Sources of finance

The finance of a business can be obtained from three sources: capital, current liabilities and long-term liabilities.

Capital. This is the amount of money invested in the business by the owner(s). The amount can increase through further investment of funds by the owner(s) or by the business making a profit and can decrease when mone is withdrawn from the business for personal use or where a business loss is suffered. Capital is regarded as a permanent source of finance since it is only repayable in full when the business ceases. Until such time the amount is regarded as a liability of the business as the amount is owed to the owner.

Current liabilities. These liabilities are defined as amounts repayable within 12 months of the balance sheet date. Typical examples include bank overdrafts and creditors. Any loans repayable within the following year are also listed under current liabilities.

Creditors can be divided into trade and other creditors. Trade creditors represent the amount owing to suppliers of stock items that have been purchased on credit terms. Other creditors could include amounts outstanding for miscellaneous services.

Long-term liabilities. These represent the amounts payable after more than 12 months. They include such items as bank loans and mortgages.

Sources of finance are arranged in order of permanence, with the most permanent

sources at the top and amounts repayable (or potentially repayable) in the near future at the bottom of the appropriate section of the balance sheet. Most sources of finance are easily classified into one or other of the three categories, but certain items cause a little more difficulty. For example, the terms of a bank loan may provide for an advance of £100,000 repayable by five equal annual instalments of £20,000. In these circumstances the liability must be divided into two parts, with the next instalment repayable shown as a current liability and the balance reported as a long-term liability. Therefore, at the end of the first year, £20,000 is reported as a current liability and £80,000 as a long-term liability.

Valuation of assets

There are four possible methods for valuing assets, although we will see that only one of these normally finds favour with the accountant. The four methods are as follows:

1 Historical cost. The asset is valued at its original purchase price.

2 Replacement cost. The asset is valued at the amount it would cost the business to buy at the balance sheet date.

3 Realizable value. This is the price at which the asset could be sold at the balance sheet date. It differs from replacement cost, as anyone who has ever attempted to sell, say, a second-hand motor vehicle will know.

4 Present value. This is a little more complicated and is the present value of cash expected to be generated, in the future, as a result of owning a particular asset. The estimated cash flows are discounted, at a rate of interest, to take account of the fact that £1 receivable, say, in one year’s time is worth rather less than £1 receivable immediately.

The appropriate method of valuation depends on the purpose for which it is required. If the company is contemplating the acquisition of an asset, purchase price is the most relevant. The replacement cost of an asset is likely to be of interest if the existing asset is worn out. Realizable value is relevant if there is an intention to sell the asset in the near future, while the present value calculation should be made if the asset is to continue in use for some time generating a stream of cash flows stretching into the future. In general, assets are shown in company accounts at their historical cost less, in the case of fixed assets, a reduction to reflect wear and tear (depreciation) that has occurred since the acquisition took place.

The analysis shows that although historical cost is of interest at the date of the initial purchase, it is the other valuation methods, particularly market price and present value, that are likely to be more relevant when a balance sheet is prepared at some subsequent date. Most assets are purchased on credit and are entered in the books at their historical cost so as to provide a record of the amount to be paid to the supplier at some future date.