Business Finance

Why business needs finance?

All businesses need finance sooner or later. Usually businesses need finance
for three main reasons.
Startup Capital
Business might need finance to at the start in the form of Capital. This is known
as startup capital. Startup capital is used up for initial investment such as land,
building, machinery, employee people etc.
Expansion
A business might need additional source of finance when it needs to expand.
This expansion may include extension of present facilities such as purchasing
additional machinery and extending capacities.
A business might also need to go in for inorganic expansion such as purchase of
another business through a takeover. Usually a business will have to arrange
huge amount of additional finances for these purposes.
Entering new markets. It involves huge investments in research and
development and aggressive marketing campaigns.
Research and Development - Businesses need finance to develop new
products. Multinational businesses usually spend millions of dollars every year
in Research and Development purposes. R & D is carried out regularly in big
businesses as a mean to get a competitive edge over its competitors.
Running of the business - Apart from investment at the initial stages a
business needs a constant flow of capital in the form of working capital. A
shortage of working capital might lead to serious consequences for the
business or cash flow problems.
During trouble times - A business might need additional dose of capital or
financial help during troubled times such as a recession, or when the sales of
the business are fall temporarily due to market conditions.
What is Working Capital?
Working Capital is the cash available to the business for carrying out its day to
day activities. It might include paying for labour wages, purchasing stock,
paying short term creditors etc.
A healthy working capital position is a measure of both a company's efficiency
and its short-term financial health.

The working capital ratio is calculated as:

Working Capital = Current Assets – Current Liabilities

Positive working capital means that the company is able to pay off its short-
term liabilities.

Negative working capital means that a company currently is unable to meet its
short-term liabilities with its current assets (cash, accounts receivable and
inventory).

Importance of Working Capital

If a company's current assets do not exceed its current liabilities, then it may
run into trouble paying back creditors in the short term. The worst-case
scenario is bankruptcy.

A declining working capital ratio over a longer time period could also be a red
flag that warrants further analysis. For example, it could be that the company's
sales volumes are decreasing and, as a result, its accounts receivables number
continues to get smaller and smaller.

Working capital also gives investors an idea of the company's underlying

operational efficiency. Money that is tied up in inventory or money that
customers still owe to the company cannot be used to pay off any of the
company's obligations. So, if a company is not operating in the most efficient
manner (slow collection), it will show up as an increase in the working capital.
This can be seen by comparing the working capital from one period to another;
slow collection may signal an underlying problem in the company's operations.

Revenue and Capital Expenditure

A statement of financial position is a financial statement that records the

assets (possessions) and liabilities (debts) of a business on a particular day at
the end of an accounting period. It was previously called a balance sheet.

An income statement is a financial statement showing a business’ sales

revenue over a trading period and all the relevant costs incurred to generate
that revenue.
Revenue Expenditure is spending on assets that are used up in a relatively
short period of time such as spending on fuel, components and raw materials.

This type of expenditure is recorded on the income statement under headings

such as ‘cost of sales’ and ‘administrative expenses’. It will only affect the
accounts in the financial year in which the expenditure occurs.
Revenue expenditure is essential to production but if not controlled, can have
an immediate and damaging effect on a business’ profits.

Capital Expenditure is spending on non-current assets that will be used by the

business for a prolonged period of time such as property, vehicles and
production equipment.

The value of non-current assets purchased through capital expenditure is

shown on the statement of financial position. The reduction in value of these
assets over time is listed on the income statement. This type of expenditure
affects the statement of financial position and income statements for a
number of years.

This type of spending has no immediate effect on profits. However, capital

expenditure is essential if a firm is to generate long-term profits.

Sources of Finance

There are a number of sources available, but the chosen will depend upon
several factors:

 The amount of money required by the business

 The purpose for which the finance is required
 The period of time over which the loan is required
 The legal structure of the business
 The financial position of the business
 The business environment

*make notes on Sections 15.5-6, pg 162 in Surridge and Gillepsie textbook

The factors above influence the choice that a business makes when
considering a wide range of sources of finances:
 Sources of Finance

Internal Exter
nal
Short- Long-
Term Term Short Long-
-term Term
Retained Sale
Workin Retained of Sale and
g Profits Overdraft
Profits Asset leaseback Long-
Capital s Term

Bank loans New

Debentures
Partners
Venture Share Capital
Capital Government
Crowdfundin Grants and
Mortgages g Loans
Microfinanc
e

Short-term sources of finance are needed for a limited period of time,

normally less than one year. It is usually needed when there is a cash flow
problem, and a business needs to pay its suppliers, purchase raw materials,
and salaries and wages. This might be caused by a decline in sales or an
increase in the price of raw materials.

Long-term sources of finance are those that are needed over a longer period
of time. This is usually paid back over a longer period of time. They are
required when the business needs to purchase major capital assets such as
land, building, heavy machinery or take over another business.

Internal Sources of Finance are ones which exist within the business:

Retained Profit is the cash that is generated by the business when it trades
profitably – another important source of finance for any business, large or
small.

 Note that retained profits can generate cash the moment trading has
begun. For example, a start-up sells the first batch of stock for £5,000
cash which it had bought for £2,000. That means that retained profits
are £3,000 which can be used to finance further expansion or to pay for
other trading costs and expenses.
Businesses (especially limited companies) usually keep some part of the profit
every year for future use. This is also known as ploughed back profit. Over a
period of time it can total up to a huge amount which can be used for financing
the business.

Advantages Disadvantages

Does not increase liabilities A new business will not have

retained profits

No need to pay interest Opportunity Cost

Sales of unwanted assets is when a business sells off old, obsolete assets
which are no longer used by the business to raise additional cash for the
business. These are usually non-current assets and they can raise large sums of
capital for businesses.

Advantages Disadvantages

Better use of capital A new business might not have

assets to sell

No need to pay interest rates Business loses access to sold assets

Sale and Leaseback

Advantages Disadvantages

Business still has use of asset to They have to pay for the use of the
conduct their business asset, which increases expenses and
might have a negative effect on long-
term profits

Working Capital is the cash required by a business to pay for its day-to-day
operations.

Working capital is needed to pay for fuel, raw materials and wages.
Reducing inventory levels, chasing up debtors and delaying payment can raise
cash generated from a firm’s working capital.

If a business is able to negotiate its credit period (the time in which the
supplier requires settlement of bill for goods and services) from 30 days to 60
days, it has essentially managed to get a loan for 1 month for those goods and
services. The working capital will be funded from the seller’s cash flow during
the credit period. This can be classified as an external source of finance.

External Sources of Finance is an injection of funds into the business from

individuals outside of the business, other businesses or financial institutions.

A business is more likely to use this form of finance when:

 A larger sum of money is required

 The level of risk associated with the source of finance is low which
encourages outsider to invest or lend money.
 The company’s profit levels are relatively low, reducing the possibility of
the use of retained profits.

An Overdraft exists when a business is allowed to spend more than it holds in

its current bank account up to an agreed limit.

Advantages Disadvantages

 No need for collaterals or security.  Interest rates are usually variable and
 More flexible and the overdraft higher than bank loans.
amount can be adjusted every month  Cash flow problems can arise if the
according to needs. bank asks for the overdraft to be
repaid at a short notice.

Bank Loans is an amount of money provided to a business for a stated purpose

in return for a payment in the form of interest charges.

Banks often require security or collateral for their loans usually in the form of
property -should the business default on the loan the bank sells the collateral
in order to recoup the money that it lent.

Advantages Disadvantages

 Business retains control of company  Interest rates may be high especially

 Relationship with lender is temporary for small businesses
  Might be difficult to qualify especially
for new businesses

Mortgages are long-term loans granted by financial institutions solely for the
purchase of land and buildings. The land or building acts as collateral.

They can be long periods of time – from 10 to 50 years.

They can have fixed or variable rates of interest and are suitable to raise large
sums of money.

Some businesses may choose to re-mortgage their premises to raise capital. A

re-mortgage either increases the existing mortgage or establishes a mortgage
where one did not exist before.

Debentures are a special type of long-term loan to be repaid at some future

date, though some do not have a fixed repayment date.

 The rate of interest paid on debentures is fixed.

 Debentures are a form of loan capital and debenture holders do not
have voting rights in the business.
 They are secured using the business’ non-current assets as collateral.

Share or equity capital It is a permanent source of finance but only available

to limited companies. Public limited companies can sell further shares up to
the limit of their authorized share capital. Private limited companies can sell
further shares to existing shareholders.

Advantages Disadvantages

 Permanent source of capital.  Dividends have to be paid to the

 In case of ordinary shares business shareholders.
will only pay dividends if there is a  Loss of control
profit.

Micro-Finance is the provision of financial services to poor and low-income

people. It refers to a movement that envisions a world where low-income
households have permanent access to high-quality and affordable financial
services to finance income-producing activities, build assets, stabilize
consumption, and protect against risks. Initially the term was closely
associated with microcredit—very small loans to unsalaried borrowers with
little or no collateral—but the term has since evolved to include a range of
financial products, such as savings, insurance, payments, and remittances.

Typical microfinance clients have low incomes and are often self-employed in
the informal economy, conditions that together typically deny them access to
banks and other formal financial institutions. They commonly run small stores
or street stalls, create and sell items they make in their homes, and in rural
areas, microfinance clients may be small-scale farmers and those who process
or trade crops and goods.

Microfinance clients are often just below or above the poverty line, commonly
defined as earnings of US$1.25 a day, and women constitute a majority of
borrowers. Over the past decades, financial institutions have been developing
a range of products to meet the diverse needs of this broad and underserved
market.

Crowdfunding is a source of finance that entails collecting relatively small

amounts of money from a large number of supporter – ‘the crowd’.

It is often performed via Internet-mediated registries, but the concept can also
be executed through mail-order subscriptions, benefit events, and other
methods.

The crowdfunding model is based on three types of actors: the project initiator
who proposes the idea and/or project to be funded, individuals or groups who
support the idea, and a moderating organization (the "platform") that brings
the parties together to launch the idea.

Government Grants and loans is a sum of money given to entrepreneurs or

businesses for a specific purpose.

Factors affecting the choice of finance

With so many sources of finance to choose from, a business has to carefully

select the appropriate one. The following points may be considered while
selecting the most appropriate source of finance.

Type of expenditure: Whether the finance is needed for capital expenditure or

revenue expenditure. Issue of shares will be more appropriate for limited
businesses who want to expand rapidly. If it is a cash flow problem then bank
overdraft may be more appropriate.

How long the business needs the finance?

How much amount is needed?

What is the status and size of the business? A small business might not be
able to raise additional capital through issue of shares.

What is the capital composition of the business? Highly geared businesses

(i.e. with more debt capital and less equity) would rather go in for equity
financing.

What will bank see before lending money?

When applying for loan the bank manager or your creditor might be interested
in knowing the status of your business. They will review your

 Balance sheet: to see how much you own and how much you owe to
others.
 Profit and loss account: to see the profitability of your business.
 Cash flow forecast: Predictions about how much and from where cash
will come in and go out.