Institute of Financial Accountants (IFA) Qualifications Financial Management for SMEs Syllabus

How does invoice discounting differ from factoring?

Invoice discounting provides finance against receivables but the business retains control of its own sales ledger and collection, and it is usually confidential to customers; factoring involves the factor managing the ledger.

State the objective of trade payables management.

To obtain the maximum useful credit period from suppliers (a free source of finance) without damaging supplier relationships, losing discounts, or risking supply.

What are the three motives for holding cash (Keynes)?

The transactions motive, the precautionary motive, and the speculative motive.

What is the purpose of the Baumol model of cash management?

It applies the economic order quantity logic to cash, determining the optimal amount of cash to transfer from investments to the current account each time to minimise total transaction plus holding (interest) costs.

State the Baumol model formula for the optimal cash transfer amount.

$$Q = \sqrt{\frac{2 \, C \, D}{i}}$$ where $C$ = cost per transaction, $D$ = annual cash demand, and $i$ = interest (opportunity) cost per period.

What does the Miller-Orr model provide that Baumol does not?

It allows for uncertainty/fluctuation in cash flows, setting an upper limit, a lower limit and a return point between which cash is allowed to vary randomly.

State the Economic Order Quantity (EOQ) formula for inventory.

$$\text{EOQ} = \sqrt{\frac{2 \, C_o \, D}{C_h}}$$ where $C_o$ = cost per order, $D$ = annual demand, and $C_h$ = holding cost per unit per year.

What is a Just-In-Time (JIT) inventory system?

A system that minimises inventory by ordering/producing goods only as they are needed for production or sale, reducing holding costs but relying on reliable suppliers and demand.

Distinguish short-term, medium-term and long-term finance by typical duration.

Short-term is usually under 1 year (e.g. overdraft, trade credit), medium-term roughly 1-7 years (e.g. bank loans, leasing, HP), and long-term over 7 years or permanent (e.g. equity, long-term loans/bonds).

Give two examples of short-term sources of finance for an SME.

Bank overdraft, trade credit, short-term bank loans, factoring/invoice discounting.

Distinguish a finance lease from an operating lease.

A finance lease transfers substantially all the risks and rewards of ownership to the lessee over most of the asset's life. An operating lease is a shorter-term rental where the lessor retains ownership risks and the asset can be leased to others.

What is hire purchase (HP)?

A method of acquiring an asset by paying instalments over time, where the user has possession and use immediately but legal ownership transfers only after the final payment.

Name the main sources of long-term equity finance for a company.

Ordinary share capital (new share issues, e.g. rights issues), retained earnings, and venture capital/private equity.

What is a rights issue?

An offer of new shares to existing shareholders in proportion to their current holdings, usually at a discount to the market price, allowing them to maintain their proportional ownership.

Distinguish ordinary shares from preference shares.

Ordinary shares carry voting rights and variable dividends with residual claims (highest risk/return). Preference shares typically pay a fixed dividend, rank ahead of ordinary shares for dividends and on winding up, and usually carry no votes.

What is the difference between debt and equity finance regarding risk and return?

Debt has a prior claim, fixed interest (tax-deductible) and must be repaid (lower risk to provider, cheaper). Equity has residual claims, variable dividends (not tax-deductible) and no repayment obligation (higher risk to provider, more expensive).

Why do small and growing businesses often face a 'funding gap' or 'finance gap'?

They are often too large for personal/family funds yet too small or risky for the public capital markets, and lack track record/collateral, making it hard to access medium-sized amounts of finance.

Name three sources of finance specifically suited to small and growing businesses.

Business angels, venture capital, crowdfunding, government grants/schemes (e.g. EIS/SEIS), and bank lending with guarantee schemes.

What is a business angel?

A wealthy individual who invests their own money (usually equity) in early-stage/growing businesses, often also providing expertise, contacts and mentoring.

Define the cost of capital.

The minimum required rate of return a company must earn on its investments to satisfy its providers of finance; it reflects the opportunity cost and risk of those funds.

State the Weighted Average Cost of Capital (WACC) formula (equity and debt).

$$\text{WACC} = K_e \frac{E}{E+D} + K_d(1-T)\frac{D}{E+D}$$ where $K_e$ = cost of equity, $K_d$ = cost of debt, $T$ = tax rate, $E$ = equity value, $D$ = debt value.

State the dividend growth model (Gordon growth) for the cost of equity.

$$K_e = \frac{D_0(1+g)}{P_0} + g$$ where $D_0$ = current dividend, $g$ = constant growth rate, and $P_0$ = current ex-dividend share price.

Define gearing (financial leverage).

The extent to which a company is financed by fixed-return debt relative to equity; e.g. $\text{Gearing} = \frac{\text{Debt}}{\text{Debt} + \text{Equity}}$ or $\frac{\text{Debt}}{\text{Equity}}$.

What is the effect of higher gearing on financial risk?

Higher gearing increases financial risk because fixed interest must be paid regardless of profits, magnifying the volatility of returns to ordinary shareholders and increasing the risk of insolvency.

Define the time value of money.

The principle that a sum of money received today is worth more than the same sum received in the future, because today's money can be invested to earn a return and is subject to less risk/inflation.

State the present value formula for a single future cash flow.

$$PV = \frac{FV}{(1+r)^{n}}$$ where $FV$ = future value, $r$ = discount rate per period, and $n$ = number of periods.

State the present value formula for an ordinary annuity.

$$PV = A \times \frac{1 - (1+r)^{-n}}{r}$$ where $A$ = the constant periodic cash flow, $r$ = discount rate, and $n$ = number of periods.

State the present value formula for a perpetuity.

$$PV = \frac{A}{r}$$ where $A$ = the constant annual cash flow and $r$ = the discount rate.

Define Net Present Value (NPV) and its decision rule.

NPV is the sum of the present values of all project cash inflows and outflows: $$NPV = \sum_{t=0}^{n} \frac{C_t}{(1+r)^{t}}$$ Accept a project if $NPV > 0$ (it increases shareholder wealth).

Define the Internal Rate of Return (IRR) and its decision rule.

The IRR is the discount rate at which a project's NPV equals zero. Accept the project if $\text{IRR} >$ the cost of capital (required return).

State the linear interpolation formula used to estimate IRR.

$$\text{IRR} \approx L + \frac{N_L}{N_L - N_H} \times (H - L)$$ where $L$, $H$ are the lower and higher discount rates and $N_L$, $N_H$ are the NPVs at those rates.

What are the two main DCF appraisal techniques and why are they preferred?

NPV and IRR. They are preferred because they account for the time value of money and consider all relevant cash flows over the project's life.

Define the payback period and its decision rule.

The payback period is the time taken for a project's cumulative cash inflows to recover the initial investment. Projects with a payback shorter than a target are accepted; among options, the shortest payback is preferred.

State two limitations of the payback period method.

It ignores the time value of money (unless discounted), ignores cash flows after the payback point, and ignores overall project profitability.

Define the Accounting Rate of Return (ARR).

$$\text{ARR} = \frac{\text{Average annual accounting profit}}{\text{Average (or initial) investment}} \times 100\%$$ It is compared against a target rate; higher is better.

State one key weakness of ARR compared with DCF methods.

ARR uses accounting profits rather than cash flows and ignores the time value of money.

Distinguish risk from uncertainty in investment appraisal.

Risk exists when the range of outcomes and their probabilities can be quantified/estimated; uncertainty exists when outcomes are unknown and probabilities cannot be reliably assigned.

What is sensitivity analysis in investment appraisal?

A technique that examines how much a key variable (e.g. selling price, volume, cost, discount rate) can change before the project's NPV becomes zero, identifying the variables to which the decision is most sensitive.

What is expected value (EV) and how is it calculated?

A weighted average of possible outcomes using their probabilities: $$EV = \sum p_i x_i$$ where $p_i$ is the probability and $x_i$ the outcome value.

Name two techniques (other than sensitivity analysis) for incorporating risk into appraisal.

Expected values/probability analysis, simulation (e.g. Monte Carlo), risk-adjusted discount rates, certainty equivalents, and decision trees.

State the asset-based (net assets) method of business valuation.

Value the business as the value of its net assets: $$\text{Value} = \text{Total assets} - \text{Total liabilities}$$ using book, realisable (break-up) or replacement values; it ignores goodwill/future earnings.

What is the P/E ratio (earnings) method of business valuation?

$$\text{Value} = \text{P/E ratio} \times \text{Earnings}$$ A suitable (often industry/comparable) P/E multiple is applied to the company's maintainable earnings.

Describe the dividend valuation (dividend growth) method of business valuation.

It values shares as the present value of expected future dividends: $$P_0 = \frac{D_0(1+g)}{K_e - g}$$ assuming dividends grow at a constant rate $g < K_e$; it suits valuing minority shareholdings.

What is the discounted cash flow (DCF) method of business valuation?

Valuing the business as the present value of its expected future free cash flows discounted at an appropriate cost of capital; theoretically the most sound method but reliant on forecast accuracy.

Why is valuing an unquoted SME more difficult than valuing a listed company?

There is no readily available market price, shares are less marketable/liquid, financial information may be limited, and reliance on the owner-manager creates additional risk.

Distinguish business (operating) risk from financial risk.

Business risk is the variability in operating profits arising from the nature of operations and fixed operating costs. Financial risk is the additional variability in returns to shareholders caused by the use of fixed-cost debt finance (gearing).

What is interest rate risk and one way to hedge it?

The risk that changes in interest rates adversely affect a company's cash flows or value (e.g. on variable-rate debt). It can be hedged using fixed-rate borrowing, interest rate swaps, forward rate agreements, or interest rate options.

Define foreign exchange (currency) risk for an SME.

The risk that movements in exchange rates adversely affect the value of a firm's foreign-currency transactions, assets, liabilities or competitive position.

Name the three types of foreign exchange risk exposure.

Transaction exposure (on specific foreign-currency transactions), translation exposure (on consolidating foreign assets/liabilities), and economic exposure (on the long-term value/competitiveness of the business).

What is a forward exchange contract and how does it manage transaction risk?

A binding agreement to buy or sell a fixed amount of foreign currency at a fixed (forward) rate on a specified future date, fixing the home-currency value of a future foreign-currency cash flow and eliminating exchange-rate uncertainty.

Describe a money market hedge for a foreign currency payable.

Borrow domestic currency now, convert at the spot rate into the foreign currency, deposit it to earn interest so it grows to the amount payable at settlement, thereby fixing the cost in domestic currency and removing exchange risk.

Name two internal (non-derivative) techniques an SME can use to reduce foreign exchange risk.

Invoicing in the home currency, matching foreign-currency receipts and payments, netting, leading and lagging payments, and using foreign-currency bank accounts.