Chapter 29 –

Business finance
Why do businesses needs finance?
All businesses need finance. Insufficient finance can
lead to business failure, and a shortage of LIQUID funds
is one of the main reasons that businesses fail.
Usually businesses need finance for several
reasons, including :

Start up Working
capital capital

In times
Expansion
of trouble
Start-up capital
Start-up capital is the capital (finance)
needed by an entrepreneur to set up a
business.
Start-up capital

Start-up capital is used for initial

investments such as land, labour,
buildings, machinery etc. as well as for
purchasing the materials required for
the production of goods or services.
Working capital
All businesses need capital to cover their
day-to-day financial needs such as
purchasing raw materials, paying
employees, repaying short-term debt and
paying day-to-day operating expenses.

Working capital is the capital needed to pay

for raw materials, day-to-day running costs
and credit offered to customers.
Working capital is also called NET CURRENT
ASSETS.
In accounting terms :

Working capital = current assets – current

liabilities
Working
A shortage of working capital might lead to
serious consequences for the business (i.e. being
unable to pay current liabilities such as wages or
suppliers, leading to insolvency).
Expansion
A business might need additional source of
finance when it needs to expand.
This expansion may include :
• extension of present buildings
• purchase of another business
• entering new markets or developing
new products
In times of trouble
A business might need additional 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.
This finance may be required either in the
short term (less than one year) or the long
term, perhaps even permanently.
 The distinction
between short- and
long-term needs for
finance
Different financial needs require different forms
and sources of financing.
The primary difference between the need for
long-term and short-term financing is in the
length of time for which the capital is required.
Short-term financing :
• a loan term that is less than one year
• used to finance things like a working capital
shortage, or the purchase of extra inventory to
cope with seasonal demand
Long-term financing :
• a loan term that is greater than one year
• used to finance things like the replacement of
large items of machinery or expansion of the firm
• the income earned by these long-term assets will
be used to repay the long-term loan
Activity 28.1 (page 419)
Long-term finance: expansion; research and development.
Expansion – may require new buildings, which will be
funded by long-term loans due to size of investment.
R&D – takes time to recoup the cost of R&D as money is
needed now but business may not see rewards for several
years.
Short-term finance: building up stocks; paying bills.
Building up stock – should be able to fund through short-
term finance, e.g. overdraft and then once sold, pay for
further stock replenishments from day-to-day revenues.
Paying bills – ongoing so need to cover from working capital
and if experiencing cash flow problems take corrective
action to ensure sufficient working capital.
The difference
between cash
and profit
The difference between cash and profit

Profit is the value of goods sold (revenue)

less costs.

Liquidity refers to the ability of a business

to pay its short-term debts.
Cash - the amount of money currently or soon-
to-be available.
• money coming into the organization either
from direct business activity or investors -
serves as the resource to pay expenses.
• profit is the amount of money left over after
all expenses are paid.
Profitable businesses can run short of cash and
into trouble. On the other hand loss-making
(unprofitable) businesses can have large cash
inflows in the short term.
Jane buys fresh fish daily from the market. She
pays cash for her purchases. She sells her stock
from her stall to consumers who pay cash. Her
father owns the stall and doesn’t charge her
anything for using it.

Cost of fish per week = $1,000

Revenue from sales per week = $2,000

1. Calculate Jane’s profit/week. [2]

2. Calculate Jane’s cash flow/week. [2]
3. Comment. [2]
Jane buys fresh fish daily from the market. She pays
cash for her purchases. She sells her stock from her
stall to consumers who pay cash. Her father owns the
stall and doesn’t charge her anything for using it.
Cost of fish per week = $1,000
Revenue from sales per week = $2,000
Profit made per week = revenue – cost of sales

=$2,000 - $1,000 = $1,000

Cash flow per week = inflows – outflows
= $2,000 - $1,000 = $1,000
Sheila owns a specialist food shop. She
bought $500 of fresh goods on one
month’s credit (she will pay for this in 30
days). The goods sold slowly and she had
to cut her prices during the month.
Eventually she sold all the goods for $300
to consumers who paid in cash.

1. Calculate Sheila’s gross profit for the month. [3]

2. Calculate Sheila’s cash flow for the month. [2]
3. Comment. [2]
Sheila owns a specialist food shop. She bought $500
of fresh goods on one month’s credit (she will pay for
this in 30 days). The goods sold slowly and she had to
cut her prices during the month. Eventually she sold
all the goods for $300 to consumers who paid in cash.
Revenue from sales for the month = $300
Cost of sales for the month = $500
Profit (loss) for the month = revenue – cost of sales
= $300 - $500 = ($200)
Cash flow for the month = inflows – outflows
= $300 - $0 = $300
In this case profit is less than cash flow
Sam owns a jewellery shop. He buys his stock
online, for cash. He has decided to increase the
credit terms he offers his customers, from one
month to two months to attract more customers
and increase his sales. He bought stock for
$3,000 last month and paid in cash. He sold all
the stock during the month for $7,000 and will
be paid in 60 days.

1. Calculate Sam’s gross profit for the month. [2]

2. Calculate Sam’s cash flow for the month. [2]
3. Comment on Sam’s current situation. [3]
Sam owns a jewellery shop. He buys his stock online, for cash.
He has decided to increase the credit terms he offers his
customers, from one month to two months) to attract more
customers and increase his sales. He bought stock for $3,000 last
month and paid in cash. He sold all the stock during the month
for $7,000 and will be paid in 60 days.
Revenue from sales for the month = $7,000
Cost of sales for the month = $3,000
Profit for the month = revenue – cost of sales
= $7,000 - $3,000 = $4,000
Cash flow for the month = inflows – outflows
=$0 - $3,000 = ($3,000)
In this case profit is more than cash flow
Sam could run out of cash to pay his day-today expenses (wages,
rent) and may have to close his business.
Administration,
bankruptcy and
liquidation
Lack of finance is the single most common cause
of business failure.
A business which fails due to lack of finance may
be placed in ADMINISTRATION. Specialist
administrators take over the running of the firm
to keep it operational and to find a buyer for it.
If this is not possible then the firm is declared
BANKRUPT. Bankruptcy leads to LIQUIDATION of
the assets of the business and the cash raised
through liquidation (selling the firm’s assets) is
used to pay back people the bankrupt business
owes money to.
Administration refers to the process of
administrators taking over the
management of a firm that is unable
to pay its debts, with the view to
selling the business as a going
concern.
Working
capital
Working capital – meaning and significance
All businesses need cash to survive.
Cash is needed to :
• Invest in fixed assets
• Pay suppliers and employees
• Fund overheads and other fixed costs
• Pay tax due to the government
Working capital is the cash available to the
business for carrying out its day-to-day
activities.
A healthy working capital position is a
measure of a company's efficiency and its
short-term financial health.
A business with sufficient working capital is
said to be LIQUID. It can pay all of its short-
term debts.
A business with insufficient working capital
is said to be ILLIQUID – it cannot pay its
short-term debts.

When this happens the business will have

to get a loan from the bank or else it may
be forced to LIQUIDATE by its creditors.
Liquidity refers to the ability of a firm to pay its
short-term debts.

Liquidation occurs when a firm ceases trading

and its assets are sold for cash to pay its
suppliers and other creditors.

Working capital = current assets – current

liabilities
Current assets are either CASH or assets
that are likely to be turned into cash within
12 months.

Current assets include :

• Cash
• Accounts receivable (debtors)
• Inventories
How does a firm get the money to buy and
hold these current assets?

In part it will come from borrowed money

in the form of overdrafts and creditors, also
known as trade payables (current
liabilities).
Current liabilities include :
• Bank loans
• Accounts payable (creditors)
• Dividends (due in the short-term)
• Taxes (due in the short-term)
Current liabilities represent amounts that are
owed by the business and which are due to be
paid within the next twelve months. Current
liabilities are normally settled from the
amounts available in current assets.
Borrowing all the money needed to fund
current assets is unwise because :

• The liabilities have to be paid back

(possibly at short notice)
• It leaves no spare working capital to buy
additional stocks or extend further
credit to customers
Working capital is the difference between
the current assets of a business and its
current liabilities.
How much working capital is needed?

A firm needs sufficient working capital to

be able to cover its current liabilities.

Too much working capital means that cash

is tied up unnecessarily when it could be
used for another purpose (invested
perhaps? Remember opportunity cost.)
The amount of working capital needed
depends on the length of the firm’s working
capital cycle.
The working capital cycle is the period of time
between the point at which cash is first spent
on production of a product and the final
collection of cash from a customer.
The longer the time period from buying stock
to receiving payment from customers, the
more working capital will be needed.
A permanent increase in working capital
As a business expands it will need higher
inventory levels and the value of products sold
on credit is likely to increase. This means that
the amount of working capital used by the firm
increases and this increase is likely to be
permanent. The finance required to fund this
will therefore also need to be permanent or
long-term – matching needs for finance with
sources of finance. A long-term source might be
a long-term bank loan while a permanent source
could be share capital (sale of shares).
Managing working capital
To manage working capital the assets and liabilities of
which it is composed must be managed. This includes :
Managing inventory
• Holding lower levels of inventory
• Using IT to track inventory and reorder
automatically
• Manage inventory to minimize losses through
damage, wastage and shrinkage
• Perhaps use just-in-time inventory management
• Deliver goods to customers quickly so that
payment is received sooner
Managing trade payables (inventory bought
from suppliers on credit)
• Delaying payment to suppliers (by
agreement?) to increase the credit period
• Only buy goods from suppliers who offer
credit
Managing trade receivables (goods sold to
customers on credit)
• Sell for cash only; no credit offered
• Reduce the credit period offered to
customers
Capital and
revenue
expenditure
Capital and revenue expenditure
The cash spent on investment in a
business is normally referred to as
"capital expenditure".
This can be contrasted with spending
on day-to-day operations (e.g. paying
for materials, staff costs) which is
known as "revenue expenditure".
Capital expenditure
Capital expenditure refers to the
purchase of assets that are expected to
last for more than a year, such as
buildings or machinery (cash spent on
investment).
Revenue expenditure

Revenue expenditure refers to

spending on all costs and assets other
than fixed assets. It includes wages
and salaries and materials bought for
stock (spending on day-to-day
operations).
Sources of
finance
An appropriate source of finance depends
on various factors, including the form of
business ownership.

Sole traders and partnerships cannot sell

shares to raise finance while private and
public limited companies can.
Finance for limited companies
Companies can raise finance from :
• Internal sources
• External sources

Sources of finance can also be

classified as short- and long-term
finance.
Internal sources of finance refer to finance
raised from the business’s own assets or
from profits left in the business (retained
profits).

External sources of finance refers to

finance raised from sources outside the
business, such as banks.
Internal sources of finance
Internal sources of finance are raised from within
the business, and include :

Retained Sale of unwanted

earnings assets

Sale and lease-

back of non- Working capital
current assets
Retained profits – this is profit held in the
company after tax and dividends have been
paid, as a source of internal finance. It can
be used for expansion or other forms of
investment in the business and, as such,
becomes a permanent source of finance
(i.e. will not be paid back to shareholders).

A start-up firm or one that is losing money

will not have retained profits.
The sale of assets – assets that are no
longer of use to the firm can be sold to
raise funds.
The sale and leaseback of non-current
assets - assets, which the firm still uses, can
be sold to another business and leased
back for continued use. This means that
the business has raised finance but it will
have to pay additional fixed costs (rental
and leasing costs).
Reduction in working capital
Holding more stocks or giving customers
more credit uses working capital.
Reducing inventories or the credit offered
to customers releases working capital that
can then be used elsewhere.
However reducing current assets in this
way will affect the firm’s liquidity (its ability
to pay current debts).
Evaluation of internal sources of finance
Internal sources of finance have a number of
advantages :
There is no cost to the business as interest is not paid
on it and the finance does not have to be repaid

It does not increase the liabilities or debts of the

business

There is no risk of loss of control of the firm as a result

of using internal finance
Internal sources of finance also have
limitations :
Internal sources of finance are not
available to all companies.

Relying solely on internal finance can

result in slow growth.

Companies that want to expand quickly

will have to use external finance.
Activity 28.3 (page 422)

a Lower retained profit as a result of losses, value of

assets available to raise finance through sale and
leaseback fallen.

b Insufficient retained profit and reserves due to

amount of finance required. Lack of cash due to
potential overtrading.

c Cash flow problems as cash has gone out of the

business but will not start to flow in until during the
festival.
External sources of finance
External sources of finance are funds raised
from outside the business, which may be
divided into :
• Short term sources such as bank overdrafts,
or loans, creditors and debt factoring
• Long term sources such as leasing, hire
purchase, share issues, debentures, loans,
grants and venture capital
Evaluation of short-term sources of
external finance :
Bank
overdrafts

Trade credit

Debt
factoring
Evaluation of bank overdrafts :
• Flexible – the amount can vary from day
to day
• Must be agreed in advance with the
bank and has a limit
• Often attracts high interest charges
• The bank can recall the overdraft at
short notice
Evaluation of trade credit :
• It is a free form of borrowing in that no
interest is paid
• However, the firm may lose out on
discounts for prompt payment (which
would be a form of cost)
• The firm may also damage its reputation
with its suppliers
Evaluation of debt factoring :
A firm can sell its trade receivables to another
firm called a debt factor. The debts will be sold
for less than their full value that means that the
firm gets less than it is owed but it will get cash
immediately.
The alternative is to insist that debtors pay up, or
credit terms are shortened, or cancelled, which
can lead to customers turning to competitors for
their purchases.
Evaluation of long-term sources of
external finance :
• Hire purchase
• Leasing
• Long-term bank loans
• Debentures
• Mortgages
• Share, or equity, capital
• Government grants
• Venture capital
Hire purchase
Hire purchase is an arrangement where the
buyer pays a deposit and then pays the balance
of the purchase price, plus interest, in
instalments.
With this kind of agreement, ownership is not
usually transferred to the purchaser until all
payments are made.
Hire purchase agreements are usually more
expensive in the long run than purchasing an
item outright.
Leasing
Leasing an asset means that the firm has the
use of that asset and pays a rental or leasing
charge over a fixed period. The firm does
not have to raise long-term capital to buy
the asset. Usually the leasing company will
repair or update the asset when necessary.
Like hire purchase, this is not a cheap option
but it will improve short-term cash flow.
Debt finance

Debt finance means borrowing money from

an outside source with the promise of
paying back the borrowed amount at a
later date, plus the agreed-upon interest,
paid at agreed upon dates.
It includes long-term loans (longer than 12
months) from the bank.
Long-term loans from the bank can have a
variable or a fixed interest rate.
In order to obtain the loan the business will have
to offer some form or collateral – an asset that
can be sold to repay the loan if the company
cannot make its payments.
Small businesses can apply to government
‘guaranteed loan schemes’ which means their
repayments are guaranteed (fully or in part) and
the bank has more security.
Debentures
Debentures (long-term bonds) are a long-
term source of finance where a company
gives its creditor (or lender, the person
buying the debenture) a document or
debenture, showing the terms of the loan.
The debenture shows when the capital sum
will be repaid and how much interest will
be paid.
No collateral security is required and
debenture holders can sell their debentures
to someone else if they need the money
before the debenture is due.

Convertible debentures can be converted

into shares after a certain period of time.
This means that the business will never
have to pay back those converted
debentures.
Mortgage
A mortgage is an old French word meaning
“death pledge”.
Mortgages are specific loans given for the
purpose of buying premises (property) The
interest rate can be fixed or variable and
the property will act as collateral for the
loan.
Equity finance (or equity capital)
Equity financing means raising capital by
selling shares of a business to investors.
This capital is permanent because it does
not have to be paid back, unless the
company closes down.
It is used to purchase assets.
Equity financing for public limited companies
• Public limited companies sell shares on the
stock exchange to the public.
• It is expensive to be listed on the stock
exchange but allows the company to raise
large amounts of finance.
• Once the initial offer of shares has been
sold the company can raise more finance
with a RIGHTS ISSUE of shares.
• The short-term effect of a rights issue may
be a fall in the share price.
A rights issue refers to shareholders being
given the right to buy additional shares at a
discounted price.

If all shareholders take up their rights in the

new issue then ownership in the company
will not have changed.
Equity financing for private limited companies
• Private limited companies can sell shares to
family and friends.
• This will raise a smaller amount of finance
than a public limited company is capable of.
• A private limited company may decide to
become a public limited company if it needs
more finance.
• Selling more shares in a company may result
in the original owners losing control if another
person buys more shares that the owners
have.
Owners of private limited companies have an
option to sell shares to the public to raise more
capital, although they will risk losing control of
the company.
They can either apply for a full listing on the
stock exchange, in other words, go public, or, in
the UK, they can be listed on the Alternative
Investment Market (AIM) that is a sub-market of
the London Stock Exchange. Other countries
may have similar markets.
The Alternative Investment Market is
designed to help smaller, more risky,
companies access capital from the public
market.

AIM allows these companies to raise capital

by listing on a public exchange with much
greater regulatory flexibility compared to
the main LSE stock market.
Remember that the finance supplied
by shareholders, when they buy shares
in a business, is a form of EXTERNAL
finance for the business.
The shareholders are the owners of
the company but the company is a
separate legal unit and therefore
shareholders are suppliers of external
finance.
 Advantages of debt financing Advantages of equity financing

Ownership is not at risk It is permanent capital and does

not have to be repaid (unless the
firm closes down)
Loans will be repaid in due course Dividends do not have to be paid
so there is no permanent increase but interest does
in liabilities
Lenders have no voting rights at
AGMs

Interest is an expense so it reduces

taxable profit but dividends are
paid after tax
Gearing increases the chance of
higher returns in the future
Other sources of long-term external
finance include :
Grants

Business angels

Venture capital
Grants
A grant is a fixed amount of money usually
awarded by the government or charitable
organisations, often to start-ups or small
businesses.
Grants are given to a business with certain
conditions e.g. they relocate and provide
jobs in an area of high unemployment.
Grants do not have to be repaid.
Business Angels
Smaller amounts of company finance
($10,000 to $250,000) may be difficult to
obtain from traditional sources such as
banks and venture capitalists. Banks
generally require security and most
venture capital firms are not interested in
financing such small amounts. In these
circumstances, companies often have to
turn to "Business Angels".
Business angels are wealthy,
entrepreneurial individuals who
provide capital in return for a
proportion of the company equity.
They take a high personal risk in the
expectation of owning part of a
growing and successful business.
Venture capital
Venture capital is money that investors
provide to a company that is starting
up or expanding.
Venture capital, from specialist
organisations or wealthy individuals, is
usually used when there is an element
of risk with the business.
Venture capital
• Venture capitalists may want a share
of the business (ownership or
profits) meaning some control may
be lost
• A larger return may be required due
to the high risk nature of the
investment
Reminder - incorporated businesses are
businesses where :
• There is a legal difference between the
business and the owners
• The company has a separate legal identity
• Owners (shareholders) have limited
liability
• Private and public limited companies are
incorporated companies
• They can raise finance by selling shares
Reminder - unincorporated businesses are
businesses where :
• The owner is the business – there is no
legal difference
• Owners have unlimited liability for the
business (including its debts)
• Most unincorporated businesses operate as
sole traders
• A small number operate as partnerships
• They cannot raise finance by selling shares
 Finance for
UNINCORPORATED
businesses
Unincorporated businesses can raise funds
through :
• Bank overdrafts and loans
• Credit from suppliers
• Loans from family and friends
• Owners’ savings and profits
• Taking on more partners to inject further
capital
• Grants
• Micro-finance
• Crowd funding
Top tip

When answering case study

questions, where necessary, analyse
the type of legal structure of the
business and what sources of finance
are available to it.
Microfinance
Microfinance is a banking service provided to
unemployed or low-income individuals or groups
who otherwise would have no other access to
financial services.
Microfinance allows people to take on small
($20?) business loans safely, and in a manner
that is consistent with ethical lending practices.
The majority of microfinancing operations are
found in developing (low-income) nations.
Microfinance
Like conventional lenders, micro financiers
charge interest on loans and institute specific
repayment plans. The World Bank estimates that
more than 500 million people have benefited
from microfinance-related operations.
Crowd funding

Crowdfunding refers to the use of small

amounts of capital from a large
number of individuals to finance a new
business venture.
Crowdfunding is not new but has become very
popular with the advent of social media and the
Internet.
Crowdfunding is used to raise large amounts of
money to fund a new project, or for charity. It
involves getting small amounts of finance from a
large amount of people that is usually done
through social media or crowd funding websites.
Various platforms (Kickstarter, Fundanything) are
used to contact millions of potential investors via
the internet.
Crowd funding investors may:
• donate money
• get rewards for their investments
• get their initial capital back, plus
interest (peer-to-peer lending)
• receive a share of the profits
Advantages of crowdfunding :
• No initial fees are paid but if the money is
raised then the platform charges a % fee.
• Entrepreneurs have access to a large
number of potential investors
• The crowdfunding campaign can be used
as a way of testing people’s reaction to
the business idea – no funding will
indicate no interest in the idea.
Advantages of crowdfunding :
• It is a fast way to raise large sums of
money.
• It can be used by entrepreneurs when
traditional sources of funds (bank loan)
are not available.
Disadvantages of crowdfunding :
• The crowdfunding platform can reject a
proposal.
• Idea could be stolen by competitors
once the crowdfunding campaign starts.
• If the total amount required is not raised
then the promised finance must be
repaid.
• Media interest and publicity is
important to improve the chances of
success.
Activity 28.6 (page 426): Financing small business start-ups

1 High risk, lack of experience, possibly poor business

plan or none at all.

2 Only requires small sum, scheme encourages

entrepreneurship; however, interest rates may be high,
he may take risks in a venture that is not a good idea.

3 Requires larger amount of investment for a business

start-up; crowd funding would allow many investors to
risk a small contribution therefore more willingness to
invest. Serena’s idea is high-risk but could be high-
reward.
 Factors
affecting the
source of
finance
Factors affecting the choice of finance

The choice of a source of finance can

have a significant impact on the future
growth and profitability of a business
as well as on who has control over the
business.
Factors affecting the choice of finance
Factors to consider include :
• What the finance is being used for
• Cost of finance
• Amount of finance required
• The legal structure of the business and the
need to retain control
• The size of existing loans
• The flexibility required
Factors affecting the choice of finance
What the finance is being used for :
• The source of finance should be matched
to the need for finance. It is not a good
idea to borrow long-term to pay short-term
needs.
• Permanent capital may be best suited to
long-term expansion
• Short-term finance (overdraft?) suits needs
such as paying creditors or increasing
stocks
Factors affecting the choice of finance
The cost of the finance :
• Internal finance comes with an
opportunity cost
• Interest is charged on external finance
• Raising funds through the sale of shares
on the stock exchange (flotation) is
extremely expensive
Factors affecting the choice of finance
The amount required :
• If large amounts are needed then share
issues or the sale of debentures would
be considered
• If small amounts are required then an
overdraft or reducing trade receivables
would be more appropriate
Factors affecting the choice of finance
The legal structure of the business and the
need to retail control :
• Share issues are only available to limited
companies. Only public limited
companies can sell on the stock
exchange
• If owners need to retain control of the
business then a shares issue may
present problems
Factors affecting the choice of finance
The extent of existing loans :
• The higher the existing debt
(borrowings) of a company (its level of
gearing), the more risky it is to lend it
more, and the less likely banks and
other lenders will be willing to do so.
Factors affecting the choice of finance
The need for flexibility :
• If the need for finance is variable,
perhaps due to a seasonal pattern of
sales, then a flexible form of finance is
likely to be more suitable than a long-
term or inflexible form. Overdrafts are a
flexible form of finance.