3 · Finance, accounts and appraisal

IB Diploma Programme Business Management HL, Unit 3 Finance and accounts (first assessment 2024). This topic covers sections 3.1 to 3.9: why businesses need finance and where they get it, costs and revenues, final accounts, ratio analysis, cash flow, investment appraisal and budgets. Debt/equity ratio analysis (3.6), budgets (3.9), net present value, intangible assets and depreciation are HL only. The worked examples use the course's repair business in its second year as a company, so every number below fits with every other.

In 2017 the bike-sharing company ofo had millions of yellow bikes on the streets of Chinese cities and had raised billions of dollars from investors. By the end of 2018 it had spent most of that money, and more than ten million users were waiting in an online queue to get their deposits back. Customers liked the product. The company failed because cash ran out. This topic shows how a business plans its money, reads its accounts and checks whether a project is worth the cost.

Must-know for this topic:

A business spends money in two ways.

• Capital expenditure 资本支出 buys non-current assets 非流动资产, things the business keeps for more than a year: a workshop, a machine, a van.
• Revenue expenditure 收益支出 pays for day-to-day running: wages, parts, rent and electricity.

The money for each should come from a source that fits. A long-term asset needs long-term finance. Paying for a new workshop with an overdraft is risky, because the bank can ask for the overdraft back at any time.

Internal finance comes from inside the business; external finance comes from outside

Internal finance 内部融资 comes from inside the business:

• personal funds 个人资金: the owner's own savings, the main source for a sole trader;
• retained profit 留存利润: profit kept in the business instead of being paid to the owners. It costs no interest, but a new or loss-making business has none;
• the sale of assets 出售资产 the business no longer needs, such as an old van.

External finance 外部融资 comes from outside:

Sources are also short term (under a year: overdraft, trade credit), medium term (one to five years: leasing, most loans) or long term (over five years: share capital, long loans). To choose, a manager weighs the cost, the amount needed, how long it is needed for, control of the business, and how much the business has already borrowed.

Worked example. The repair business built a second workshop for 120,000. Half came from retained profit and half from a five-year bank loan. The workshop will earn money for many years, so long-term finance fits. The monthly parts bill uses trade credit. For eleven days in December, when wages were paid before customers paid their bills, the business used its overdraft.

Costs and revenues

• A fixed cost 固定成本 does not change with output: rent, salaries, insurance.
• A variable cost 可变成本 changes with output: car parts, paint, energy for the machines.
• A semi-variable cost 半可变成本 has a fixed part and a variable part, such as a phone contract with a monthly charge plus a cost per call.
• A direct cost 直接成本 belongs to one product or department, such as the parts used in one repair. An indirect cost 间接成本, or overhead 管理费用, is shared, such as the manager's salary.

Total revenue 总收入 is price × quantity sold. The repair business does 2,000 repairs a month at an average price of 25, so its revenue is $2{,}000 \times 25 \times 12 = 600{,}000$ a year. Many businesses also have other revenue streams 收入来源: the repair business sells tyres, rents out its car wash and earns a fee from an insurance company for every customer it sends.

Final accounts

The final accounts 财务报表 are prepared at the end of each year. Many stakeholders 利益相关者 read them: owners and shareholders check profit, banks check the business can repay, suppliers check it can pay its bills, employees check their jobs are safe, and the government checks tax.

The income statement 损益表 shows how much profit the business made over the year.

Brackets mean the number is taken away. Cost of sales 销售成本 is the direct cost of the repairs that were sold: opening stock 18,000, plus parts bought 372,000, minus closing stock 30,000, gives 360,000.

The statement of financial position 资产负债表, or balance sheet, is a picture of the business on one day: what it owns (assets 资产), what it owes (liabilities 负债) and the owners' money (equity 所有者权益).

Current assets 流动资产 turn into cash within a year. Debtors 应收账款 are customers who still owe money. Current liabilities 流动负债 must be paid within a year; creditors 应付账款 are suppliers the business still owes. Current assets minus current liabilities is working capital 营运资本: $80{,}000 - 40{,}000 = 40{,}000$, the money available for day-to-day running. Net assets always equal equity, because everything the business owns is paid for either by borrowing or by the owners.

The balance sheet balances: total assets of 400,000 are paid for by equity, long-term debt and short-term debt

Intangible assets and depreciation (HL)

An intangible asset 无形资产 has value but cannot be touched: a brand, a patent 专利, a copyright, a trademark, or goodwill 商誉 (the extra a buyer pays for a business's reputation and customers). They are hard to value, and the value can fall fast after a scandal.

Depreciation 折旧 is the fall in value of a non-current asset as it is used and gets older. It spreads the cost of the asset over its life and is counted as an expense each year. The repair business buys a diagnostic machine for 22,000. It expects to use it for 4 years and then sell it for 2,000, its residual value 残值.

• Straight-line method 直线法: $\dfrac{\text{cost} - \text{residual value}}{\text{years of life}} = \dfrac{22{,}000 - 2{,}000}{4} = 5{,}000$ a year, the same every year.
• Units of production method 工作量法: the machine is expected to do 20,000 tests in its life, so each test costs $(22{,}000 - 2{,}000) \div 20{,}000 = 1$. In a year with 6,000 tests, depreciation is 6,000. This method fits machines that are used more in some years than in others.

Ratio analysis 比率分析 compares numbers from the final accounts so that a business can be compared with last year and with its rivals.

Profitability ratios 盈利能力比率 measure profit against sales or against the money invested.

Capital employed 运用资本 is non-current liabilities plus equity: $160{,}000 + 200{,}000 = 360{,}000$.

The return on capital employed 资本回报率 (ROCE) of 25% is far above the roughly 6% interest on the bank loan, so borrowing to invest has paid off. To raise profitability, a business can raise prices where customers are loyal, buy parts more cheaply, cut waste, or sell more of its high-margin services.

Liquidity ratios 流动性比率 show whether the business can pay its short-term debts.

A current ratio between 1.5 and 2 is usually safe. The acid test ratio 速动比率 leaves out stock, because stock may be slow to sell; a result above 1 is usually safe. Both results here are healthy. A ratio far above the safe range is not good either: money is sitting idle instead of earning a return. To improve liquidity, a business can sell old stock, collect money from debtors faster, or turn an overdraft into a long-term loan. Each step has a cost: discounts to sell stock lower profit, and pushing customers to pay faster may lose some of them.

Efficiency ratios 效率比率 show how well the business manages its stock and its credit. Average stock is (opening stock + closing stock) ÷ 2 $= (18{,}000 + 30{,}000) \div 2 = 24{,}000$.

or, in days, $\dfrac{24{,}000}{360{,}000} \times 365 = 24.3$ days. The business sells and replaces its stock of parts about every 24 days. Faster stock turnover 存货周转率 frees cash; too little stock means customers wait for parts.

Debtor days 应收账款天数 is how long customers take to pay; creditor days 应付账款天数 is how long the business takes to pay its suppliers. Here customers pay about two days more slowly than the business pays its suppliers, so the business pays out before it is paid. It could ask insurance companies to pay within 20 days, or ask suppliers for 45-day terms.

The gearing ratio 资本负债率 shows how much of the long-term finance is borrowed. Above 50% a business is usually called highly geared. High gearing is risky: interest must be paid even when sales fall, and banks may refuse more loans. When profit is strong, though, borrowing lets the owners earn more without giving away shares. At 44.4% the repair business is close to the line, so its next project should be paid for with share capital or retained profit, not another loan.

Profit 利润 and cash flow 现金流 are different. Profit is revenue minus costs for the year. Cash flow is the money that actually comes in and goes out, and when. A repair finished on 28 December counts as revenue in December, but if the customer pays in February, the cash arrives in February. A profitable business can still fail if it has no cash to pay wages and suppliers. A business with cash can survive a loss-making year.

The working capital cycle 营运资本周期 is the time between paying for inputs and receiving cash from customers.

The longer the working capital cycle, the more cash the business needs to keep running

Businesses hold cash for three reasons: to pay day-to-day bills, to keep a safety reserve for surprises, and to take chances when they come, such as a supplier's discount for buying in bulk.

A cash flow forecast 现金流量预测 shows the cash a business expects to receive and pay out, month by month. Each month:

• net cash flow = cash in − cash out;
• closing balance = opening balance + net cash flow;
• the closing balance becomes next month's opening balance.

Worked example. The repair business forecasts the first half of next year (in $000).

In April the yearly insurance and a large parts order are paid in the same month, and the balance falls to −5,000. The forecast shows the problem in January, so the manager has three months to arrange an overdraft or move a payment.

The closing balance falls below zero in April and May: the forecast warns of a cash shortage three months early

A forecast is only as good as its guesses. Sales may be lower than expected, customers may pay late, and costs may rise. Managers should change it as new information comes in.

A business can deal with a cash flow problem in three ways:

Investment, profit and cash flow are linked. A new workshop uses a lot of cash now and earns profit only later, so even a good investment can cause a cash shortage in its first months.

Investment appraisal 投资评估 checks whether a capital project is worth its cost. The repair business plans a third workshop. It costs 120,000 and should bring in a net cash flow of 40,000 a year for four years.

The third workshop pays back its 120,000 cost after exactly three years

The payback period 投资回收期 is the time a project takes to earn back its cost. After three years the workshop has earned $3 \times 40{,}000 = 120{,}000$, so the payback period is 3 years. If the cash flow is not the same each year, add the years until the total covers the cost, then work out the part year: months $= \dfrac{\text{amount still needed}}{\text{cash flow in that year}} \times 12$. Payback is simple and shows risk, because money that comes back sooner is safer. It ignores everything that happens after the payback date.

The average rate of return 平均收益率 (ARR) is the average yearly profit as a percentage of the cost.

ARR uses all the years of the project and can be compared with the interest rate on a loan. It ignores timing: 40,000 received in year 4 is treated the same as 40,000 received in year 1.

Net present value (HL)

Money received in the future is worth less than money today, because money today could be saved and earn interest. Net present value 净现值 (NPV) turns each future cash flow into its value today with a discount factor 折现系数, then subtracts the cost. At a discount rate of 6%:

NPV $= 138{,}600 - 120{,}000 = +18{,}600$. A positive NPV means the project earns more than the 6% the money could earn elsewhere, so it is worth doing. NPV counts timing, but the result depends on the discount rate chosen, and it is harder to explain to non-specialists.

All three methods depend on forecasts of cash flow, which may be wrong. Managers also weigh things the numbers leave out: the effect on staff, the business's image, and the risk that a rival opens nearby.

A budget 预算 is a financial plan for a future period, such as next year's sales or costs for one workshop. A forecast predicts what will happen; a budget sets a target for what should happen. Budgets help a business plan, share out resources, give managers clear targets, and check results.

A cost centre 成本中心 is a part of the business whose costs are recorded, such as the repair business's IT department. A profit centre 利润中心 has both costs and revenues recorded, so its profit can be measured, such as each workshop. Profit centres show which parts do well, but they can make managers compete with each other instead of working together.

A variance 差异 is the difference between the budget and the actual result. It is favourable 有利 (F) when it raises profit and adverse 不利 (A) when it lowers profit.

Worked example. Workshop 3, one month:

Revenue rose because the workshop cut its price to win more repairs. But the extra repairs needed more parts, and parts became dearer, so profit is 60 below budget. A manager should find the cause of each variance before acting: was the price cut a good decision, or did parts cost more because of a new supplier? Used this way, budgets and variances feed back into the business's plans for next year.

• Capital and revenue expenditure; internal sources (personal funds, retained profit, sale of assets) and eight external sources; short, medium and long term; matching the source to the need (3.1–3.2).
• Fixed, variable, semi-variable, direct and indirect costs; total revenue and revenue streams (3.3).
• The income statement from sales revenue 600,000 to retained profit 40,000; the statement of financial position with net assets and equity of 200,000; who reads the accounts. HL: intangible assets; straight-line depreciation 5,000 a year and units of production 1 per test (3.4).
• Gross profit margin 40%, profit margin 15%, ROCE 25%; current ratio 2.0, acid test 1.25; ways to improve each (3.5).
• HL: stock turnover 15 times (24.3 days), debtor days 27.4, creditor days 25.3, gearing 44.4%; ways to improve each (3.6).
• Profit against cash flow; the working capital cycle; the January–June forecast with its −5,000 in April; three ways to fix a cash problem (3.7).
• Payback 3 years, ARR 8.3%; HL: NPV +18,600 at 6%; what each method can and cannot show (3.8).
• HL: budgets, cost and profit centres, the variance table with its 60 A profit variance (3.9).

Paper 2 tests the calculations: write the formula, put in the numbers and give the answer with its unit, then say what it means for the business. Paper 1 asks about sources of finance and cash flow in the case-study business. All numbers here are original.