Business Finance Study Notes

5.1 Business Finance Cambridge (CIE) IGCSE Business

Contents

  • The Need for Business Finance

  • Internal and External Sources of Finance

  • Short-Term and Long-Term Sources of Finance

  • Choosing the Best Type of Finance

The Need for Business Finance

Why do businesses need finance?

  • Purpose of Finance: All businesses require finance for various reasons, including starting up, growth, and the funding of ongoing operations.

  • Capital Definition: The money required to start and run operations is typically referred to as 'capital'.

1. Starting a Business

  • Start-up Capital: This is the initial finance necessary for a new business to acquire fixed and current assets before it can commence trading.

    • Businesses estimate their start-up capital in a business plan.

    • Example of Start-up Loans: Many small businesses obtain start-up loans to cover initial expenses.

2. Expanding a Business

  • Growth Financing: As businesses expand, they require additional finance for capital expenditures.

    • This can include purchasing more equipment, buildings, IT infrastructure, or vehicles to enhance output.

    • Research and Development Costs: For product development, significant capital investment is necessary.

    • Example: Apple's research and development expenditure in 2023 amounted to $29.915 billion, representing a 13.96% increase from 2022, heavily focusing on AI and product innovation.

3. Working Capital

  • Operational Finance: Working capital is vital for day-to-day expenses (e.g., purchasing raw materials, paying wages, and utility bills).

    • Continuity of working capital flow is crucial for business operations.

    • Insufficient working capital can lead to cash flow problems, potentially resulting in business failure.

Distinction between Short-term and Long-term Finance

Short-term Financial Needs

  • Purpose: Short-term finance helps maintain a positive cash flow in various scenarios:

    • Addressing seasonal cash flow issues (e.g., poor weather affecting sales for specific products).

    • Bridging gaps from delayed customer payments, ensuring bills can still be paid.

    • Sourcing additional cash for unexpected order increases.

    • Example: An Etsy craft business utilizing an overdraft due to a sudden influx in demand.

Long-term Financial Needs

  • Purpose: Long-term finance is typically used to acquire fixed assets.

    • These assets are expensive and used over extended periods (e.g., a new factory installation).

    • Example: Investing more than £1 million into new production facilities which enhance output efficiency and product range.

Internal and External Sources of Finance

Internal Sources of Finance

  • Definition: Internal sources originate from within the business.

    • Examples include:

    • Owner's Capital: Personal savings introduced by the owner.

    • Retained Profit: Profits reinvested into the business, a cost-effective measure without borrowing fees.

    • Sale of Assets: Selling unneeded assets relieves financial pressure.

External Sources of Finance

  • Definition: External financing is sourced from outside the business.

    • Classification: Common forms include loans, share capital, and grants.

    • Owner's Capital: Owners may use personal savings or redundancy money to fund business operations.

    • Retained Profit: Profits held for reinvestment.

    • Sale of Assets: Assets can be sold and/or a sale-leaseback agreement may be arranged.

      • Example: Sainsbury’s discussed selling and leasing back a £500 million property in early 2023.

    • Sale of Stock: Reducing stock prices to raise emergency funds without overly disappointing customers.

Advantages and Disadvantages of Internal and External Finance

Internal Finance

Advantages

  • Often free from interest or additional costs.

  • No external parties influencing business decisions.

  • Can be organized quickly with little documentation.

Disadvantages

  • Opportunity cost of not using profits elsewhere.

  • May be insufficient to meet all business needs.

  • Less tax-efficient compared to external sources.

External Finance

Advantages

  • Availability of substantial funds for significant projects.

Disadvantages

  • Interest and fees can vary greatly among providers.

  • Possible loss of ownership (in cases of share issuance).

Short-Term and Long-Term Sources of Finance

Overview of Financing Types

Short-Term Sources:

  • Bank Overdraft: A facility allowing account holders to exceed their balance which is charged daily interest. Useful for immediate cash needs but can become costly.

  • Trade Credit: Agreement with suppliers to delay payment, aiding cash flow.

  • Debt Factoring: Selling accounts receivable to increase immediate cash.

Long-Term Sources:

  • Bank Loans: Typically over two to ten years; can be secured (against assets) or unsecured. Fixed repayment schedules are used.

  • Hire Purchase: Acquiring equipment through installment payments rather than an outright purchase.

  • Leasing: Renting equipment instead of purchasing, which does not require capital upfront but involves ongoing payments.

Choosing the Best Type of Finance

Factors to Consider

1. Purpose of Finance

  • Determine if finance is for assets, cash flow needs or operational costs.

2. Duration of Requirement

  • Identify if finance is needed short-term (under a year) or long-term.

3. Amount of Finance Required

  • Different methods may be needed based on the required amount.

Recommendations

Fixed Assets

  • Long-term sources (e.g., bank loans) are preferred.

Short-term Operational Costs

  • Options like short-term overdrafts are suitable for immediate cash needs.

Business Ownership Structure

  • Limited companies may issue shares while sole traders often rely on personal capital.

Case Studies and Examples

Example of a Limited Company

  • A successful limited company manufacturing wooden furniture might consider issuing shares for expansion into new markets, while also analyzing long-term bank loans as options for larger investments.

Example of a Sole Trader

  • A sole trader needing immediate cash to replenish stock could consider trade credit or an overdraft, weighing the advantages of each option in terms of cash flow management.

Examiner Tips

  • Analyze the advantages and disadvantages of financial sources in exams.

  • Understand how business ownership affects financing options available.

Income Statements and Financial Indicators

Importance of Profit

  • Profit Purpose: It serves as a vital indicator of business success and plays a longstanding role in attracting investment.

  • Profit Calculation:

    • Formula: Profit = Sales Revenue – Total Costs
      ext{Gross Profit} = ext{Sales Revenue} - ext{Cost of Sales}
      ext{Net Profit} = ext{Gross Profit} - ext{Expenses}

Financial Analysis Elements

  • Understanding profit differentiation:

    • Gross profit measures profitability before overheads.

    • Net profit reflects the overall financial health of the business, including all costs and fees.

Contrast with Cash Flow

  • Importance of cash: A profitable firm might face bankruptcy if cash is insufficient to cover short-term obligations, as observed in the closure of Lifestyle retailer Joules despite previous profits.

Financial Statements as Decision-Making Tools

Income Statement Features

  • An income statement encompasses revenue, expenses, profits over a certain time frame (typically annually).

  • Performance Indicators: Year-on-year comparisons can offer insight into operational changes and profitability trajectories.

Stakeholders and Their Interests

  • Different groups, from investors to creditors, assess financial health through these reports to determine their level of risk and potential returns.

Recommendations for Improvement

  • Upscaling sales through marketing, controlling costs, and optimizing stock management are strategies to enhance profit margins and overall health.