Business Finance

ü The need for business finance

ü Working capital
ü Sources of finance

Chapter 29
Importance of finance
• Start-up capital: money and
capital needed to start a business.
Includes owners equity or cash
injection.
• Working capital: cash and capital
required to fund day-to-day
operations and expenses.
Working capital = Current assets –
current liabilities
Why businesses need financ
e
Finance: the money required to support
business operations.
• To start / set up the business. Start-up capital: the initial
finance needed by entrepreneurs to pay for all expenses in
creating a new business.
• To pay for day-to-day expenses i.e. salaries, raw material, bills,
fuel this is Working capital (measures short-term liquidity).
Equals to current assets – current liabilities.
• For Revenue expenditure: frequent spending on to maintain
assets & other costs unrelated to fixed assets (i.e. selling
expenses such as delivery & advertising). Spending on ongoing
expenses i.e. wages, repair of fixed assets (maintain rather
than enhance assets & is not a measure of liquidity); produces
short term benefits.
• For Capital expenditure: infrequent spending on long-term
non-current assets that produce lasting benefit i.e. upgrade a
machine or new technology.
Why businesses need fi
nance

• To purchase fixed / non-current assets i.e.

machines, equipment, land, furniture…etc. This is a
long-term (more than 1 year) item of value the
company owns.​
• To purchase current asses, resources owned by the
company that can be turned into cash in less than 1
year i.e. inventory, trade receivable, cheques.​
• To finance business expansion i.e. external
integration or organic growth.​
• To finance R&D.
Revenue expenditure
Spending on everything other
than fixed assets i.e. salaries &
on-going operational costs.
Spending to maintain capital
Incurred to run the business
Implications Buying a Van ?
Petrol costs for the Van?
• Short-term Repairing the Van?
Legal cost of buying the Van?
• Generates revenue Adding extra headlights to the Van?
Capital expenditure
Spending on fixed assets, machinery and equipment. Typically, spending
on new projects, vehicles, construction...etc.
Incurred when acquiring the asset
Implications
• Long-term impact
• High initial cost
• Depreciation – loses its worth
• Commitment – hard to reverse
• Infrequent purchases
https://www.investopedia.com/terms/c/capitalexpenditure.asp
CAPITAL EXPENDITURE
https://www.investopedia.com/ask/answers/021115/what-difference-between-capital-expenditure-and-revenue-expenditure.asp#:~:text=Reven
ue%20expenditures%20or%20operating%20expenses,or%20profit%20for%20the%20period.
CURRENT ASSETS CURRENT LIABILTIES
Items of value owned by the Payments / financial obligations
company that are expected to be the company must pay within 1
turned into cash within 1 year year

Short-term cash inflow Short-term cash outflow

Inventory Payment for suppliers
Cash in bank account Bank loan payment
Cheques Taxes
Payments from customers to be Salaries
received overtime (less than 1
year)
Significance of
working capital
 Necessary for the survival of the
business and its ability to make
profit.
Its needed to:
• Pay for wages
• Buy stocks
• Settle debts
• Increases confidence internally &
externally
• Capitalize on opportunities
• Ensure a continuous work-flow
How much
working
capital is
needed?
 A business should have a
balanced amount.
• Too little is risky
• Too much has opportunity cost
• Each business sector will have
different working capital needs.
• Depends on the size of the
organization
• Is affected by the sales-cycle
Working capital cycle

The time it takes to

convert current assets
& liabilities into cash.
The longer the cycle is
the greater the need
for working capital.
A shorter cycle is a
cost-effective way to
fund growth. 1. Stock-management
2. Payment to suppliers
3. Cash / debt collection
 Reducing inventory levels

Managing Reduces storage costs

working
capital- Frees up finance to be used for other
internal purposes

Possible issue of having too little inventory

 Reducing trade / accounts receivables

Reduce the length of time extended to

Managing custmers i.e. pay within 20days instead of
30days
working
capital- Have a stricter credit policy & offer it to
internal less customers

Offer discounts discounts for early

paymens
 Cash ≠ Profit
Cash Profit
Money coming into the organization from all sources Profit is the amount of money left over after all expenses are paid.

Example Example
Sale of company asset Gross profit
Loan Operating profit
Tax refunds

Amount of money available There can be profit without realizing / having cash
Trade receivables
A profitable company might be low on cash because they reinvested
or because they buy inventory before selling
Paying a lot of dividends

More important in the short-run for liquidity More important in the long-run for expansion & investment

The business can’t live without cash “oxygen” The business can survive without profit for a short-time “food”
 Importance of cash

To pay for:
 Salaries of employees
 Suppliers
 Overheads such as rent, and
electricity & telephone bills
 Emergency & unexpected
expenses (i.e. legal fees,
natural disasters…etc.)
Cash is the “lifeblood” of
the business & is needed
for survival
 Internal sources: capital and cash generated via normal business operations
of the company itself
 Retained profits = gross profit (revenues – cost of goods) – all other
expenses & dividends. Such as taxes & interest payments.
Advantages & disadvantages
Sources of
finance -
internal
 Sale of non-current /
fixed assets -internal
Disadvantages
• Takes time to sell the asset, & it depends on its
commercial viability (its usability)
• The asset could sell for less than the original price
i.e. due to depreciation
• Annual lease payments
• The business may need to buy the asset again in
the future
Sale of unused / Advantages
Leaseback: selling
unwanted fixed
the fixed asset & • Does not become debt for the business, unlike
assets i.e.
then leasing it
machines, surplus
from the new
a loan.
equipment, or • Some asset of the unutilized assets may have a
owner
land
running cost i.e. storage & warehousing or
maintenance.
• Could raise large sums of money.
Sources of finance - internal
 Sources of finance - External

EXTERNAL SOURCES: CAPITAL AND CASH SHORT-TERM LONG-TERM

GENERATED FROM OUTSIDE PARTIES OR
ORGANIZATIONS OTHER THAN THE BUSINESS
ITSELF.
 Sources of finance - External

Main •Bank overdraft

methods of
short-term •Trade credit
financing •Debt factoring
sources are:
Sources of
finance -
External
•Main methods of long-term
financing sources are:
• Hire purchase
• Leasing
• Share capital
• Debentures
• Bank (long-term) loans
• Business mortgage
• Venture capital
• Government grants
 • Bank overdraft: exceeding the current
amount available of money available in the
business’s bank account (below zero up to a
fixed amount).
Bank • Flexible to finance day-to-day operations.
overdraft • Easy to frequently use as needed.
– short • Interest is paid only on the amount
term & overdrawn.
• High interest rate charged on the overdrawn
external funds.
• Over-reliance leads to high cost of
borrowing in the long-run.
 Trade credit– short
• Trade credit: when suppliers agree to sell inventory to a
business without demanding an immediate payment. term & external
Buy NOW & pay LATER
• Increases liquidity so increases the level of working capital The amount of money the business owes as
• A business is able to obtain stocks, even if it does not have credit to suppliers is called trade / account
the cash for it. payable, but to the supplier it is called trade /
account receivable.
• Exploit market opportunity & get inventory to meet
seasonal demand.
• Losing out on discounts that are offered to early or quick
payments
• Late payments discourage suppliers to extend future credit
• Suppliers may refuse to deliver further orders if the
business did not pay for the previous ones.
Debt factoring– short term &
external
Debt factoring: when a business
sells its trade receivables to
another organization (usually a
collection agency) for a
discounted amount

Avoids the risk of defaulting or

late paying customers

Acquires immediate access to The business does not receive

funds the full profit margins.

If consistently used in the long-

Frees-up resources and time
run, significant profits are
invested in customer collection
foregone

The customer information

would not longer be private.
This can lead to dissatisfaction.
 External sources of finance 5+yrs

Long-term bank loan: when a business rents or buys

non-current asset (fixed asset)
Advantages
Immediate access to significant amounts of funds
Can be used to fund expansion, and achieve strategic
objectives
The business can benefit from government loan
guarantee schemes
Banks often provide financial and expert advice
Drawbacks
• The business will be in-debt for a long time
• The longer the debt period the more
interest payments accumulates
• Valuable collaterals are demanded
• Collaterals can be seized
Leasing– External & long term
Renting or using a fixed asset in exchange for paying a fixed amount
over a known time period of the lease.

Ownership of the asset When the leasing period Usually the

belongs to the leasing expires the asset is maintenance &
company (the company returned to the leasing repair of the asset is
receiving the payment). company. done by the leasing
company.

The firm does not need a Suitable if the company is Expensive in the long-run:
large sum of money to use concerned about short- The total cost of leasing
the asset. term cash liquidity. may end up being more
than the cost of buying
the asset.
Hire purchase–
External & long
term
Buying the fixed asset & paying a fixed
amount with interest over an agreed period
of time (i.e. monthly payment for 5 years).

• Ownership of the asset belongs to the paying company (after the end of the time period).

• Maintenance & repair of the asset is done by the paying company.

• The firm does not need a large sum of money to use the asset.

• Expensive / high interest charges: The total cost of leasing may end up being more than the cost
of buying the asset.
 Long-term sources of finance
• Long-term bonds: a legal document a business sells to
investors or the public. It entitles the buyer to interest
payments.
• Secured-bonds: the business offers buyers an asset,
which they gain sell in the case of defaulting payments
Advantages
• Some governments exempt income generated from
bonds (no taxes)
• Secured-bonds encourage buyers
• Companies can raise large amounts of funds
• Companies do not lose ownership (unlike stocks)
Drawbacks
• Issuing bonds hurts credit-worthiness
• A damaged company reputation will lower the value
of the bonds
• The business is in long-term debt, it may not be
doing well in the future
• Possible loss of assets from secured-bonds
sources of finance

• Debentures: unsecured bonds

Advantages & disadvantages similar to bonds
Long-term sources
of finance
• Equity finance: selling of shares in
exchange for ownership(equity is traded for
money)
2 main ways to sell shares
1. Full-listing: stocks are listed in the Stock
Exchange market. Strict requirements.
o Public issue by prospectus – public
announcement to sell shares, & invitation
of buyers.
o Rights of issue – when a plc sells share only
to pre-existing stockowners at a discount Advantages
• The companies is not legally obligated to pay dividends
2. AIM: list in the Alternative Investment • If the business is private limited company, it can retain control
Market. The part of the stock market specific • Significant amounts of funds can be acquired within a short time
• The prices of the stocks can increase
for small companies. Looser requirements. Disadvantages
• Permanent liability – loss of ownership & control
• Short-termism – conflict between shareholders & the board of directors
• Volatile market
 Venture capital
(long-term)

• Venture capital: special

or private investors
that fund up-coming,
risky and businesses
with potential. Also
called Angel investors
or risk capitalists.
• Common for tech,
software, & innovation
companies
 Angel investors

ADVANTAGES OPTION FOR ACCESS TO CAPITAL STRATEGIC EXPERTISE AND

UNINCORPORATED PARTNERSHIPS MENTORSHIP
BUSINESSES
 Angel investors

Disadvantages

• Investors get a percentage of future profits

• Loss of control
• Conflicting objectives
Internal VS external sources
 Other external
finance sources
Micro-finance
In lesser developed countries it can be hard for
poor entrepreneurs to get bank loans (little
income & no collateral so high risk for banks)
Repaid within a short period of time
Micro-finance organizations specialize in giving
small / micro loans to these disadvantaged /
poor people not served by traditional banks i.e.
100$ or 1,000$
 Other external
finance sources
 Do not have to be paid back
$40 Billion  Very competitive
 Conditional (what type of
business or area)

Government grants
Micro-
finance
http://www.faten.org/
https://www.kiva.org/categories

Micro-
finance
 Crowd-funding

Other Raising capital for a business from many doners / investors, via social media &
the internet.
external • State how much is needed
finance • What would the money be used for

sources • The potential benefits for investors / doners

https://www.kickstarter.com/
https://www.gofundme.com/
Factors influencing the choice of
finance

• Business legal structure & size: Unincorporated V.S incorporated

• Amount required: significant amounts may need selling of shares or issuance of
debentures, while smaller amounts could be satisfied via overdraft.
• Length of time: if long-term finance is needed the businesses may want to improve &
use retained profits or take a long-term loan. While short-term finance could be debt
factoring. The longer the business is in debt the more costly it will be to repay (higher
interest).
• Existing borrowing: if the business is already in-debt it will be harder to borrow more.
• Specific use of finance: if land or buildings use mortgage, if for equipment or
machinery maybe lease or hire-purchase.
Factors influencing the choice
of finance
• Ownership & control: if owners wish to have complete control then selling of shares may not be
a good idea. Converting from partnership to private or public limited dilutes original ownership.
• Degree of risk: to what extend would the business want to accept the risk? Extending trade
recievables is risky because customers may not pay on time, long-term borrowing is risky
because of uncertainity.
• Retained profit: reduce divdends to increase retained profit has an impact on shareholders. A
hard approach to cut costs such as lay-offs & redundancy has an impact on stakeholders.
• Borrowing capacity: if the business more collaterols to offer or if it is successful & profitable it
can obtain bank loans easier.
• Country of operation: the government finance available in that country i.e. grants & subsidies.