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Business decision making

One of the reasons why larger businesses become public limited companies is because they find it easier to sell new shares in the business. A new share issue by a public limited company is likely to be organised by a bank or a merchant bank. It might offer the shares for sale to the general public, or it could sell the shares to existing shareholders. In any one year, only a few per cent of all the money to finance investment in the UK comes from raising new capital. The most important source of finance is retained or undistributed profit. This is profit, which has been made by the business and is not distributed to the owners of the business. Instead, it is kept back, or retained. Retained profit is an internal source of finance because the money has come within the business. New capital in contrast, is an external source of finance because the money comes from outside the business.

Another way for a business to raise money internally is to sell assets. Larger businesses might be able to negotiate a sale and lease-back scheme. Here the business sells some or all of its property to another company, like a property

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company. At the same time, it signs an agreement to lease back the property for a fixed annual rent. The business receives a lump sum of money, which can be used to pay for expansion. The drawback is that the business now has to pay rent on the property. It shows how much net profit a business is making per ½ of a product sold. The higher the profit per � and therefore the higher the ratio, the more profitable a business is likely to be. On the other hand, a lower ratio is often a sign that the business is not doing as well.

One way, in which a company could find out whether they have enough working capital, is to work out the current ratio. This is the ratio of current liabilities:

Current Ratio = Current Ratio

Current Liabilities

The higher the ratio of current assets to current liabilities, then the higher the amount of working capital in the business. The higher the ratio, therefore, the safer the business. Return on Capital Employed (ROCE). A third ratio that is useful when looking at how well a business has performed is the rate of return on capital employed (ROCE). For example, for example say you received �10 interest on money you had put into a bank account a year ago. You can’t say whether you have invested your money well until you know how much you had in the account (your capital). If you had �20 in the account, you would have made 50% on your money – a very good rate of return. If you had �1 million in the account, then you have done very badly. Similarly, a business can’t say how well it has done until it compares its profit with the amount of capital in the business. This is what ROCE shows: ROCE (%) = Net Profit

 

Stock is part of the working capital of the business. A business could have plenty of working capital, but far too much of it could be in stock and far too little in the form of cash. Businesses can monitor this type of problem by calculating another ratio, the acid test ratio. This excludes stock from current assets in calculating the ratio of current assets to current liabilities: Acid Test Ratio = Current Assets – Stock

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