Business Finance Notes

Business Finance

Specific Learning Outcomes

• J1. Explain business situations which will require finance.
• J2. Analyse the advantages and disadvantages of the main internal and external sources of finance available to businesses.
• J3. Explain the factors influencing the choice of business finance, including an understanding of gearing.
• J4. Recommend appropriate source(s) of finance for a given situation.

Why Businesses Need Finance

• To finance expansions to production capacity.
• To develop and market new products.
• To enter new markets.
• Take-over or acquisition of businesses.
• Moving to new premises.
• To pay for the day to day running of business including working capital.

Business Finance Definitions

• Start-up capital: the capital needed by an entrepreneur to set up a business.
• Working capital: the capital needed to pay for raw materials, day-to-day running costs and credit offered to customers.
• In accounting terms, working capital = current assets - current liabilities.
  Working Capital = Current Assets - Current Liabilities
• Current assets: assets that either are cash or likely to be turned into cash within 12 months (inventory or trade receivables).
• Current liabilities: debts that usually have to be paid within one year.

Capital vs. Revenue Expenditure

• Capital expenditure: the purchase of assets that are expected to last for more than one year, such as building and machinery.
• Revenue expenditure: spending on all costs and assets other than fixed assets and includes wages and salaries and materials bought for stock.

Working Capital

• Working capital is often described as the ‘lifeblood’ of a business.
• Finance is needed by every business to pay for everyday expenses, such as the payment of wages and buying of stock.
• Without sufficient working capital a business will be illiquid – unable to pay its immediate or short-term debts.
• What happens in cases such as this?
  • Either the business raises finance quickly – such as a bank loan – or it may be forced into ‘liquidation’ by its creditors.
• Liquidity: the ability of a firm to be able to pay its short-term debts.
• Liquidation: when a firm ceases trading and its assets are sold for cash to pay suppliers and other creditors.

Importance of Working Capital

• Sufficient working capital is essential to prevent a business from becoming illiquid and unable to pay its debts.
• Too high a level of working capital is a disadvantage; the opportunity cost of too much capital tied up in inventories, accounts receivable and idle cash is the return that money could earn elsewhere in the business – invested in fixed assets, perhaps.

Working Capital Cycle

• The working capital requirement for any business will depend upon the length of this ‘working capital cycle’.
• The longer the time period from buying materials to receiving payment from customers, the greater will be the working capital needs of the business.
• Credit to customers given by the business will lengthen the time before a sale is turned into cash.
• Credit received by the business will lengthen the time before stock bought has to be paid for.
• To give more credit than is received is to increase the need for working capital. To receive more credit than is given is to reduce the need for working capital.

Simple Working Capital Cycle

• The longer this cycle takes to complete, the more working capital will be needed.

Choosing the Right Source of Finance

• What SEVEN factors might influence the type of finance chosen by a company?
  • Type of business.
  • Existing levels of debt.
  • Amount of money required
  • How quickly the money is needed
  • The cheapest option available
  • The amount of risk involved in the reason for the cash.
  • The length of time of the requirement for finance.

Sources of Finance

• Companies are able to raise finance from a wide range of sources.
• It is useful to classify these into:
  • Internal sources: raising finance from the business’s own assets or from profits left in the business (retained earnings).
  • External sources: raising finance from sources outside the business, for example banks.

Time Periods for Finance

• Finance is generally considered to be either:
  • SHORT TERM: UP TO 3 YEARS
  • MEDIUM TERM: 3-10 YEARS
  • LONG TERM: OVER 10 YEARS

Internal Sources of Finance

• Profits retained in the business
  • If a company is trading profitably, some of these profits will be taken in tax by the government (corporation tax) and some is nearly always paid out to the owners or shareholders (dividends). If any profit remains, this is kept (retained) in the business and becomes a source of finance for future activities.
• Sale of assets
  • Established companies often find that they have assets that are no longer fully employed. These could be sold to raise cash.

Internal Sources of Finance: Sale and Leaseback

• Sale and leaseback of non-current assets
  • Some business will sell non-current assets that they still intend to use, but which they do not need to own.
  • The assets could be sold to specialist financial institution and leased back by the company.
  • This will raise capital, but the lease payments becomes an additional fixed cost.
  • Non-current assets: assets kept and used by the business for more than one year.

Internal Sources of Finance: Reductions in Working Capital

• Reductions in working capital
  • When businesses increase stock levels or sell goods on credit to customers (trade receivables), they use a source of finance.
  • When companies reduce these assets – by reducing their working capital – capital is released, which acts as a source of finance for other uses.
  • There are risks in cutting down on working capital, however.
  • Cutting back on current assets by selling inventories or reducing debts owed to the business may reduce the firm’s liquidity – its ability to pay short-term debts – to risky levels.

Internal Sources of Finance: Evaluation

• This type of capital has no direct cost to the business, although if assets are leased back once sold there will be leasing charges.
• Internal finance does not increase the liabilities or debts of the business, and there is no risk of loss of control by the original owners as no shares are sold.
• However, it is not available for all companies, for example newly formed ones or unprofitable ones with few ‘spare’ assets.

Internal Sources of Finance: Evaluation (Cont.)

• Solely depending on internal sources of finance for expansion can slow down business growth, as the pace of development will be limited by the annual profits or the value of assets to be sold.
• Internal finance tends to be the cheapest form of finance since a business does not need to pay interest on the money.
• However, it may not be able to generate the sums of money the business is looking for, especially for larger uses of finance.

External Sources of Finance: Short-Term

• There are three main sources of short-term external finance:
  • bank overdrafts
  • trade credit
  • debt factoring

External Sources of Finance: Bank Overdrafts

• Bank overdrafts
  • A bank overdraft is the most flexible of all sources of finance.
  • This means that the amount raised can vary from day to day, depending on the particular needs of the business.
  • The bank allows the business to ‘overdraw’ on its account at the bank by writing cheques or making payments to a greater value than the balance in the account.
  • Businesses may need to increase the overdraft for short periods of time if customers do not pay as quickly as expected or if a large delivery of stocks has to be paid for.
  • This form of finance often carries high interest charges.

External Sources of Finance: Trade Credit

• Trade credit
  • By delaying the payment of bills for goods or services received, a business is, in effect, obtaining finance.
  • Its suppliers, or creditors, are providing goods and services without receiving immediate payment and this is as good as ‘lending money’.
  • The downside to these periods of credit is that they are not free – discounts for quick payment and supplier confidence are often lost if the business takes too long to pay its suppliers.

External Sources of Finance: Debt Factoring

• Debt factoring
  • When a business sells goods on credit, it creates trade receivables.
  • The longer the time allowed to pay up, the more finance the business has to find to carry on trading.
  • One option is to sell these claims on trade receivables to a debt factor.
  • In this way immediate cash is obtained, but not for the full amount of the debt.
  • This is because the debt-factoring company’s profits are made by discounting the debts and not paying their full value.
  • When full payment is received from the original customer, the debt factor makes a profit.

External Sources of Finance: Medium-Term

• There are two main sources of medium-term external finance:
  • hire purchase and leasing
  • medium-term bank loan

External Sources of Finance: Hire Purchase and Leasing

• Hire purchase: an asset is sold to a company that agrees to pay fixed repayments over an agreed time period – the asset belongs to the company once the final payment has been made.
• Leasing: obtaining the use of equipment or vehicles and paying a rental or leasing charge over a fixed period, this avoids the need for the business to raise long-term capital to buy the asset; ownership remains with the leasing company. The risk of using unreliable or outdated equipment is reduced as the leasing company will repair and update the asset as part of the agreement.

External Sources of Finance: Long-Term

• The two main choices here are debt or equity finance.
  • Debt finance: increases the liabilities of a company. Debt finance can be raised in two main ways:
    • long-term loans from banks
    • debentures (bonds issued by companies to raise debt finance, often with a fixed rate of interest.).
  • Equity finance: permanent finance raised by companies through the sale of shares.

External Sources of Finance: Long-Term Bank Loans

• Long-term loans from banks
  • These may be offered at either a variable or a fixed interest rate.
  • Fixed rates provide more certainty, but they can turn out to be expensive if the loan is agreed at a time of high interest rates.
  • Companies borrowing from banks will often have to provide security or collateral for the loan; this means the right to sell an asset is given to the bank if the company cannot repay the debt.
  • Businesses with few assets to act as security may find it difficult to obtain loans – or may be asked to pay higher rates of interest.

External Sources of Finance: Long-Term Bonds or Debentures

• Long-term bonds or debentures
  • A company wishing to raise funds will issue or sell such bonds to interested investors.
  • The company agrees to pay a fixed rate of interest each year for the life of the bond, which can be up to 25 years.
  • The buyers may resell to other investors if they do not wish to wait until maturity before getting their original investment back.
  • Long-term loans or debentures are usually not secured on a particular asset.
  • When they are secured, which means that the investors have the right if the company ceases trading to sell that particular asset to gain repayment, the debentures are known as mortgage debentures.

External Sources of Finance: Sale of Shares – Equity Finance

• Sale of shares – equity finance
  • All limited companies issue shares when they are first formed. The capital raised will be used to purchase essential assets.
  • In the UK, this can be done in two ways and these are quite typical for many countries:
    • Obtain a listing on the Alternative Investment Market (AIM).
    • Apply for a full listing on the Stock Exchange.
  • Rights issue: existing shareholders are given the right to buy additional shares at a discounted price.

External Sources of Finance: Evaluation of Debt Finance

• Debt finance has the following advantages:
  • As no shares are sold, the ownership of the company does not change.
  • Loans will be repaid, so there is no permanent increase in the liabilities of the business.
  • Lenders have no voting rights at the annual general meetings.
  • Interest charges are an expense of the business and are paid out before corporation tax is deducted, while dividends on shares have to be paid from profits after tax.
  • The gearing of the company increases and this gives shareholders the chance of higher returns in the future.

External Sources of Finance: Evaluation of Equity Capital

• Equity capital has the following advantages:
  • It never has to be repaid; it is permanent capital.
  • Dividends do not have to be paid every year; in contrast, interest on loans must be paid when demanded by the lender.

Other Sources of Long-Term Finance

• Grants: A grant is an amount of money that a government or other institution gives to an individual or to an organization for a particular purpose.
• Venture capital: risk capital invested in business start-ups or expanding small businesses that have good profit potential but do not find it easy to gain finance from other sources.

Finance for Unincorporated Businesses

• Unincorporated businesses (sole traders and partnerships) cannot raise finance from the sale of shares.
• Owners of these businesses will have access to bank overdrafts, loans and credit from suppliers. They may borrow from family and friends, use the savings and profits made by the owners and, if a sole trader wishes to do this, take on partners to inject further capital.
  • Microfinance: providing financial services for poor and low-income customers who do not have access to banking services, such as loans and overdrafts offered by traditional commercial banks.
  • Crowd funding: the use of small amounts of capital from a large number of individuals to finance a new business venture

Sources of Finance - Limited Companies

• Internal:
  • Retained profit
  • Sales of assets
  • Reductions in working capital
• External:
  • Short term:
    • Bank overdraft
    • Bank loan
    • Creditors
    • Factoring
  • Medium term:
    • Leasing
    • Hire purchase
    • Medium-term loan
  • Long term:
    • Share issue
    • Debentures
    • Long-term loan
    • Grants

Sources of Finance: Overdraft vs. Loan

• A bank overdraft is a limit on borrowing on a bank current account. With an overdraft the amount of borrowing may vary on a daily basis.
• A bank loan is a fixed amount for a fixed term with regular fixed repayments arranged well in advance of needing the money!
• The interest on a loan tends to be lower than an overdraft

Gearing

• Gearing measures the degree to which the capital of the business is funded from long-term loans.
• Gearing: the relationship or ratio of a company’s dept-to-equity (D/E).
  Gearing = Debt-to-Equity (D/E)

Gearing: Measures of Financial Health

• Gearing is one of the main measures of financial health of a business – it measures the firm’s level of debt.
• Gearing measures long-term liabilities as a proportion of a firm’s capital employed.
• It shows how reliant a firm is on borrowed money.
• The Americans call gearing “leverage”.
• If a company has high leverage ratios, it can be thought of as being highly geared.
• The appropriate level of gearing for a company depends on its sector and the degree of leverage of its corporate peers.

Gearing: Calculation

• How to calculate
  • Long-term liabilities include loans due more than one year + preference shares + mortgages
  • Capital employed = Share capital + retained earnings + long-term liabilities

Suitability of Different Sources of Finance

• Different sources of finance are suited to different business contexts, for example, start-up businesses, businesses experiencing cash flow issues, and expanding businesses.

Start-up business

• owner’s capital – owners are likely to use their own money to start the business.
• family and friends – often provide new business owners with finances.
• a bank loan – could be difficult to get, but is possible with a detailed business plan.
• venture capital and business angels – may be willing to take the risk on a new business.
• trade credit – can be used to help a start-up business spread its costs.
• leasing and hire purchase – are both used by new businesses to spread costs on equipment, otherwise may not be able to afford.
• government grants may be used if a business fits the criteria

Cash flow issues

• owner’s capital – owners are likely to use their own money to cover some of the debts.
• family and friends – may help out in difficult financial times.
• bank loan – could be difficult to get, but is possible with a detailed business plan.
• overdraft – this will allow the business to gain some temporary finances.
• share issue – this could be used to sell off part of the business to raise finance.
• trade credit – can be used to help delay some business costs.
• selling assets – may be used as a last resort to gain money.

Expansion

• retained profit – an expanding business will likely have some spare profit they can use to invest.
• bank loan – could be used to provide money to grow the business.
• venture capitalists and business angels – they will look for opportunities to invest in growing businesses to help maximise their financial returns.
• share issue – this could be used to sell off part of the business to raise finance.
• new partners – a business may invite new partners to invest and help them grow the business.

Activity – True or False

• Loans usually have higher interest payments than overdrafts. (False)
• Share capital is a good short-term source of finance. (False)
• The larger and the more successful the business, the easier it is likely to be for it to raise finance. (True)
• Sale of assets is an external source of finance. (False)

Activity: Multiple Choice

• Which of the following is an internal source of finance?
  • B. Sale of surplus assets
• Finance sourced directly from a firm’s activities is known as?
  • D. Internal
• A key difference between a bank loan and bank overdraft is
  • C. Has fixed repayment and interest
• What does sources of finance mean?
  • b. Where businesses get money from to fund their business activities
• What are the two main categories of sources of finance?
  • a. Internal and external
• Which of these is the correct definition of trade credit?
  • c. Trade credit is an agreement with a supplier to pay bills at a later date
• Which of the following is a disadvantage of an overdraft?
  • b. Usually has a high interest rate
• Which source of finance leads to a dilution of ownership?
  • b. Share capital
• Which of the following sources of finance incurs interest?
  • c. Bank loan
• Which type of finance is not appropriate for a new start-up business
  • c. Share issues
• What is retained profit?
  • a. Where business profits are reinvested back into the business
• Which of the following is not a type of internal finance?
  • c. Family and friends
• What is an advantage of a bank loan?
  • a. Can get a significant amount of money at one time