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💰 5 : Financial Information and
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5.1 : Buisness Finance : Needs and Sources
Finance → the money required in the business. Finance is needed to set up the
business, expand it and increase working capital (the day-to-day running
expenses).
Start-up capital → the initial capital used in the business to buy fixed and current
assets before it can start trading.
Working Capital → The finance needed by a business to pay its day-to-day
running expenses
Capital expenditure → the money spent on fixed assets (assets that will last for
more than a year). Eg: vehicles, machinery, buildings etc. These are long-term
capital needs.
Revenue Expenditure → similar to working capital, is the money spent on day-today expenses which does not involve the purchase of long-term assets. Eg:
wages, rent. These are short-term capital needs.
A buisness needs to finance for ↓
Start-up capital → the finance needed by a new business to pay for fixed
assetsand current assets before it can begin trading
Capital for expenditure : For more equipment to increase output or to develop new
products by spending more on R&D
Working Capital : Having a steady flow of working capital is essential to keep the
business operational. Without working capital, the business would be unable to
cover its day to day expenses
Short-term financial needs → It is used to help maintain a positive cashflow,
incase of need to meet unexpected costs or to pay bills and suppliers.These are
likely to be relatively small amounts and are rarely needed beyond a year
Sources of Short-term sources of finance ↓
Overdrafts
Advantages ↓
A limit is agreed and interest is charged only when a business ‘goes
overdrawn’
Offers significant flexibility and aids cash flow
Disadvantages ↓
An overdraft may be called in if the bank is concerned about a
business's ability to repay what it owes
Interest on overdrafts tends to be higher than on other loans
Trade Credit
Advantages ↓
Trade credit is usually interest-free
A business can increase its stock without having to immediately pay
for it, which can significantly enable positive cash flow if the stock is
sold before payment becomes due
Disadvantages ↓
Suppliers may prioritise delivery to customers who have the shortest
repayment dates
Cash needs to be carefully managed to ensure the business has the
money availableto pay its suppliers on the agreed date
Debt factoring
Disadvantages ↓
The third-party debt company will keep a percentage of the debts
collected as reward
The business does not get paid the total value of their debts
Advantages ↓
Debt factoringprovides a source of Immediate cash to the business
The business does not have to handle the debt collectionthemselves
Long-term financial needs → It is usually used to buy fixed assets, in a long period
of time and therefore tends to be expensive. It's usually used for expansion.
Long-term Sources of Finance ↓
Debentures
Advantages ↓
Can be used to raise very long-term finance, e.g. over 30 years
Unlike share capital, debenture holders have no share in the company
itself
Disadvantages → Interest and the loan itself has to be repaid
Share issue
Advantages ↓
Large amounts of money can be quickly raisedfrom wealthy investors
Shareholders who buy a large number of shares may also bring and
share expertise which can be beneficial to the business
Disadvantages ↓
Shareholders are the owners of shares and they are entitled to a share
of the company’s profitwhen dividendsare declared
Shareholders usually have a vote at a company’s Annual General
Meeting (AGM) where they can have a say in the composition of the
Board of Directors
Leasing
Advantages → The business does not own the asset during the
period of the lease and so is not responsible for maintenance or repair
costs
Disadvantages → Leasing is usually more expensive in the long run
than buying an asset
Hire purchase
Advantages → The firms does not need to spend a large sum of
money to acquire and use an asset
Disadvantages ↓
A deposit is usually payable before the asset is delivered
Interest charges can make the overall cost higher that buying an asset
outright
Bank loans
Advantages ↓
Bank loans are usually unsecuredand are typically repaid over two to
ten years
Interest rates are fixed for the term of the loan so repayments are
made in equal instalments, which helps with business planning
Disadvantages → Interest is payable and the business assets are at
risk if the business does not make repayments as planned
Internal Source of Finance
internal source of finance → money that comes from within a business such
as owners capital, retained profit and money generated from selling assets
Types of internal source of finance ↓
Owner’s capital: personal savings → Personal savings are a key source of
funds when abusiness starts up. Owners may introduce their savings or
another lump sum, e.g. money received following a redundancy. Owners
may invest more as the business grows or if there is a specific need, e.g. a
short-term cash flow problem
Retained Profit → The profit that has been generated in previous years
and not distributed to owners is reinvested back into the business. This is
a cheap source of finance, as it does not involve borrowing and
associated interest and arrangement fees
Sales of assets → Selling business assets which are no longer required
(e.g. machinery, land, buildings) generates finance. A sale and leaseback
arrangement may be made if a business wants to continue to use an asset
but needs cash. The business sells an asset (most likely a building) for
which it receives cash. The business then rents the premises from the
new owners
Sales of stock → Stock may be sold at reduced prices in order to raise
additional finance. This reduces the opportunity cost and storage cost of
high inventory levels. It must be done carefully to avoid disappointing
customers if stock runs low
Managing working capital → A business can also generate additional
finance internally by managing its working capital more effectively. They
can negotiate extended payment terms with suppliers. They can
incentivise customers to pay more promptly for credit purchases
Advantages of use of Internal Finance ↓
Internal finance is often free (e.g. it does not involve the payment of interest
or charges)
It does not involve third parties who may want toinfluence business decisions
Internal finance can often be organised quickly and without significant
paperwork
Businesses that may fail credit checks (necessary for a bank loan) can
access internal finance sources more easily
Disadvantages of use of Internal Finance ↓
There is a significant opportunity cost involved in the use of internal finance
e.g. once retained profit has been used it is not available for other purposes
Internal finance may not be sufficient to meet the needs of the business
Using an internal finance method is rarely as tax-efficient as many external
methods e.g. loan repayments may be treated as a business cost and offset
against tax
A new business will not have retained profit. Profits may be too low to finance.
Keeping more profits to be used as capital will reduce owner’s share of profit
and they may resist the decision.
External Sources of Finance
External source of finance → money that is introduced into the business from
outside such as a loan or share capital. In some cases, a business may not be
able to fulfil its needs with internal sources of finance. Some projects or
investments may require a significant amount of finance. External sources,
such as loans or issuing shares, can provide the necessary funds for these
expensive projects
The implications of the different types of external finance need to be carefully
considered ↓
Interest and fees to arrange finance can vary significantly between financial
providers
The percentage of company ownership required in exchange for finance
depends on how much risk investors are willing to take
The length of time allowed to repay borrowings or achieve investment targets
also varies
External sources of finance ↓
Grants and subsidies → These are sums of money provided to the
business by governments and some outside agencies . They do not
usually have to be repaid
The money is often provided with certain conditions attached, such as the
business must locate in a particular area in order to create jobs
Trade credit → Where a business has an agreement to delay paying its
suppliers for a period of 30, 60 or 90 days
This helps to improve the cash position of the business
Debt factoring → Businesses can sell their accounts receivable
(invoices) to a third party at a discount
The third party pays the business immediately, which means that cash is
received immediately
Customers then pay the third party over the agreed time frame (possibly
several months)
Share issue/debentures ↓
Shares in private limited companies may be sold to venture capitalists
orangel investors
Venture capitalists may provide guidance and expertise as part of the
arrangement
Debentures are long-term loan certificates issued by limited companies
Debentures must be repaid with interest to lenders
A company can raise finance by selling shares on the stock market
This can raise large amounts of capital but requires a business to
follow strict regulations
A rights issue allows existing shareholders the right to buy new shares
in the business to raise further finance
Hire purchase/leasing → Instead of purchasing and owning assets
outright businesses can opt to lease or use hire purchase agreements. A
business acquires equipmentsuch as machinery or vehicles, spreading
the cost of its use over time
This is not a method to raise capital but allows the business use of an
asset they would otherwise need to purchase
Bank loan → A sum of money is borrowed from the bank and repaid (with
interest) over a specific period of time
Loans can be short-term or long-term
Banks must approve the loan application
Loans must be repaid with interest
Bank Overdraft → An arrangement for business current account holders to
spend more money than it has in their account. Overdraft users are
typically charged interest at a daily rate .
Using an overdraft for a long period can be expensive compared to other
methods
Factors that affect choice of source of finance ↓
Purpose: if a fixed asset is to be bought, hire purchase or leasing will be
appropriate, but if finance is needed to pay off rents and wages, debt factoring,
overdrafts will be used.
Time-period: for long-term uses of finance, loans, debenture and share issues are
used, but for a short period, overdrafts are more suitable.
Amount needed: for large amounts, loans and share issues can be used. For
smaller amounts, overdrafts, sale of assets, debt factoring will be used.
Legal form and size: only a limited company can issue shares and debentures.
Small firms have limited sourced of finances available to choose from
Control: if limited companies issue too many shares, the current owners may lose
control of the business. They need to decide whether they would risk losing
control for business expansion.
Risk- gearing: if business has existing loans, borrowing more capital can increase
gearing- risk of the business- as high interests have to be paid even when there is
no profit, loans and debentures need to be repaid etc. Banks and shareholders will
be reluctant to invest in risky businesses.
Alternate source of finance ↓
Micro-finance → special institutes are set up in poorly-developed countries
where financially-lacking people looking to start or expand small businesses
can get small sums of money. They provide all sorts of financial services
Crowdfunding → raises capital by asking small funds from a large pool of
people, e.g. via Kickstarter. These funds are voluntary ‘donations’ and don’t
have to be return or paid a dividend.
Chances of a bank willing to lend a business finance is higher when ↓
A cash flow forecast is presented detailing why finance is needed and how it will
be used
An income statement from the last trading year and the forecast income statement
for the next year, to see how much profit the business makes and will make.
Details of existing loans and sources of finance being used
Evidence that a security/collateral is available with the business to reduce the
bank’s risk of lending
A business plan is presented to explain clearly what the business hopes to achieve
in the future and why finance is important to these plans
5.2 – Cash Flow Forecasting and Working Capital
Why cash is important to a buisness? → Cash is the 'blood' of a
business, as without it, a business will die.It is a liquid asset in
the form of notes, coins and money in the bank. If a firm doesn’t
have any cash to pay its workers, suppliers, landlord and
government, the business could go into liquidation– selling
everything it owns to pay its debts. The business needs to have
an adequate amount of cash to be able to pay for all its shortterm payments.
Cash is especially important for a new buisness as ↓
A supplier may then give the business trade credit of 30 or 60 days
This means that the business can receive their stock now and only pay for it in
30 or 60 days; the cash outflow is delayed
As the business sells its products, they receive money generated from the
business revenue and this represents a cash inflow
At the end of 60 days they will pay their supplier (cash outflow), but the firm
may still have half of its stock available for sale
pay cash on purchase for all of its supplies until its suppliers trust them
enough to provide credit terms (buy now, pay later)
Cash-flow Cycle
Cash flow cycle → The process of managing the inflow and outflow of cash in
a business over a specific period. It shows the stages between paying out
cash for labour, materials, and so on, and receiving cash from the sale of
goods
Diagram of the cycle →
Explanation of cash-flow cycle ↓
1. The diagram shows that cash is needed to pay for materials used to produce
the product
2. Time is needed to produce the products before they can be sold to
customers
3. If customers purchase the goods using a credit facility provided by the
business, then they will not have to pay immediately, which will delay cash
inflows
4. When they do pay for the goods immediately, this money will be used to pay
business expenses
5. Due to the time between each stage, the business needs to make sure it has
enough working capital to keep running and pay bills
6. Businesses, particularly start-ups, need to ensure that they manage cashflow to ensure that it does not run out of money
Cash inflows → the sums of money received by the business over a period of
time.
E.g ↓
sales revenue from sale of products
payment from debtors– debtors are customers who have already
purchased goods from the business but didn’t pay for them at that time
money borrowed from external sources, like loans
the money from the sale of business assets
investors putting more money into the business
Cash outflows → The sums of money paid out by the business over a period
of time.
Eg ↓
purchasing goods and materials for cash
paying wages, salaries and other expenses in cash
purchasing fixed assets
repaying loans (cash is going out of the business)
by paying creditors of the business- creditors are suppliers who supplied
items to the business but were not paid at the time of supply.
Issues with cashflow which a buisness may face ↓
Production is likely to cease as workers will not work without pay and suppliers
will not supply goods if they are not paid
Unable to pay utility bills and rent
Unable to pay key stakeholders, such as workers and suppliers
The business could be forced into liquidation and, ultimately, is likely to fail
Cash-flow Forecast
A cash-flow forecast → a prediction of the anticipated cash inflows and
cash outflows typically for a three, six or twelve month period
Typical outflows → It include payments for raw materials, paying staff
wages and salaries, paying bills such as electricity and repaying loans
Typical inflows → It include receipts from sales, money received from a
new bank loan, money from the sale of an asset and money from investors
net cash flow = inflow - outflow
Net cash flow + opening balance = closing balance
Opening balance → The amount of cash available at the beginning of a
specific period.
Closing balance → The amount of cash available at the end of a specific
period after accounting for inflows and outflows.
Cash flow forecasts are useful in the following situations ↓
Starting up a business: identifying how much cash is needed in the first few
months
Running an existing business: recognising where a fall in sales may require use of an
overdraft facility
Supporting applications for borrowing: determining the size of loan or overdraft
needed, when and for how long it is needed and by when it is likely to be fully repaid
Managing transactions: identifying how much or how little cash is deposited at the
bank can determine when bills should be paid
The Methods used to Overcome Short-term Cash-flow Problems ↓
Seek to increase the trade credit period : The business may approach some of its most
trusted suppliers and ask them for more generous repayment terms
Only sell in cash, not credit : Businesses can choose to only accept cash as payment,
meaning it receives money immediately. Customers may buy from competitors that sell
on creditinstead
Overdraft facility : Temporary cash-flow problems can be solved by arranging to spend
more than the businesses current account balance/ Interest rates may be relatively high,
increasing business costs
Delay plans to purchase new equipment : Postponing the purchase of new equipment,
such as vehicles, may significantly reduce cash outflows
Apply for a bank loan : Businesses can often arrange short-term bank loans in a very
short time frame, ofetn a couple of days. Internest will have to be paid
Shorten debtor repayment periods : If the business offers customers the ability to 'buy
now, pay later', this delays the cash inflow. Removing the option to pay later will improve
cash-flow
However, the business may lose some customers to competitors who are able to keep
offering credit terms
In the long-term, to improve cash flow, the business will need to attract more investors,
cut costs by increasing efficiency, develop more products to attract customers and
increase inflows.
Working Capital
Working capital → the money that a business has available to fund its day-to-day
activities. Working capital is all of the liquid assets of the business– the assets that
can be quickly converted to cash to pay off the business’ debts.
Working Capital = Current Assets - Current Liabilities
Current assets → include cash, cash equivalents or assets which can be converted
to cash within a one year period. Eg. cash, debtors, inventories [stock]
Current liabilities → are short-term financial obligations that are usually repayable
within one year, or as demanded by creditors. Eg. Creditors, Short-term loans,
Overdrafts
Cash is the most liquid of a business's current assets and can be used to settle
debts immediately
Stock takes time to be sold and converted to cash to pay debts so is the least liquid
current asset
Problems with a shortage of working capital ↓
Businesses may look to convert debtorsand stock into cash as quickly as possible.
This may mean they have to sell stock at low prices, reducing revenue
Suppliers may not allow an extension of trade credit terms as the business is seen as
too much of a risk
Making use of short-term borrowing options such as overdrafts can improve a
businesses working capital situation but relatively high level of interest must be paid
Problems with excess of working capital ↓
Holding large amounts of cash may mean missing outon benefits of investing it in
fixed assets or investments
This may represent a significant [popover id="rwgdJTaybPhZJ4sJ"
label="opportunity cost"], as the money is not being put to work for the business
If a business is holding large amounts of stock, it may incur extra storage costs, and
the cash value of thestock could be used for other purposes