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2.3.1 Profit

A) Calculation

Revenue – The total amount of money made from the sales of a good.

Cost of sales – The costs associated with making the good e.g. raw materials

 

Gross profit = Revenue – Cost of sales.

Operating profit = Gross profit – Other operating expenses e.g. marketing

Net profit = Operating profit – Interest e.g. on loans

 

B) Statement of comprehensive income (profit and loss account)

Gross profit margin = Gross profit/revenue x 100

Operating profit margin = Operating profit/revenue x 100

Net profit margin = Net profit/Revenue x 100

This shows the different types of profit as a percentage of revenue. The higher the costs the lower the profit margin on goods will be. Therefore, the lower the profit margin percentage the more inefficient the business is likely to be as it indicates they are likely to have high costs. Therefore to increase the profit margin on goods is by increasing their revenues or lowering costs. If a business is making an operating profit but a net loss then it suggests that they’re spending a significant amount of money on interest repayments.

 

C) Distinction between profit and cash

Profit is recorded straight away after a sale, whereas cash inflows and outflows will be recorded after the respective debtor and creditor periods have elapsed, allowing the profit to be realised in cash terms. Therefore a business that is making a profit can fail if they have no cash to pay their debtors.

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2.2.4 Budgets

A) Purpose of budgets

Budget – An agreed spending limit within the business

By having a budget it allows the business to plan. This is because they can anticipate any areas in which there may be overspending and are able to fix the problem before it arises. In addition to this, it may be motivating to managers due to the fact that they are in control of their budget which gives managers responsibility as well as allowing them flexibility on where money is spent as long as it is in budget. This is a benefit as the managers/people within the business making financial decisions are in the best position to make them due to the fact that they’re in charge of the department. Budgets can also be used as a comparison tool in order to measure how well the business is doing in comparison to its aims and objectives.

 

B) Types of budget

Historical budget – This is when the budget is based on previous year’s budgets. For example, if the budget was underspent in the last year then it will be cut for the present year.

Zero based budget – This is when the budget is not based on potential performance rather than previous budgets. Therefore managers must negotiate their budgets and justify why they need a certain amount of money.

 

C) Variance analysis

Favourable variance – This is when the manager underspends their budget. For example, if the manager’s budget was £2,000 and they only spent £1,500 then there would be a favourable variance of £500

Adverse variance – This is when the manager overspends their budget. For example, if the budget was £2,000 and the manager spent £3,000 then there would be an adverse variance of £1,000.

 

D) Difficult ties of budgeting:

Inflexible – The budget is a set amount of money that managers are able to spend and therefore can often be inflexible. This is unlikely to work for businesses that work in dynamic markets

Managers may spend up to the limit – If the business uses a historical budget then managers may spend up to the limit unnecessarily to make sure that there next year’s budget does not fall.

Time consuming – It can be very time consuming to make the budget as well as monitoring them and keeping them up to date.

Inter-department rivalry – There may be disputes between departments if they have been set different budgets.

Short-termism – By setting departments a budget it may make them focus on the short term to meet the budget rather than what is best for the long term future of the business.

Difficult to plan ahead – Businesses may be faced with many uncertainties making it difficult to plan ahead. For example, in industries such as farming unpredictable weather such as floods can have a massive impact on the business and therefore the budget also.

Demotivation – If the budget set is unrealistic it can make managers feel unmotivated as they will not be able to achieve it despite working hard.

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2.2.3 Break-even

A) Contribution

Contribution – The profit made on individual products.

Contribution = Selling price – Variable cost per unit.

B) Break-even point

Break-even – The point at which the business is making neither a profit nor a loss.

Break-even point = Total fixed costs + Total variable costs = Total revenue (The point at which Total costs = Total revenue)

C) Using contribution to calculate the break-even point

Break-even Total fixed costs/Contribution (Contribution already takes into account variable costs and therefore total variable costs is not included in the equation) – This shows the number of goods that need to be sold in order to reach the break-even point.

D) Margin of safety

Margin of safety diagram_

Margin of safety – The difference between the actual level of output and the level of output needed to break even. This shows how much output can fall before the business reverts back to the break-even level of output. For example, if the break-even level of output was 2000 goods but the business’s actual level of output was 2500 goods then the margin of safety for the business would be 500 goods.

E) Interpretation of break-even charts

Breakeven

F) Limitations of break-even analysis

Assumes all output is sold – The break-even point assumes that all the goods made by the business will be sold.

Assumes prices are the same – The break-even point also assumes that the prices of the business’s products are all the same. However, businesses often have goods that are sold at different prices thus making it hard to work out the break-even point.

Changing variable costs – The variable costs of the business often change on a regular basis thus making it difficult for the business to use break-even as it would have to be updated regularly as variable costs change.

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2.2.2 Sales, revenue and costs

Sales volume – The total number of goods/services that are sold by a business

Sales revenue – The total amount of money earned from the sale of goods/services

Fixed costs – Costs that do not change with the level of business output e.g. rent and salaries

Variable costs – Costs that change with the level of business output e.g. Wages and raw materials

 

A) Calculation of sales volume and sales revenue

Sales revenue = Price x Quantity

Selling price Sales volume Sales revenue
£5.50 40,000 £220,000
30p 125,000 £37,500
£2.00 80,000 £160,000

Sales volume = Sales revenue/Selling price

Sales revenue Sales price Sales volume
£125,000 50p 250,000
£100,000 £1.00 100,000
£115,000 £4.00 28,750

 

B) Calculation of fixed and variable costs

transformation-rules-graphs

transformation-rules-graphs

Average variable cost = £6

Total variable costs = Average variable cost x Output (£6,000)

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2.2.1 Sales forecasting

Sales forecasting – This is the process of estimating the future sales of the business

 

A) Purpose of sales forecasts

Sales forecasting allows the business to decide whether it needs to increase productive capacity and employ more workers in the future. For example, if sales are forecasted to be much higher in certain months then temporary staff may be needed in order to cope with the increased demand. Sales forecasting also allows the business to work out its cash flow forecast as it helps to estimate the cash inflows of the business. In addition to this, sales forecasting can help the business to identify when a business should start its promotional activity. For example, if sales are forecasted to decline, the business could then start to promote the product in order to extend its product life cycle.

 

B) Factors affecting sales forecasts:

  • Consumer trends – Businesses sales forecasts may be affected regularly if they work in an industry that is based on consumer tastes and fashions e.g. the clothing industry. Changes in tastes and fashions may result in a business’s good/service becoming less popular and therefore resulting in the business having to revise down their sales forecast.
  • Economics variables – Demand for good/services can be affected by a range of economics variables such as interest rates and exchange rates. For example, if the economy was to experience a recession then the demand for goods/services would drop dramatically due to a reduction in consumer incomes. Therefore businesses would have to revise down their sales forecasts. However, for some businesses that sell inferior goods such as Aldi may revise their sales forecasts upwards. This is due to the fact that the as incomes fall the demand for inferior goods increases as they have a negative income elasticity of demand.
  • Actions of competitors – Competitors may make actions that cannot be anticipated that may have a big impact on businesses sales forecasts. For example, if a major competitor suddenly adopted a predatory pricing strategy then it is likely to result in a big fall in the demand for the businesses goods/services. As a result of this, sales forecasts may have to be revised down.

 

C) Difficulties of sales forecasting

Dynamic markets – Markets that are rapidly changing will be extremely hard to forecast sales for due to the fact that they will have to keep on being adjusted in order to reflect the changing market conditions. Therefore, sales forecasting will be very inaccurate beyond a very short period of time in the future. This reduces the benefits gained from sales forecasting for businesses in dynamic markets.

Start-up businesses – Businesses that are just starting up will find it extremely difficult to forecast sales due to the fact that they have no experience of the market conditions. Furthermore, they have no previous sales data that could give them a clue as to what future sales are going to be.

Income and price elastic demand – If the demand for a business’s goods/services is very income or price elastic then it will have a big impact on the ability on the accuracy of sales forecasting. This is due to the fact that small changes in the market (price) or changes in the economics conditions (incomes) will have a significant impact on the demand for the businesses goods/services. As a result of this the impact on the sales forecasting will be massive. Therefore there is a greater risk of sales forecasting being inaccurate.

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2.1.4 Planning

Business plan – A document containing a business’s strategy, aims and objectives and how it plans to achieve them

 

A) Relevance of a business plan in obtaining finance

By having a business plan it helps to reduce the risk to investors of the business failing. This is due to the fact that by having a business plan it helps to organise the business, for example cash flow forecasts within the business help to ensure that the business has enough current assets to maintain day to day trade and to pay off any current liabilities. This will help to ensure the success of the business and help investors to decide whether or not the business is viable and therefore there decision about whether or not to invest. This is likely to help businesses when obtaining finance such as loans as well as lowering the interest rate on the loans. This is due to the fact that the business plan helps to persuade the bank that they will be able to pay back their loan with interest. In addition to this, it may also allow the business to raise finance through sources such as venture capital while reducing the percentage of the business that they have to sacrifice.

 

B) Interpretation of a simple cash flow forecast and calculations based on changes in cash-flow variables

Cash flow forecast – Shows the predicted cash inflows and cash outflows of a business.

  OCT £ NOV £ DEC £ JAN £ FEB £ MARCH £
Cash inflows 14,000 11,000 15,000 3,000 4,000 12,000
Cash outflows 10,000 10,000 12,000 8,000 8,000 10,000
Net cash flow 4,000 1,000 3,000 -5,000 -4,000 9,000
Opening balance 1,000 5,000 6,000 9,000 3,000 -1,000
Closing balance 5,000 6,000 9,000 3,000 -1,000 1,000

The business is making a profit each month up until January. The cash flow forecast suggests that demand falls in the months of January and February. As a result of this, the business could fix this by reducing their cash outflows in these months. For example, they may reduce the staff that they have working in months January and February. This would help to reduce cash outflows thus improving their net cash flow. Furthermore, the business could be taken out in the months of January and February in order to try and improve their cash flow. In addition to this, they may also use trade credit in February in order to delay their payment of supplies thus reducing their cash outflows preventing a negative closing balance in February.

Cash inflows – This is the total cash going into the business e.g. from sales or returns on investments.

Cash outflows – This is the total cash going out of the business e.g. Supply costs and marketing costs.

Net cash flow – This is the total cash inflows – the total cash outflows

Opening balance – This is the cash that the business has at the start of the month. The closing balance of the previous month is the opening balance for the month after.

Closing balance – This is the cash that the business have at the end of the month and is the net cash flow + the opening balance.

 

C) Use and limitations of a cash-flow forecast

Uses:

  • Identify shortages in cash – A cash flow forecast allows the business to identify months in which they may have a shortage of cash. Therefore, it gives the business a chance to fix this.
  • Comparison to financial objectives – Businesses are able to compare the cash flow forecast to the financial objectives that they set out in their business plan.
  • Helps to get a loan – Most investors will want to see a cash flow forecast before they invest in the business. This is due to the fact that it helps them to know whether or not the business will be able to pay back the loan with interest

 

Drawbacks

  • Bias – The business may overestimate their predicted cash inflows and underestimate their cash outflows in order to make the business seem better/more viable on paper then it actually is. This may be in an attempt to persuade potential investors to invest in the business.
  • Prediction – The cash-flow forecast is only a prediction of the cash inflows and outflows of a business. Therefore, there is likely to be some margin of error in the predictions. Furthermore, it cannot take into account unforeseen events such as extreme weather affecting the supplies.
  • Time consuming – The cash-flow forecasts can take a lot of time to make, especially if the size of the business is relatively large. Furthermore, it will need to be updated on a regular basis which can be very time consuming.
  • Mistakes – A cash-flow forecast is a relatively difficult document to make. This is especially if the owner is inexperienced. As a result of this, the document is prone to mistakes which may result in a reduction in the accuracy of the cash-flow forecast.
  • Accuracy – As the time period in which the cash-flow forecast is predicting, the accuracy of it is likely to decrease. This is due to the fact that the uncertainty of what may happen to the business increases as time goes on.
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2.1.3 Liability

Unlimited liability – This is when an owners personal assets are at risk. This means that if the business were to fail and go bankrupt, the owner’s personal assets e.g. their house would be sold in order to try and recover the debt. Sole traders and Partnerships have unlimited liability.

Limited liability – This is when an owners personal assets are not at risk due to the business’s legal identity being separate to the owners. Therefore, the owner is only liable for their original investment if the business was to fail. Both Private Limited Companies (LTD) and Public Limited Companies (PLC) have limited liability.

 

A) Implications of limited and unlimited liability

Unlimited liability (Sole trader and Partnership)

  • Personal assets at risk – The owner could lose their personal assets if the business fails in order to pay off debts.
  • Unable to sell shares – Businesses with unlimited liability are unable to sell shares in their business.
  • May take less risks – Businesses with unlimited liability are likely to take less risks due to the fact that if the decision goes wrong then they may lose their personal assets if the business fails. This may also mean that banks are more willing to loan them money knowing that they are likely to take less risky decisions, but also that they are able to sell their personal assets if the business fails.

Limited liability (PLC and LTD)

  • The owner and business have separate legal identities – This means that the business is able to carry on even if the owner dies.
  • The business can sue and can be sued – The business is able to be sued e.g. due to unsafe products and can sue others.
  • The business can sell shares – LTD’s are able to sell shares to family as friends whereas PLC’s are able to sell shares on the stock exchange.
  • Personal assets are not at risk – If the business fails then the owner will only lose any money that they have invested in the business.
  • The business is registered with companies’ house – The business needs to register with the companies’ house before it can become a LTD or PLC.

 

B) Finance appropriate for limited and unlimited liability businesses

Unlimited liability (Sole trader and Partnership)

  • Small loan – Businesses with unlimited liability will still be able to take out loans, however they still may find it difficult and could be charged relatively high interest rates.
  • Overdraft – Small businesses may take out an overdraft if they suffer a poor trading period.
  • Venture capital – Businesses that are starting up may look at this as a source of finance as well as a way to get business angels on-board with the business and exploit their business knowledge and experience.
  • Leasing – Small businesses may lease equipment if they cannot afford to buy it.
  • Trade credit – Smaller businesses may use trade credit so they are able to sell their goods before having to pay suppliers.
  • Grants – Sole traders and partnerships may be eligible to receive grants.
  • Owner’s capital – Sole traders and partnerships are likely to use owner’s capital as a source of finance to reduce the amount of debt that they may acquire.

Limited liability (PLC and LTD)

  • Retained profit – PLC’s and LTD’s are likely to receive significant amounts of profit. As a result of this, they are likely to be able to use it in order to invest in big business projects such as expansion.
  • Sale of assets – PLC’s and LTD’s are likely to have a large number of assets, some of which they may not need and therefore can sell them for money.
  • Loans – Large businesses will be able to take out substantial loans due to the big reputation that they have. They will also be able to do this at a relatively low interest rate due to the bargaining power that business gain when they grow in size.
  • Share capital – PLC’s and LTD’s are able to sell shares in their business. PLC’s are more likely to do this due to the large amounts of money that they can make selling shares on the stock market.
  • Overdrafts – This may be a source of finance used if the business has a business has a low acid test ratio and therefore cannot pay some of its current liabilities.
  • Leasing – Large businesses may lease equipment if it is only needed for a short period of time.
  • Trade credit – Businesses may use trade credit if they want to improve their cash flow.
  • Grants – The government is much more likely to give grants to larger businesses due to the large number of jobs that they offer.
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2.1.2 External finance

A) Sources of finance:

  • Family and friends – Family and friends may be able to lend the business some money; however this is only likely to be suitable for sole traders. This is due to the fact that the money that friends and family will be able to loan the business will be limited.
  • Banks – This is the source of external finance that most businesses use. Large sums of money are able to be loaned from the bank, but it is likely to be much easier for bigger businesses such as PLC to lend money from banks than smaller businesses such as Sole traders. This is due to the fact that banks deem bigger businesses as less of a risk and therefore are willing to loan them money at a relatively low interest rate.
  • Peer-to-peer funding – This is when a business able to take out a loan from a group of individuals or an institution. The loan will then be paid back after a certain amount of time. However, there is a risk to the borrower due to the fact that it is an unsecured loan. Therefore, they are only likely to lend to relatively established businesses.
  • Business angels – This is when a group of business experts invest in the business in exchange for a percentage share in the business. This can be beneficial to the business due to the fact that the investors are able to help the business in the decision making process. E.g. Dragons Den. This would usually be a source of finance used by businesses that are starting up.
  • Crowd funding – This is when individuals are able to invest in a business in return for a share of their business. This would usually be used by businesses that are starting up.
  • Other businesses – Business may get finance through other businesses that are looking to invest in the business in return for a percentage of their shares.

 

B) Methods of finance

  • Loans – Business may go to banks in order to raise finance for their business. This is likely to be a more suitable option for bigger businesses. This is due to the fact that it can be hard for smaller businesses to get a loan due to the fact that they are seen as more of a risk. This is in contrast to big businesses such as PLC’s and LTD’s which are already established in the market and therefore are able to get bigger loans at a much lower interest rate (economies of scale). Loans are likely to be used for big re investments in the business such as expansion where lots of funds are required. Interest will then have to be paid on top of the loan; however big businesses are likely to be able to pay a lower interest rate.
  • Share capital – Businesses may raise finance through selling some of their shares. This can raise a significant amount of money if the businesses is large, however, dividends will have to be paid to shareholders. This method of finance is only available to LTD’s and LTD’s. Although this is the case, the amount of shares that LTD’s will be able to sell will be limited due to the fact that they are only able to sell shares to friends and family. In addition to this, it means that the owners will have to give up a percentage of shares in their business. Only percentage of the businesses share are likely to be sold due to the fact that there is a risk of selling a high percentage of shares (above 50%) that someone will attempt to make an aggressive takeover of the business.
  • Venture capital – Businesses can also raise finance through venture capital. This is when venture capitalists invest in the business in return for a percentage of shares in the business in an attempt to make a high rate of return on their initial investment. This is usually a source of finance that is used by start-up businesses. Although it is a risky investment for venture capitalists, the potential for an above average rate of return is higher. Venture capital is often provided by business angels.
  • Overdrafts – Businesses may also take out overdrafts. This allows the business to go over their available cash balance. The overdraft limit is agreed by the bank. For example, a business may be able to go £2500 over their bank balance. This may be useful to a business in order to get through poor trading periods. Interest is charged on the overdraft which will need to be paid back by the business. The interest charge on the overdraft is usually at a higher rate than loans. Furthermore, there can also be big fines for a business if they go over the overdraft limit. Although an overdraft can be a good way of solving short term financial difficulties, it is not suitable as a permanent source of finance or for funding big investment projects such as expansion. An overdraft is suitable for all types of businesses but should only be used as a source of short term finance.
  • Leasing – This is when a business pays a sum of money in order to use a certain assert e.g. machinery for a period of time. This will save the money due to the fact that they do not have to spend money buying the asset. Although this is the case, the business will never own the asset. This source of finance is suitable for all types of business.
  • Trade credit – This is when a business receives the good e.g. stock but pays the suppliers at a later date. Therefore the business is able to sell the goods before paying the supplier. This source of finance is suitable for all types of business.
  • Grants – The business may obtain grants given to them by the government. For example, if the business locates in an area of high unemployment then they may be given a grant due to the fact that they will be employing staff thus bringing down the local unemployment figure. The benefit of this is that the business does not have to pay back the grant. However, they may have to meet certain requirements to receive the grant or the government may decide where it has to be spent. This source of finance is suitable for all types of businesses.
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2.1.1 Internal Finance

Types of internal finance:

  • Owner’s capital/personal savings – The personal savings of the business’s owner.
  • Retained profit – The profit that the business has made so far through trade.
  • Sale of assets – The sale of business assets such as machinery.

 

A) Owner’s capital

Benefits

  • No debt – By using owner’s capital as a source of finance it means that the business does not have to take out any loans. As a result of this they will not have any debt that will need to be paid off.
  • Quick – No approval is needed in order to use owner’s capital to invest in the business. This allows the business to re-invest the capital quickly and therefore may be useful when operating in a dynamic market.

Drawbacks

  • Limited funds available – The Capital that the owner has available to invest in the business is likely to be limited. As a result of this, owner’s capital would be an unsuitable source of finance if the business were looking at sources of finance for activities such as expansion which would require a much larger amount of capital
  • Risk of losing savings – If the business fails and goes bankrupt then the owner will lose any capital that they have put into the business. As a result of this, there is a risk when using owner’s capital as a source of finance that the owner will lose the savings that they have invested into the business.

 

B) Retained profit

Benefits

  • No debt – By using this source of finance it means that the business may not have to use loan capital. As a result of this, no interest has to be paid. This will reduce the long term liabilities of the business which will result in a lower gearing ratio.
  • Flexible – The amount of retained profit used to invest in the business is chosen by the owner. They will also decide where to invest the profits which can be in contrast to some of the other types of finance. Therefore retained profit is a flexible source of finance.
  • Retain control – Owners are able to raise finance without having to dilute some of the power that they have in the business. This is due to the fact that they will not have to sell any shares. This will also mean that the profit spent on dividends will also be low. This is a benefit as it reduces the chances that another business will be able to successfully takeover the business through buying more than 50% of the business’s shares.

 

Drawbacks

  • Reduce dividends for shareholders – By using retained profits to reinvest in the business it means that there will be less profit left to give to shareholders. As a result of this, the dividends that they receive will be lower. This may result in shareholders becoming unhappy. This is especially the case if the return on capital employed is low meaning that the benefit of investment is limited (ROCE % = Operating profit/Capital employed X 100).
  • Businesses with higher profit can afford debt – This is due to the fact that the business is likely to have a relatively low gearing ratio. This is due to the fact that high profits will mean that the business has a high amount of capital employed (capital employed = Non-current assets +current assets – current liabilities). Therefore, they can afford to increase their long term liabilities through loaning money as their gearing ratio will remain relatively low regardless meaning they will be able to pay for their loan repayments.
  • Slow process – It can take a long time for a business to gain enough profit that is substantial enough in order to reinvest in the business. This is especially the case for new businesses due to the fact that most businesses aim to survive in their first year. Therefore some smaller businesses will not have any profit at all in order to invest. Furthermore, by the time that the business has made enough profit to reinvest, competitors may have done so a long time ago. Therefore the business risks losing market share if they wait to make a substantial amount of profit. This is especially the case in dynamic markets.
  • Limited profits – Most businesses are unlikely to have the retained profit required in order to fund big investments in their business e.g. expansion. Therefore, the source of finance is unlikely to be suitable when making big investments in the business. This is especially the case for smaller businesses that make small amounts of profit.

 

C) Sale of assets

Benefits

  • Assets depreciate in value – By selling assets as a source of finance it means that the business will be able to get the money from the assets before they depreciates in price.
  • Poor quality assets can be sold to buy better quality assets – Selling some of the business’s assets could be used in order in order to buy other assets that are of better quality e.g. newer machinery. This means that they are able to do the same job but more efficiently. This is likely to save the business lots of money in the long term.

Drawbacks

  • Lose benefit from the asset – By selling the asset it means that the business can no longer benefit from the function of the asset. For example, if a business were to sell some machinery then it means that the machinery could no longer be used in order to produce goods. Therefore, by selling assets it may result in a decrease in productivity and therefore output if it is not replaced.
  • Asset no longer on the balance sheet – By selling business’s assets it will result in a reduction in the value of the non-current assets that a business has such as machinery. As a result of this, the value of a business’s total assets will be reduced and therefore the overall valuation of the business will be reduced also.

Sole Trader – A sole trader is likely to use owner’s capital as an internal source of financing. This is due to the fact that they are unlikely to be able to use retained profits as they are unlikely to have a substantial amount. Furthermore, they are unlikely to have very many assets and therefore won’t be able to raise sufficient funds. This is especially the case if the business has just started up.

Partnership – A partnership may be able to use retained profit depending on how successful the business is. Furthermore, they could also use sale of assets and owners capital.

LTD and PLC – Both types of business are most likely to use retained profits as they are likely to be much more profitable than sole traders and partnerships. Therefore it would be unnecessary for them to use owner’s capital. However, they could use sale of assets as a means of raising finance. However, if the business is run efficiently then they are unlikely to have a surplus of assets available to them that they can sell.