Comprehensive Study Guide on Business Finance
Lesson Objectives
In this lesson, students will:
1. Identify the main reasons why businesses require finance, including:• Start-up capital•
Capital for expansion• Additional working capital
2. Understand the distinctions between short-term and long-term finance needs.
Reasons Why Businesses Need to Raise Finance
Businesses often find the need to raise finance for various critical reasons:
1. Business Start-Up
• Start-Up Capital: This is essential financing required by new companies to cover both
non-current (fixed) and current assets before they commence trading. For example, new
entrepreneurs need money for purchasing equipment, renting an office space, and marketing efforts.
2. Acquiring New Equipment or Technology
• As companies grow, they may need to invest in new machinery or software to enhance
efficiency or productivity. This could mean replacing outdated equipment or integrating
modern technology into existing processes.
3. Potential Acquisitions
• Businesses may wish to acquire or merge with other organizations to expand their services
or market reach, which typically requires substantial capital investment.
4. Expansion Initiatives
• Growth is often a key goal for businesses. Financing may be required to open new
locations, develop new products, or enter new markets.
5. Day-to-Day Running Costs (Working Capital)
• Working Capital: This refers to the financing necessary to cover daily operational expenses, including payroll, inventory, and overhead costs. Having sufficient working capital
ensures that businesses can operate smoothly without disruption.
Finance Requirements
Understanding the two main types of expenses is critical:
• Capital Expenditure (CapEx): Refers to the purchase of fixed assets. Examples include:•
Buildings• Vehicles• Furniture• Equipment and machinery
• Revenue Expenditure: This involves funds required for daily operational expenses. Examples include:• Wages• Bills• Rent• Stock purchases
Activities: Identifying Expenditures
Determine whether each of the following expenses is capital (C) or revenue (R):
1. Purchase of Land and Building - C
2. Marketing and Advertising Expenses - R
3. Installation of New Machinery - C
4. Repairs and Maintenance of Existing Equipment - R
5. Employee Training Program - R
6. Research and Development of New Product - C
Short-Term vs. Long-Term Finance
Short-Term Finance
• Definition: Finance that is expected to be repaid within one year.
• Examples: • Bank overdrafts• Trade credit
• Use: Typically used for everyday operational needs.
• Risk: Generally viewed as less risky for lenders.
Long-Term Finance
• Definition: Finance that is expected to be repaid over several years, typically exceeding
one year.
• Examples: • Mortgages• Bank loans
• Use: Usually designated for larger projects such as expansion efforts.
• Risk: Considered riskier for lenders; often requires collateral.
Internal and External Sources of Finance
Internal Finance
Internal sources of finance are derived from within the business itself, yielding the following
options:
1. Retained Profit• Advantages: No interest payments; serves as a permanent source.•
Disadvantages: Not available for new businesses; opportunity cost must be considered
(dividend vs. retained profits).
2. Sale of Assets• Advantages: Better utilization of tied-up capital; zero increase in debts.•
Disadvantages: Only possible if assets are surplus; time-consuming to sell assets.
3. Sale of Inventories• Advantages: Reduces opportunity and storage costs.• Disadvantages: Potential disappointment for customers if inventory is low.
4. Owners' Savings• Advantages: Immediate availability; no interest obligations.• Disadvantages: Limited funding capacity and increased risk due to unlimited liability.
External Finance
External sources of finance are obtained from outside the entity. Some common forms include:
1. Issue of Shares: Selling equity in the business to raise funds.
2. Bank Overdrafts: Allowing businesses flexibility to borrow as needed.
3. Bank Loans: Borrowing a specific sum which is paid back over time with interest.
4. Trade Credit: Buying goods where payment is deferred.
5. Leasing/Hire Purchase: Financing arrangements for assets.
Leasing vs. Hire Purchase
• Leasing: The asset is owned by the lessor; the business pays rent to use it.
• Hire Purchase: The asset is owned by the buyer after making installment payments.
Importance of Alternative Sources of Capital
• Micro-Finance: Provides small loans typically to low-income individuals or groups.
• Crowd-Funding: Collects small amounts of money from numerous people, usually through
online platforms, enabling individuals to fund their projects.
Factors Considered in Financial Decision-Making
When deciding on a financial source, managers typically consider the following:
• Length of time finance is needed.
• The total amount of capital required.
• Cost of finance.
• Current profit levels.
• Risks involved with the finance source.
• Owner's preferences, especially in family-run businesses.
• The type of business (e.g., start-ups versus established firms).
Recap of Sources of Finance
Tick the correct columns that apply to the sources of finance:
• Sale of shares to the public (Long-term finance, available to private and public limited
companies).
• Bank overdraft (Short-term finance, available to all business types).
• Sale of Debentures (Long-term, available to limited companies).
Key Definitions
• Short-term Finance: Finance available for less than one year.
• Medium-term Finance: Finance available for one to five years.
• Long-term Finance: Finance available for over five years.
• Gearing: The ratio of a company’s debt to its equity, indicating financial leverage.
• Factoring: Selling unpaid invoices to a third party at a discount in exchange for immediate
funds.
This comprehensive study guide aims to provide a clear understanding of the reasons why businesses need finance, the distinctions in financing types, and the various internal and external
sources available for obtaining capital. Through engaging with the activities and understanding
the concepts outlined, students can enhance their financial literacy in the business context.