Business Finance

Why does a business require finance?

• To buy machinery, capital equipment while set-up of the business. It is
called start-up capital
• To fund its day-to-day expenditure. It is called working capital
• While business expansion
• Needed to merge/acquire other businesses
• Unforeseen expenses and difficulties
• Fund research and development
Types of Expenditure
Capital expenditure
• Long term spending (more than one year) like purchase of assets
Revenue expenditure
• Short term, day-to-day expenditure like wages, salaries, insurance
Working Capital
Start up capital
Finance the founder of the business/entrepreneur requires in order to purchase
necessary factors of production to set up their business.
Working capital
• It is the finance required to pay for day-to-day expenses
• It is the lifeblood of the business
• Without sufficient working capital, a business will become illiquid (cannot
repay its short-term debts)
• Working capital = current assets - current liabilities
How much working capital is required?
• Too high of working capital leads to opportunity cost of too much capital
being tied up and can be used elsewhere
• Working capital requirement of a business is determined by its working
capital cycle
• Longer the cycle, greater the amount required
Managing working capital
• Maintain smaller inventory level to minimize costs and storage needs.
• Track sales and inventory via computer system, and automate reordering.
• Prevent losses from damages and wastage by efficient inventory handling
and control.
• Reduce working capital tied up in inventory by using Just in time production
system.
• Ensure delivery of product is done as fast as possible to customers to speed
up payment.
Businesses also have trade receivables and payables.
Trade payables can be managed by:
• Delay payments to suppliers to lengthen the credit period.
• Choose suppliers that offer credit terms, preferably the one who offers the
longest window.
Trade receivables can be managed by:
• Sell products only by cash payment to avoid credit risks.
• Decrease the credit period offered to customers to improve cash flow.
Internal sources
1. Profits retained in the business
• The retained earnings of a business can be used as a source of finance to
fund expansion, purchase of assets
• These do not have to be repaid and are a permanent source of finance
• But they may not be enough and new businesses may not have this option
2. Sale of assets
• Assets which are no longer needed/fully employed can be sold in order to
get funds
• It will help raise permanent capital for the business
• They can be sold to a leasing company and leased back for business use.
But, through this fixed cost will rise
• Also, these assets could have been used as collateral or be used during
future expansions
3. Reductions in working capital
• Lowering the amount tied up in working capital may free up some money to
be used elsewhere
• It will help reduce the opportunity cost of tying up money in current assets
like inventories and trade receivables
• But this may negatively affect the company’s liquidity position, affecting
stakeholders like potential investors, bankers, etc
External sources
Short term sources
1. Bank overdrafts
• Most flexible
• The bank allows the business to overdraw its account
• High interest rates
• Bank can ask the business to repay anytime
2. Trade credit
• The business can lower the credit period provided to trade receivables and
ask for greater period from trade payable
• Customers may switch to competitors if they provide greater credit period
• Suppliers may not provide discounts
3. Debt factoring
• This involves selling of a company’s trade receivable claims to a debt factor
for immediate money
• Lowers risk for the business
• Full amount is not given
Medium-term sources
1. Hire purchase
• It is a way of purchasing an asset for credit where money is paid in
instalments over the time
• It helps avoid large initial cash payment
• Ownership of asset is obtained
2. Leasing
• It allows a business to obtain the use of an equipment by paying a fixed
rental charge, instead of buying the asset
• Leasing company is responsible for maintenance and repairs
• No ownership is gained, can’t be used as collateral during bank loans
3. Medium-term bank loan
Long term sources
1. Long-term bank loans
• Maybe given for fixed/varying interest rates
• Fixed provide greater certainty but maybe more expensive
• Companies will have to provide collateral/security to obtain the loan
• They require a business plan and cash flow forecast
2. Debentures
• A company can issue bonds to potential investors and pay a fixed rate of
interest for the life of the bond
• No collateral security is required
Sale of shares – equity finance
• Limited companies issue shares when first formed and use it to purchase
necessary assets
• They can sell shares anytime required up to a limit of their authorised
capital
• It is a method of permanent finance
• Way to sell shares:
o Public issue by prospectus: company advertises its share sale and
invites interested people to apply for them. It is very expensive
o Arranging a placing of shares with institutional investors without the
expense of a full public issue: this is done by the means of a rights
issue. The short-term share price falls which reduce shareholders
confidence
Debt or equity capital – evaluation
• Debt finance benefits:
o Ownership is not diluted
o No permanent increase in liabilities as the loans will be repaid
o Lenders have no voting rights
o Interest is paid before corporation tax
• Equity benefits:
o Never needs to be repaid
o Dividends must be paid whenever the business has enough profits
Other sources of long-term finance
1. Grants
• Grants may be given with certain conditions up on number of jobs, location,
etc
• They do not need to be repaid
2. Venture capital
• It is the risk capital invested by wealthy individuals in business start-ups
which have good profit potential but can’t find other sources of finance
• Venture capitalists provide advice for the business owners
• But they may expect a part of ownership in the business
Finance for unincorporated businesses
• Unincorporated = sole trade & partnership
• Can not raise finance from the sale of shares
• Unsuccessful in raising finance through sale of debentures
• Sources of finance –
o Overdrafts
o Loans
o Credit from suppliers
o Borrow from friends and family
o Own savings
o Grants
o Crowdfunding
o Microfinance
Microfinance
• Involves selling financial services to poor, low-income customers or small
businesses who do not get finance from banks
• High interest rates
Crowd-funding
• Crowdfunding websites allow entrepreneurs to promote their business and
encourage individuals to each invest a small amount
• Effective form of promotion
• Investors may expect a return on investment
• Investors, when the business is successful will receive: initial capital plus
interest, equity stake in the business
• Must keep accurate records of thousands of investors
• Increased risks of idea being copied
Importance of business plan
• Business plan is a detailed document giving information about a business to
convince external stakeholders to lend money to the business
• Helps gain loans and credit facilities
• Helps lower risks
Financial Stakeholders
Making the decisions – factors influencing finance choice
Choosing the right finance source is utmost important for long-term success.
Costly or inflexible sources, or those that can be withdrawn quickly, can harm the
business harshly. Finance managers must carefully evaluate options before making
decisions. The factors influencing such decisions are the following:

Why finance is required and time period Costs

when it is needed

Avoid using long-term finance for short- No finance source is free to obtain,
term needs to minimize risk and cost. including internal finance, due to
opportunity costs.

Use permanent capital, like issuing shares, Rising interest rates can increase the
for long-term expansion or research projects cost of loans.
for long term finance.
Why finance is required and time period Costs
when it is needed

Go for short-term finances to address Listing a new public company in the

immediate needs such as increasing Stock Exchange can incur high fees and
inventory or paying creditors. promotional costs.

Once equity finance has been raised.

Dividends are not tax-deductible, unlike
loan interest