if the firm has enough assets to be able to pay its liabilities – to see whether it is at risk If the firm has more debts than it has assets it will be at risk of failure Balance sheet : this lists the value of a company’s assets and liabilities Assets : items of value owned by a business Liabilities : debts owed by a business

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Balance Sheets Assets can be divided into 2 categories Current Non-current Current assets are things that the firm could potentially change into cash relatively easily if they needed to pay some debt When you see the word current think ‘assets that you have only short term’ - they are things that the firm has for less than 12 months Examples are cash and stock (raw materials, finished goods, components etc) We also include the money that is still owed by customers that have not yet paid (debtors) So, at the end of the year if I still have customers that owe me money I will put this amount on my balance sheet as a current asset Assets : items of value owned by a business Current Assets : items owned in the short term such as cash, stock and money owed by customers

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Balance Sheets Non- Current assets are the opposite to current – they are assets that could not be changed into cash quickly (fixed assets) Examples are buildings, equipment, machinery etc When you see the word non-current think ‘assets that you have long term’ Assets : items of value owned by a business Non-Current Assets : items owned in the long term such as buildings, equipment, vehicles, machinery

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Balance Sheets Assets are what the business owns Liabilities are what the business owes Liabilities can also be divided into 2 groups Current liabilities Non-current liabilities Again when we see the word current we think ‘short term’ and non-current is the opposite ‘long term’ When we talk about current liabilities we are talking about money we owe in the next 12 months such as payments that have not yet been made to suppliers or payment of the overdraft interest Current liabilities : debts that must be paid within 12 months e.g. suppliers, overdraft Liabilities : debts owed by a business

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Balance Sheets Non-current liabilities is money that is owed in the long term (more than 12 months) be divided into 2 groups This is mostly long term loans Now that we know that assets are what the business has and liabilities are what the business owes We can now use these numbers to see if the business has enough to pay its liabilities We look at this in the short term – is the business going to be able to pay their short term debts as they come up? Does the business have enough current assets to cover its current liabilities? This tells us how good the business is at managing their cash flow – this is called liquidity Non- Current liabilities : long term debts that must be paid but not within 1 year e.g. long term loans used to buy fixed assets Liabilities : debts owed by a business Liquidity : how easy it is for a business to pay its short-term debts

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Balance Sheets We know that cash is the blood of a business If it does not have enough cash or assets that it can quickly change into cash it may not be able to pay its short term liabilities If it is not able to pay its suppliers then it will have no goods to sell and may go out of business Therefore liquidity is very important We use two different ratios to measure liquidity Current ratio Acid test ratio The current ratio compares the firm’s current (short term) assets with the firm’s current (short term) liabilities If there are enough assets to cover liabilities this is good – the firm has good liability and is not at risk of failure Current ratio : how many current assets in proportion to current liabilities e.g. 1:1 means for every £1 of liabilities the firm has a £1 of assets it can use to pay the liabilities Liquidity : how easy it is for a business to pay its short-term debts

Current ratio:

Current ratio Current ratio = Current assets Current liabilities Current assets = £6,945k Current liabilities = £3,750k Current ratio = 1.85 Example In the exam you will be given the formula but you need to know how to analyse the result

Evaluating the current ratio:

Evaluating the current ratio Interpreting the results Ratio of 1.5-2.0 would suggest efficient management of working capital Low ratio (e.g. below 1) indicates cash problems High ratio: too much working capital – could be investing the cash rather than hoarding it Look out for Industry norms (e.g. supermarkets operate with low current ratios because they low debtors) Trend (change in ratio) is perhaps most important

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Current ratio = Current assets less stocks Current liabilities Current assets = £5,620k Current liabilities = £3,750k Acid test ratio = 1.50 Example Acid Test Ratio Stock if often not so easy to turn into cash so if a firm holds a high stock (e.g. a grocery) a better test of liquidity may be the acid test ratio It is better because we remove the stock from the current assets and then see if they still have enough current assets to cover liabilities

Evaluating the Acid test ratio:

Evaluating the Acid test ratio Interpreting the results A good warning sign of liquidity problems for businesses that usually hold stocks Significantly less than 1 is often bad news but it does depend on the type of firm Look out for Less relevant for business with high stock turnover e.g. large supermarket like Tesco Trend: significant deterioration in the ratio can indicate a liquidity problem Acid ratio : a more stringent measure of liquidity because it removes the stock. More applicable to firms that have large inventories/stock

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Why was he worried about the liquidity ratios? Answers might include: ● The standard current ratio for a business should be higher than 1.33:1. ● Similarly its acid test ratio looks low at 1:1. ● He may be concerned that Susie’s business will not be able to pay its debts as they fall due. Complete all activities on P127

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