Putting a business idea into practice

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1 Putting a business idea into practice Objectives when starting up What is an objective? An objective is what the business is trying to achieve eg make profit Why do entrepreneurs start a business? There are many possible reasons eg they want to make big profits and so become wealthy or they want a challenge or to help others Describe potential financial objectives. Motives for wanting to start up and run a firm include Earning an income from business profit. financial security: being confident running a business carries less risk than current work becoming wealthy by eventually selling the business for a large sum of money Are entrepreneurs motivated by other factors apart for money? Owners may have nonfinancial objectives including: The personal satisfaction from setting up and running your own business The challenge and excitement of taking calculated risks successfully Independence and control that comes from being your own boss Wanting to help others eg by starting a charity Entrepreneurial qualities Successful entrepreneurs show Determination to take control and make things happen - even after setbacks An ability to plan ahead and anticipate opportunities and challenges Initiative. Entrepreneurs are self-starters. They take the first step and are able to work independently without anyone telling them what to do A willingness to accept calculated risks and live with the possibility of business failure An ability to make decisions between alternative options. They have good judgement. Good powers of persuasion eg they can persuade customers to buy their products and suppliers to deliver goods on time and at a competitive price Leadership a vision for where the business can be and how it can achieve success Good luck eg by launching the right product at the right time and avoiding a recession Describe the challenge facing start-up businesses. New firms lack customers. It takes time to win and retain sales and so generate sufficient revenue to cover all costs and move into profit.

2 Estimating revenues, costs and profits Price Define price. Price is the amount customers pay for goods or a service Explain the difference between price and cost. Each has different meanings in business. Cost is the amount spent by firms making products Selling price is the amount customers are charged when buying a product Estimating revenues What is revenue? Revenue is income earned by a business from sales over a period What determines revenue? The amount of income earned by business from selling depends on two things: the number of items sold and their selling price. State the formula for calculating revenue. Revenue = price x quantity Give an example of estimating revenue. The total revenue raised when 2,000 items priced 30 each are sold = 30 x 2,000 = 60,000. List alternative terms for revenue. Revenue is sometimes called sales, sales revenue, total revenue or turnover. List alternative terms of quantity. Quantity sold, amount sold or sales volume What is a forecast? A forecast is a guesstimate or prediction about the future. Forecasts may or may not turn out to be true. Many firms overestimate sales and underestimate costs How do firms estimate revenue? Forecasting revenue requires the entrepreneur to predict the likely volume of sales over say, the next month and their average price Why is it particularly hard for start-up firms to predict revenue? What is total revenue? Total revenue is the amount of income received from selling products How does price affect revenue? The higher the price charged the greater the revenue earned. Eg if a window cleaners charges 12 and completes 5 jobs in a morning, total revenue = 12 x 5 = 60. If the cleaner can persuade customers to pay 20 and retain all his customers then total revenue = 20 x 5 = 100 How do sales volumes affect revenue? The greater the number of times sold, the higher the revenue earned eg if a window cleaner charges 12 and has 5 customers in a morning, total revenue is 60. If he can clean 8 houses, revenue is 12 x 8 = 72 Estimating costs What are costs? Cost is the amount spent by firms making products. State the main types of cost. There are two main types of cost: fixed cost and variable cost Explain fixed costs. Fixed costs are costs that do not change as output changes. Fixed costs such as rent and interest stay the same even if more is produced. Make a list of common fixed costs. Examples of fixed costs include rent of the business premises, interest payments, loan repayments, administration staff wages, internet and phone bills, insurance payments, and advertising costs. These costs remain the same even if output rises in a period.

3 Explain variable costs. Variable costs change with the amount produced. For example, the cost of raw materials used in production rises as more output is made. Make a list of common variable costs. Examples of variable costs include the wages of production workers; raw materials; fuel, gas, electricity and petrol used in production; packaging of the finished product How can entrepreneurs determine which costs are fixed or variable? A business person asked themselves: does this cost go up if just one more item is made? Extra production increases variable costs but leaves fixed costs unchanged What are total costs? Total costs are the amount of money spent by a firm on producing a given level of output. Total costs are made up of fixed costs (FC) and variable costs (VC). Profit What is profit? Profit is the amount left over from revenue after paying all costs How is profit calculated? Profit is found by deducting total costs from revenue ie turnover What is a profit margin? A profit margin is the amount of profit made on each 1 of sales. Eg a profit margin of 20% means 20p for every pound of sales. Explain losses. A business makes a loss when total revenue is not enough to cover costs State the formula for calculating profit or loss. Profit or loss = total revenue total costs Give an example of profit. The window cleaner estimates he has 40 houses to visit next week. Given an average selling price of 8 total revenue is forecasted to be 8 x 40 = 320. Total costs are 250 giving an expected profit of 320 total revenue less 250 total costs = 70 profit. Give an example of loss. One day that week the van breaks down and 10 houses are not cleaned. Revenue is 8 x 30 = 240. If costs remain the same at 250, a 10 loss is made How are profits used? Profit can be used to reward owners for risk taking or ploughed back into the business to fund growth and hopefully increase future profits How can profits fund future growth? Reinvesting profits allows a business to buy new equipment, premises, computers, research and development or extra marketing Why do firms make a loss? Losses are made when expected revenues fail to cover costs. What do losses say? Losses mean the firm must cut costs or increase revenue if it is to survive. How can costs be cut? The entrepreneur can Use cheaper components or raw materials Cut wages or even sack some staff How can revenue be raised? By increasing the volume of sales at current prices or by increasing price while maintaining the volume of sales Do loss making firms stop trading. Most businesses can cope with small losses for say a few months. Large losses for month after month threaten the survival of the firm How can competition affect profits? If rivals offer a new, better products or cut prices then the business may lose sales and profits. How can costs affect profits? Controlling costs is important. Eg, a business employing more staff than is needed, or is wasteful with energy, has unnecessary costs that cut into profits.

4 Forecasting cash flows Receipts and payments What is cash? Cash is the amount of money the firm has in notes, coins, and money in the bank Explain cash flow. Cash flow is the movement of money in and out of the business. What are cash inflows? Cash inflows are receipts: money the firm receives. Money comes into the business List sources of cash inflow. Money comes into the business as receipts eg from cash sales, ie customers paying their bills, a loan from the bank or cash injections from the owners What are cash outflows? Cash outflows are payments: money the firm pays out to others. Money leaves the business List reasons for cash outflow. Cash can leave the firm as payments for eg raw materials and components, wages and salaries, utility bills such as electricity, advertising or interest payments on loans Is cash flow the same as profit? Cash flow and profit are very different. Profit is the income left from sales revenue once all costs are paid. Cash flow is the difference between money coming into the business and money leaving the business, over a period Why is cash important? Cash is used to pay bills. A firm that runs out of cash cannot pay its bills and becomes insolvent Explain insolvency. An insolvent business can no longer pay its bills, as it has run out of cash How can a business avoid insolvency? A firm draws up a cash flow forecast to predict how cash will flow in and out of the business in the future How can a firm avoid cash flow problems? Creating a cash flow forecast helps a business identify times when it is likely to run out of cash and so avoid insolvency. What is a cash flow forecast? A cash flow forecast predicts the future flow of cash in and out of the business over a given period of time eg three months. Interpret January s cash flow forecast. At the beginning of January the business has 1,000 worth of cash. This is the opening balance for the month of January The total flow of cash into the business (receipts) for January is expected to be 12,000, while the total outflow from the business (payments) is forecast at 10,000. Net cash flow is the difference between receipts and payments of money over a period. January s net cash flow is 12,000 from cash in less 10,000 from cash out. This means net cash flow is = 2,000. Given an opening balance of 1,000 and a net cash flow of 2,000 there is a closing balance of 3,000 at the end of January that can be carried forward to February Why is projected net cash flow negative in February? In February cash outflows are greater than cash inflows by 2,000. The firm has received 8,000 in cash but paid out 10,000 cash.

5 Why is the firm predicting cash flow problems in March? The firm starts March with 1,000 cash. Given payments of 13,000 and cash receipts of only 10,000 net cash flow is - 3,000. Unless action is taken the firm does not have enough cash to pay its bills at the end of the month Can the business survive until the end of April? The business has a cash flow problem for just one month: March. If they take action and say arrange a one month overdraft with the bank for 2,000 during March they can avoid becoming insolvent ie being unable to pay their bills How can the firm tackle its future cash problem? The owners can take action to Increase receipts by getting more cash in from sales or arranging a loan from the bank or put more of their own money into the business. Reduce payments by cutting costs eg cut staff wages, or delaying paying suppliers Define net cash flow. Net cash = business receipts minus business payments What are cumulative cash flows? Cumulative cash flow is the total amount of money that flows through a business over a given period and is calculated by adding net cash inflows and deducting cash outflows. The cumulative cash flow in the diagram from January to May inclusive is 2,000-2,000-3, ,000 = 6,000 Stock and credit What is stock? Stock is materials and components stored in warehouses for eventual use in manufacture, and finished goods awaiting sale Why do businesses buy more stock? Manufacturers buy more stock so that they have the materials and components needed to increase production. Shops hold more stock when they expect an increase in sales eg toy shops buy more stock in October to be ready for Christmas How can stock levels affect cash flow? Suppliers expect payment for stock. Manufacturers may have to pay for materials to use in production far earlier than they receive payment for finished goods made using these components. Cash flow suffers Retailers may have to pay for stock before they receive cash from sales. Some items may even remain unsold and so tie up cash in unsold stock Explain credit. Credit is when customers buy now and pay later What are credit terms? Most firms offer credit - customers buy now and pay later. In offering longer periods of credit to customers, payment is delayed and cash flow suffers. How can credit terms affect firms? If suppliers offer improved credit and ask for payment within 90 rather than 28 days, this gives the firm longer to pay its bills. Cash flow is helped. If the firm offers its own customers longer time to pay then their own cash flow suffers. What is a business plan? A business plan is a report by a new or existing business, setting out its market research, competitor analysis, cash flow forecast, and sales and profit projections. Why draw up a business plan? Drawing up a business plan helps entrepreneurs avoid two of the major reason for business failure Insufficient thinking ahead. Writing a business plan gets owners to think about customer needs, competitors and how their firm can succeed Insufficient finance. A business plan forecasts the amount of money needed to set up and run the business for the first year and potential cash flow problems.

6 Raising finance What is finance? Finance is the amount of money at the disposal of a business Why do businesses need finance? Firms need enough money to start-up: buy or hire equipment; establish a workplace and staff ; meet marketing costs survive by having enough cash to pay its bills eg wagers and remain solvent grow by more buying more machinery or a new premises or investing in R&D What is a source of finance? The source of finance is the origin of money a business has eg a bank or owners Distinguish between creditors and debtors. A creditor lends funds and so is owed money. A debtor borrows funds and so owes money. What is interest? Money borrowed from creditors is paid back over time, usually with an additional payment called interest. Interest is the cost of borrowing and the reward for lending What is the interest rate? The interest rate is the annual percentage charge made for borrowing money eg 10% Give an example of interest rates. A firm borrows 5000 at 5% pa interest. The amount of interest each year equals amount borrowed x interest rate/100 = 5000 x 5/100 = 250 What is collateral? There is always the risk that a borrower cannot repay a debt. Collateral is an asset owned by the borrower that is used to guarantee repayment. If a debt is not repaid the asset offered as security can be sold by the lender. Collateral is also known as security Short term finance Explain the term short term source of finance. A short term source of finance is money that must be paid back quickly eg an overdraft or trade credit List potential sources of short-term of finance for a small business. Trade credit: suppliers agree customers can pay for products sometime after they take delivery eg within 28 days. In effect trade credit is an interest free loan Overdraft: a bank allows a customer to spend more than it has in its bank account Factoring: a firm sells its debts now, eg to a bank, and gets up to 95% of money it is owed by customers immediately Explain the main features an overdraft. An overdraft is a flexible way a firm can arrange to take out more money that it has in its bank account. An overdraft facility comes with conditions: The overdraft has a limit ie a maximum amount by which the firm can go into the red Firms only pay interest on the amount borrowed The rate of interest charged is variable and can change at any time up or down The bank can ask for the overdraft to be paid back any time How do firms use an overdraft? Because an overdraft can be withdrawn at any time, firms use an overdraft to tackle a temporary cash flow problem, and to buy stock What happens if a business exceeds its overdraft limit? Entrepreneurs exceeding their agreed overdraft limit may find their bank makes a large charge for a non-authorised overdraft increases the rate of interest charged on the overdraft refuses to honour cheques written by the firm. Bills go unpaid cancels the overdraft facility. This means the firm must find the cash to repay the full amount by which it is in the red within say 24 hours. There is a risk of insolvency.

7 Explain the main features of trade credit. The supplier offers the firm trade credit. The supplier delivers the goods to the business and issues an invoice asking for payment by a given date eg in 28 days time. In effect, trade credit is an interest free loan. What happens if trade credit terms are broken? If the business fails to pay the supplier within the agreed period of time eg 28 days, trade credit may be withdrawn. This means the supplier demands payment in advance or on delivery. Cash flow problems may arise. Can new businesses always secure take credit? Suppliers need to be confident customers can pay their bills. For this reason they may be reluctant to offer credit to new untried businesses. Long term finance Explain the term long term source of finance. A Long term source of finance is money that can be paid back over many years, if at all, eg bank loans and shares List potential uses of long-term of finance. Long term finance is used to buy expensive equipment, premises or other fixed assets needed to make products List potential sources of long-term of finance Owners who invest money in the business. Eg o sole traders and partners can invest personal savings o limited company shareholders buy new shares and so contribute to share capital Loans from a bank or, in the case of sole traders and partners, from family and friends. A mortgage to property with monthly payments spread over, say, 25 years. The property is used as security to guarantee the mortgage is repaid Hire purchase or leasing where monthly payments are made for use of equipment such as a car. Leased equipment is rented and not owned by the firm. Items bought on hire purchases are owned by the firm only after the final payment Grants from charities or the government Reinvesting past retained profits to finance growth Explain the main features of share capital. When investors buy shares in a new company they become part owners of the business. The total amount of money raised is called share capital. Eg if 5 investors each contribute 10,000, then 50,000 of share capital is raised. What are venture capitalists? Venture capitalists are entrepreneurs who buy shares in another business expecting to resell shares in the future and at a profit. Venture capitalists also often contribute advice and give access to their own connections to help the business succeed What is the potential reward for owning shares? A limited company can use profits to reward shareholders by making a payment called a dividend for every share owned. The price of shares can rise if the business grows and makes larger profits. Do companies pay interest on shares? Shares earn dividends and not interest When is share capital repaid? Shareholders contribute capital for the life of the business. In the meantime, they can sell their shares to others. What are loans? A loan is a sum of money borrowed from a creditor over a period of time and repaid with interest eg a 5,000 bank loan to be repaid over 3 years at an 18% rate of interest Explain mortgages. A mortgage is a loan used to buy property. The property acts as security for the loan which is repaid with interest over a long period of time eg 25 years Why lease? Leasing is low cost method of renting equipment for an agreed period of time. At the end of the lease equipment is returned to the owner or bought for an extra payment

8 How are leasing and hire purchase different? Both methods give immediate use of equipment for regular payments. Leased items are not owned by the user. Hired items are only owned after the final payment. Hire payments are higher than leasing for the same item Do grants have to be repaid? Grants do not need to be repaid and no interest is charged Internal & external finance sources What are internal sources of finance? Funds found inside the business eg retained profit What are external sources of finance? Funds found outside the business eg a loan List potential internal sources of finance. A firm can raise finance from within by Retained profits ie using past profits to pay for future growth selling assets (items it owns) that are no longer really needed running down stocks to free up cash List potential external sources of finance. A business can raise funds from Owners: sole traders and partners can invest personal savings. Shareholders can buy more new shares Banks: by securing an overdraft, loan or mortgage Another business willing to offer trade credit, leasing or hire purchase arrangements Government and charities offering grants to help businesses get started or expand How do firms decide on the best type of finance? Entrepreneurs take account of Cost: Some sources are interest free eg shares and trade credit. Others types charge interest eg overdrafts, loans and mortgages Length of time for which finance is required: some finance must be paid back quickly eg trade credit. A loan can be paid back over say 3 years. Share capital need never be repaid

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