Finance
This section contains information on Finance Information. As with the other
sections it is in no particular order.
Q. How much working
capital should a business have?
A. As little as the smooth running of the business will allow.
Working capital is used to finance such items as stock, work in progress and
customers who haven't yet paid up. Any money tied up in this way has a cost, either
in interest charges if such funds come from a bank or interest forgone if you
have to use your own or other shareholder's money.
It follows, therefore, that you should have as little money tied up in working
capital as the smooth running of the business will allow. That means, for example,
that you should have enough stock to meet demand, but not so much you have to
dust it!
Q. A highly geared business is one that:
A. Has very little shareholders capital in relation to its borrowed
capital.
Gearing is the term used to describe the relationship between a firm's debt
capital and its equity. The higher the proportion of debt, the more highly geared
is the business. The more borrowed money a business uses, as opposed to that put
in as equity by the shareholders (either through initial capital or by leaving
profits in the business) the more highly geared the business is. Highly geared
businesses can be vulnerable when either sales dip sharply, as in a recession,
or when interest rates rocket as in a boom. In either case a business will struggle
to make sufficient profit to cover interest charges.
Q.
From the following figures work out how much this business will need to borrow
to meet its current liabilities: Debtors £52,000; Creditors £161,500;
Stock and work in progress £81,000: Tax due £15,200:
A. See if you can work it out...
To answer this question you need to put together a mini balance sheet of assets
and liabilities.
A balance sheet is the accounting report showing a statement of assets owned
by a business and the way they are financed from liabilities and owner's equity.
On the current asset side of the balance sheet we have debtors of £52,000
and stock and work in progress of £81,000, making a total of £133,000.
On the current liabilities side we have creditors of £161,500 and tax due
of £15,200, making a total of £176,700. So we have £43,700 more
of current liabilities than we have of current assets. It is that sum we need
to have on hand to make sure we can pay our bills in reasonable time.
The term current, in the accounting sense, is used to describe a transaction
to be carried out within twelve months as distinct from longer term assets and
liabilities, such as premises, equipment and term loans, that stay on the balance
sheet for years.
A. £43,700
Q. Reserves in finance are:
A. The cumulative undistributed profit as shown in the balance sheet
Reserves is the name given to the accumulated and undistributed profits of
the business. Reserves belong to the ordinary shareholders, but they are not necessarily
available in cash. They are usually tied up in other business assets, such as
stock, buildings and debtors, for example. The figures show up in the business
balance sheet near to the amount of shareholders initial investments. It is just
one of a long list of terms with slightly misleading names that are always cropping
up in accounting.
Q. Depreciation is:
A. A way to allocate the cost of an asset over its working life
The depreciation is how we show the asset being "consumed" over its
working life. It is simply a bookkeeping record to allow us to allocate some of
the cost of an asset to the appropriate time period. The time period will be determined
by such factors as how long the working life of the asset is. Tax authorities
usually do not allow depreciation as a business expense - but do allow tax relief
on the capital expenditure. The proportion of capital purchase allowed by the
Inland Revenue to be offset against tax is called the "writing down allowance".
Depreciation is not a method of providing for new equipment to replace old.
It is simple a bookkeeping event. For example machine mentioned has been bought
and paid for. The only real events that have occurred are the machine being paid
for (£10,000), and it becoming the property of the company buying it. The
depreciation is a notional figure put in for the reasons given. It follows that
the book value of the machine of £5,000 after 2 years is also a notional
figure. The machine could be worth next to nothing (as in the case of a computer)
or it could even be worth more (as with a vintage vehicle or personalized number
plate for example).
The principle methods of depreciation used in business are:
The straight line method. This assumes that the asset will
be "consumed" evenly throughout it's life. In the example below we have
assumed a computer, for example is being bought for £1200 and sold at the
end of five years for £200. The amount we have to write off therefore is
£1000. Using 20% as the write down amount, we can work out the "book
value" for each year.
The declining balance method. This works in a similar way,
but instead of an even depreciation each year we assume the drop will be less.
Some assets, motor vehicles for example, will reduce sharply in their first year
and less so later on. So whilst at the end of year one in both these methods of
depreciation will result in a £200 fall, in year two the picture starts
to change. The straight line method takes a further fall of £200, whilst
the declining balance method reduces by 20% (our agreed depreciation rate) of
£800 (the balance of £1000 minus the £200 depreciation so far),
which is £160. 
Sum of the digits method. This is more common in the US than
in the UK. Whilst the declining balance method applies a constant percentage to
a declining figure, this method applies a progressively smaller percentage to
the initial cost. It involves adding up the individual numbers in the expected
life span of the asset to arrive at the denominator of a fraction. The numerator
is year number concerned, but in reverse order.
For example if our computer asset bought for £1200 had an expected useful
life of five years (unlikely) then the denominator in our sum would be 1+2+3+4+5
which equals 15. In year 1 we would depreciate by 5/15ths times the
initial purchase price of £1200, which equals £400. In year 2 we would
depreciate by 4/15ths (£320) and so on.
These are just three of the most common of many ways of depreciating fixed
assets. In choosing which method of depreciation to use, and in practice you may
have to use different methods with different types of asset, it is useful to remember
what you are trying to do. You are aiming to allocate the cost of buying the asset
as it should apply to each year of it's working life.
Q.
Working Capital is calculated as:
A. Current assets less current liabilities.
The terms, current is used in financial language to describe something that
is going to be realised or consumed within one year. The term net means a position
after the relevant liability has been taken away. So the net current assets, are
the current assets less the current liabilities. The resulting sum is also referred
to as working capital
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