Finance Basics

Finance Basics

Secrets

The experts tell all!

Stuart Warner

Table of Contents

Cover Page

Title Page

Financial awareness is fundamental to business success

Introducing business finance

1.1 Know the different business entities

1.2 Find out how a business gets money

1.3 Find out how a business uses money

1.4 Appreciate the need for record-keeping

1.5 Know what a finance department does

1.6 Understand the key financial systems

1.7 Differentiate financial and management accounting

Accounting fundamentals

2.1 Make sense of the jargon

2.2 Discover why timing is essential

2.3 Know about doubleentry bookkeeping

2.4 See how accounting systems work

2.5 Understand the balance sheet

2.6 Understand the income statement

2.7 Understand the statement of cash flows

2.8 Watch out for non-cash costs

2.9 Be aware of accounting regulation

2.10 Know who uses financial statements

Making profit

3.1 Realize that not all ‘costs’ are the same

3.2 Know what is meant by ‘profit’

3.3 Differentiate mark-ups and margins

3.4 Consider the impact of discounting

3.5 Forecast costs, volumes and profit

3.6 Know when to use CVP analysis

3.7 Know how to manage profitability

3.8 Be aware of tax

Managing cash

4.1 Understand why cash is king

4.2 Avoid the overtrading trap

4.3 Understand the cash operating cycle

4.4 Measure the cash operating cycle

4.5 Improve cash flow – 1

4.6 Improve cash flow – 2

4.7 Collect cash from customers

4.8 Prepare regular cash flow forecasts

Budgeting

5.1 Understand budgets

5.2 Follow the steps forpreparing budgets

5.3 Choose the best way to budget

5.4 Understand participative budgeting

5.5 Calculate variances from budget

5.6 Monitor budgets effectively

Evaluating business opportunities

6.1 Focus on the relevant costs

6.2 Work out if an opportunity pays back

6.3 Calculate return on investment

6.4 Understand the time value of money

6.5 Use NPV and IRR toappraise investments

Measuring business performance

7.1 Evaluate a business using ratios

7.2 Measure profitability

7.3 Measure short-term solvency and liquidity

7.4 Measure long-term solvency and stability

7.5 Calculate investor ratios

7.6 Estimate the value of a business

Jargon buster

Further reading

About The Author

Copyright

About the Publisher

Financial awareness is fundamental to business success

Many business people, professionals and senior executives who may be experts in their field are sometimes less confident in finance. Quite often this is unfounded and can easily be overcome. In the business world the ability to understand finance and communicate financially is essential.

To date, I’ve spent almost two decades working in finance. I’ve spent a large proportion of this time teaching others. Early on, I found that learning finance was akin to learning a language. One of my own finance teachers told me, “It’s not the numbers, it’s the English you’ll find hard!” – and my own experience proves that this is certainly true. Accountants will often use several names for the same thing. Where possible I’ve tried to give alternative explanations when introducing a financial term. The Jargon Buster at the back of the book should also help you get to grips with some key financial terminology.

In this book I’ve picked 50

secrets

 that will help you get to grips with finance basics. I’ve divided the

secrets

 into seven chapters which cover seven crucial areas every business person should understand.

Introducing business finance.

 Business owners, managers and employees need to have a basic level of financial awareness to help a business succeed.

Accounting fundamentals.

 Make sure you know basic financial terminology and concepts. Be familiar with the main financial statements produced by a business.

Making profit.

 Profit is the raison d’être for most businesses. Knowing how to make and increase profit is one of the key ingredients for business success.

Managing cash.

 “Profit is sanity but cash is reality.” Without cash a business cannot survive for long. Effective cash management will help a business to endure.

Budgeting.

 Many businessess invest considerable time in budgeting but few do it successfully. Some practical tips can improve the process.

Evaluating business opportunities.

 Businesses should use established techniques to help decide whether or not to commit time, resources and money on investment opportunities.

Measuring business performance.

 A successful business can be judged by the size of its market value. Its performance can be measured by using financial ratios.

From students who are interested in business finance to chief executives who want to know more, this book can help you get to grips with finance basics. You’ll even find it interesting and it can help you with your future business activities.

Financial knowledge is not just for accountants – it’s for everyone!

Introducing business finance

Owners, managers and employees need to be aware of the financial consequences of running their business. In this chapter I’ll explain the different types of business entities. I will show you where a business gets its money from and what it does with it. You’ll appreciate the need to record, analyse and summarize business transactions. I’ll also explain the essential difference between financial accountants and management accountants.

1.1 Know the different business entities

A useful starting point to understanding business finance is to appreciate the different ways of trading. There are three main categories: sole traders, partnerships and limited companies. Each offers advantages and disadvantages in relation to legal issues, taxation and the personal liability of its owners.

1

Sole traders.

 A sole trader or proprietorship is a business with 1 one owner, who has unlimited personal liability. If the business becomes insolvent, the proprietor is personally liable for any unpaid debts. Examples can include shopkeepers, tradesmen (e.g. electricians), hairdressers and florists. 

2

Partnerships.

 A partnership is a business with multiple owners, who share profits or losses. The partners can share unlimited personal liability or can take limited liability status. Examples tend to include doctors, dentists, lawyers and accountants.

“A friendship founded on business is better than a business founded on friendship”

John D. Rockefeller, industrialist

3

Limited companies.

 A limited company is a business incorporated by law. Its owners are ‘shareholders’ who have the benefit of limited liability. If the business becomes insolvent the shareholders are only liable for the amount they invested in the company. Limited liability is a key advantage of turning a business into a limited company and can help to attract potential investors. In practice, however, banks may require personal guarantees from shareholders of small owner-managed businesses for loans or overdrafts. There is also an increased administrative and financial burden, in comparison to sole traders.

A limited company can be ‘private’ or ‘public’. Most companies, especially small ones, are private and are owned by a small number of shareholders. In the UK, private limited company names end with the suffix ‘Limited’ or ‘Ltd’. The directors of a private limited company are also likely to be the majority shareholders.

Public companies are usually much larger than private compa-companies. Their shares can be sold and purchased on a public stock exchange. In the UK public company names end with the suffix ‘Public Limited Company’ – or ‘PLC’.

This book will be useful to all entities and in particular limited companies which experience the most regulation.

Limited liability is a key advantage for limited companies.

1.2 Find out how a business gets money

The majority of businesses need money to get started. The ability to raise finance is essential to the initial and ongoing success of a business. A lack of finance is one of the main ways that businesses fail.

Imagine you about to start a new business that requires $1 million initial investment. Let’s say this money is needed for premises, a motor vehicle, computer equipment and goods to sell. If you don’t have $1 million, where can you get the money from?

Most entrepreneurs will initially invest their own money when starting a new business. This is known as ‘share capital’ and for limited companies the owners are called ‘shareholders’. ‘Share capital’ is sometimes referred to as ‘equity finance’.

If more money is needed, there are three main options:

1

Raise further equity finance.

 Ask existing shareholders for more money or find investors who wish to become joint owners/shareholders of the business and contribute to the share capital. As these investors will become joint owners of the business, they will have a say in the running of the business. They will also expect returns on their investment in the form of dividends.

“Never spend your money before you have earned it”

Thomas Jefferson, 19th-century American President

2

Borrow money.

 Typically from a bank or family and friends. This is known as ‘loan finance’ or ‘debt finance’. It is a common route for shareholders who don’t want to share ownership of their business. Equity finance does not have to be repaid, and dividends to shareholders are discretionary. Loan finance, on the other hand, needs to be repaid and will incur interest costs. 

3

Use surplus cash generated from operating activities.

 See Secret 4.5 for more on this. The surplus cash must not have been paid as dividends to shareholders or committed elewhere in the business.

There are many other alternative sources of finance for a business. Examples include leasing assets (as opposed to purchasing assets outright), government grants and even sponsorship. Reading a company’s financial statements should reveal where they have got their money from (Secret 2.5).

A successful financing strategy is just as important as a successful business strategy.

1.3 Find out how a business uses money

If the first thing a business does is raise finance, the next thing it does is to spend it, usually on assets. These are resources owned or controlled by a business and are used to generate money. Assets are generally the biggest investments made by businesses. Both long-term and short-term assets are essential for most businesses.

There are four main categories of assets, as follows:

1

Fixed assets.

 The term ‘fixed assets’ refers to assets that are a ‘fixed’ item within a business, usually for more than a year (and hence long-term assets). Fixed assets are also referred to as ‘property, plant and equipment’ and sometimes as ‘non-current assets’. They are for continuous use in the business and are essentially used to make money. There are many different types of fixed assets found in businesses. The most common types are land, buildings, machinery, fixtures and fittings, office equipment, computers and motor vehicles.

2

Intangible assets.

 Intangible assets are also long-term assets. They are non-physical resources and rights owned by a business that offer a competitive advantage or add value to the business. Examples of intangible assets include brands, trademarks and patents. 

3

Investments.

 Many businesses spend their money on investments, which they intend to ‘hold’ for the future and hence are also long-term assets. Investments include assets such as shares held in other companies and rental property. 

4

Current assets.

 The term ‘current assets’ refers to assets that help on a short-term basis, usually for less than a year. These are assets which are traded e.g. inventory, or by their nature ‘liquid’, e.g. cash. Money owed by customers is also a current asset because it is a ‘future benefit’. The customer will pay cash in the future. Money owed by customers is also referred to as ‘debtors’, ‘accounts receivable’, trade receivables’ or more simply ‘receivables’.

Reading a company’s financial statements should reveal what they have spent their money on (Secret 2.5).

Investing money in both long-term and short-term assets is essential for most businesses.

1.4 Appreciate the need for record-keeping

Successful businesses know that accurate record-keeping is not only essential for accounting but also provides infor m ation that can be a key source of competitive advantage.

 Accounting and bookkeeping. ‘Accounting’ can be defined as the provision of financial information concerning the results of a business over a period of time. A business needs to ‘account’ for what it has done and accounting is a process of recording, analysing and summarizing commercial transactions. The term ‘bookkeeping’ generally refers to just the recording of transactions.

case study

 Tom runs a computer services company and understands the benefits of recording, analysing and summarizing all business transactions. The list opposite shows the inf