Business Finance: Needs and Sources - Vocabulary Flashcards

Business Finance: Needs and Sources – Study Notes

Overview

  • This chapter explains why businesses need finance, where it comes from, and how to choose appropriate sources of finance.
  • Main topics:
    • Why businesses need finance (start-up capital, expansion, working capital).
    • Internal vs external sources of finance.
    • Short-term vs long-term sources.
    • Alternative sources: micro-finance and crowdfunding.
    • Factors influencing financial choices (size, legal form, amount, time, existing loans).
    • How to justify and recommend suitable finance in given circumstances.
  • Finance departments responsibilities:
    • Recording all financial transactions (payments to suppliers, revenue from customers).
    • Preparing final accounts.
    • Producing accounting information for managers.
    • Forecasting cash flows.
    • Deciding which source of finance to use for different purposes within the business.

Key Definitions to Learn

  • Start-up capital: The finance required by a new business to pay for essential non-current (fixed) and current assets before it begins trading.
    • Note: cash flow in the early stages is crucial; lack of working capital before cash inflows can cause failure.
    • extStart−upcapital<br/>ightarrowextfinancefornon−currentassetsandinitialworkingcapitalext{Start-up capital} <br /> ightarrow ext{finance for non-current assets and initial working capital}
  • Working capital: Finance needed to pay day-to-day costs.
    • Also described as the firm’s short-term liquidity.
  • Capital expenditure (CapEx): Money spent on non-current (fixed) assets that will last more than one year.
    • extCapEx=extexpenditureonfixedassets(e.g.,buildings,machinery)ext{CapEx} = ext{expenditure on fixed assets (e.g., buildings, machinery)}
  • Revenue expenditure (OpEx): Money spent on day-to-day expenses not involving long-term asset purchases (e.g., wages, rent).
    • extOpEx=extrecurringoperatingcostsext{OpEx} = ext{recurring operating costs}

The Three Core Business Needs for Finance

  • Start-up capital: finance to launch a new business (buildings, land, equipment).
  • Capital to expand: finance to grow the business (larger buildings, more machinery, new product lines, research & development).
  • Additional working capital: finance to cover day-to-day needs (wages, materials, utilities).
  • Note on working capital: it is the business’s life blood; shortages can force closure even if profitable.

Internal vs External Sources of Finance

Internal Finance

  • From within the business itself.
  • Main examples:
    • Retained profits: profits kept after owners’ share; advantages: no repayment or interest; raised from within; disadvantages: new businesses have none, profits may be too low, reduces payments to owners (dividends).
    • Sale of existing assets: selling off assets no longer needed (e.g., redundant buildings, surplus equipment).
    • Advantages: better use of capital; does not increase debt.
    • Disadvantages: time to sell, amount not certain until sale; not available for new businesses (no surplus assets yet).
    • Sale of inventories (reducing inventories): lowers carrying costs and opportunity costs; potential risk to customer satisfaction if inventory is too low.
    • Owners’ savings: owners (sole traders/partners) inject personal funds; advantages: quick access, no interest; disadvantages: savings might be limited; increases owner risk due to unlimited liability.

External Finance

  • From sources outside the business.
  • Main forms:
    • Issue of shares (equities): available only to limited companies; permanent capital; no obligation to repay; no interest; but dividends payable after tax; ownership can shift as shares are sold; risk of dilution and loss of control; not available to sole traders/partnerships.
    • Note: Public limited companies (PLCs) can offer shares to the public; rights issues are common to maintain existing ownership proportions.
    • Bank loans: money borrowed from banks; repayable with interest; usually quick to arrange; fixed-term with varying lengths; larger loans often attract lower interest; risk: security/collateral may be required; personal security may involve the owner’s home.
    • Debentures: long-term loan certificates issued by limited companies; can be very long-term (e.g., up to 25 years); must be repaid with interest; similar risk to loans.
    • Factoring of debts: selling debtor claims to a factor for immediate cash (e.g., 90% of debt upfront); risk migrated to factor; drawback: you don’t receive 100% of debt value.
    • Micro-finance: small loans to poor people not served by traditional banks; often provided by specialized institutions (e.g., Grameen Bank); aims to support micro-entrepreneurs in developing economies.
    • Grants and subsidies from outside agencies (e.g., government): usually do not have to be repaid; sometimes come with conditions (strings attached such as location requirements).

Alternative Sources of Capital

  • Micro-finance: growing importance for small-scale entrepreneurs, especially in developing economies; examples and case studies show transformative impact.
  • Crowdfunding: raising money from a large number of people contributing small amounts via the internet (platforms like Kickstarter, Rocket Hub, FundAnything).
    • Benefits claimed: no initial platform fees; platform takes a commission only if funds are raised; rapid access to capital; tests public interest in the idea; no need for traditional institutions.
    • Drawbacks/risks: not suitable for very small sums; if target isn’t reached, funds may need to be repaid; platforms may reject proposals; requires publicity; potential risk of idea theft or competitive leakage; media attention needed to attract backers.
    • Global reach allows testing demand but also increases exposure to competitors.
    • Not ideal for early validation of very small funding needs (e.g., $1,000).
    • Global campaigns can raise substantial sums (e.g., high-profile campaigns like Star Citizen raising $148 million).
    • Platform fees: typically a percentage of the funds raised, with no upfront fees.

Short-Term vs Long-Term Finance

Short-Term Finance (Working Capital Financing)

  • Purpose: meet daily/short-term cash needs; bridge cash-flow gaps.
  • Common options:
    • Overdrafts: bank allows spending beyond account balance up to a limit; interest charged only on overdrawn amount; flexible; usually cheaper than short-term loans; however, rates are variable and banks can demand repayment on short notice.
    • Trade Credit: delaying payment to suppliers to improve cash position; effectively an interest-free loan for the period of credit; risk: suppliers may reduce discounts or refuse further supply if late; may affect supplier relationships.
    • Factoring of debts: see external finance above; provides immediate cash but with a cost and loss of some debt value.

Long-Term Finance (Capital Financing)

  • Purpose: finance non-current assets, acquisitions, expansions, or major overhauls.
  • Common options:
    • Loans from banks: repayable over fixed periods; interest; can be secured with collateral; suited to larger, stable borrowers; more expensive if riskier; not permanent capital.
    • Hire Purchase: acquire asset over time with monthly payments including interest; deposit required; ownership transferred after final payment; interest costs can be high.
    • Leasing: use asset without purchasing; monthly lease payments; maintenance often handled by the leasing company; may decide to buy at end; total cost higher than purchase; flexibility for upgrading equipment.
    • Sale and Leaseback: sell an asset and lease it back; frees up cash while retaining use of asset.
    • Debentures and bonds: long-term debt securities issued by firms to raise long-term funds; interest paid; principal repaid at maturity.
    • Issue of shares / Rights issues (for PLCs): long-term equity finance; dilutes ownership but does not require repayment; rights issue preserves current ownership proportions; suitable for large-scale financing needs.

Important Considerations When Choosing a Finance Source

  • Purpose and time period: match the use to the appropriate term of finance.
    • Long-term needs (e.g., non-current assets) should be financed with long-term sources.
    • Short-term needs (e.g., working capital) should be financed with short-term sources.
    • Example: using a long-term bank loan to finance short-term inventories would be unwise.
  • Amount needed: large needs may justify public share issuance or debentures; small needs may not.
  • Legal form and size: PLCs have more options (shares, debentures) than sole traders/partnerships; large firms have more access to bank loans at favorable rates.
  • Risk and gearing: gearing = long-term debt relative to total capital; high gearing increases risk due to fixed interest obligations.
    • Common measure: if gearing exceeds around 0.50.5 (50%), the business is considered highly geared and riskier; banks wary of high gearing.
    • ext{Gearing ratio}= rac{ ext{Long-term debt}}{ ext{Total capital}} where total capital = long-term debt + equity.
  • Control: issuing external equity can dilute owner control; loan finance generally does not affect ownership.
  • Other information: cash flow forecasts, income statements (past and forecast), existing debt details, security/collateral availability, and a clear business plan.
  • Case-specific factors: potential for growth, takeover opportunities, and timing of expansion.

Case Studies and Practical Examples

  • Case study: Godrej Properties (India)
    • Raised over USext90extmillionUS ext{ }90 ext{ million} from issuing new shares.
    • Founders initially owned about 84ext84 ext{ }% of the company; post-issue ownership fell to 73ext73 ext{ }%.
    • Use of funds: reduce bank loans and buy more land for long-term development.
    • Discussion points:
    • Was the financing internal or external? Explain.
    • Why were shareholders eager to buy the new shares?
    • Why did the company want to reduce bank loans?
  • Case study: Micro-finance impact (Kaneez Fatima example)
    • Micro-finance loan used to set up a textiles business; later expanded to 20 workers.
    • Illustrates how micro-finance can empower individuals and contribute to local employment.
  • Crowd-funding case: Star Citizen example (video game project)
    • Global crowdfunding raised a large sum (e.g., USext148extmillionUS ext{ }148 ext{ million}).
    • Demonstrates ability to test interest and viability before large-scale investment; but not every project succeeds; platform publicity can attract attention and risk idea theft.

Activity Highlights (Illustrative Examples from the Text)

  • Activity 22.1: Classify sports centre expenses into revenue vs capital expenditure.
    • Revenue: day-to-day costs (water bills, wages).
    • Capital: assets like buildings, gym equipment, office computer.
  • Activity 22.2: Paul's taxi business
    • Explain why finance is needed for a new business; list first-month setup costs; classify costs as revenue or capital; justify.
  • Activity 22.3: Paul’s finance choices
    • Why retained profits aren’t available initially; importance of owner savings; selling inventories may not be viable for a taxi business.
  • Activity 22.4: Micro-finance case study
    • Questions on why traditional banks might refuse, and the broader impact of micro-finance on the individual and country.
  • Activity 22.5: Paul’s expansion
    • Compare using profits to buy a taxi vs bank loan; when to take a bank loan for expansion.
  • Activity 22.6–22.9: Choice and timing of finance
    • Classify various sources as short-term or long-term.
    • Consider purpose, amount, legal form, control, risk, and gearing when choosing sources.
    • Case-based questions on three companies: one needing shop decoration, another planning acquisition, and other finance scenarios.

Exam-Style Questions (Examples and Key Points)

  • Short-answer and data-response style prompts from the chapter:
    • Define micro-finance and explain two reasons why someone might need $100 to start a business.
    • Explain two likely reasons for avoiding crowdfunding in certain scenarios.
    • Explain two benefits of using internal sources of finance for expansion.
    • Evaluate whether converting to a private limited company to raise funds is appropriate after ten years.
    • Define long-term finance and identify two short-term finance options for a farm with fluctuating income.
    • Outline two internal finance forms that could fund a tractor purchase.
    • Explain two information pieces a bank would check before granting a loan.
    • Identify two finance sources suitable for a takeover and justify which should be used.
    • Analyze why banks may refuse loans to small businesses and what improves lending chances (cash flow forecast, income statement, existing debt information, security, and a business plan).

Key Takeaways for Decision Making

  • The general rule: match the source of finance to the use; long-term needs → long-term finance; short-term needs → short-term finance.
  • Ask and document:
    • What is the purpose and time period of the finance?
    • How much is needed?
    • What is the legal form and size of the business?
    • What is the risk/ gearing level, and how will it affect control?
    • What other information would be useful (cash flow forecast, income statement, security)?
  • Consider externalities of finance decisions:
    • Dilution of control (share issues)
    • Increased fixed obligations (loan repayments and interest)
    • Potential for higher costs if financing becomes expensive or if profits fall
    • Strategic considerations (growth vs. maintaining control)

Revision Tips and Summary Points

  • Remember the three main reasons businesses need finance: start-up, expansion, and additional working capital.
  • Distinguish CapEx vs OpEx:
    • CapEx for assets lasting > 1 year.
    • OpEx for day-to-day expenses.
  • Internal finance options: retained profits, sale of assets, sale of inventories, owners’ savings.
  • External finance options: shares (PLCs), bank loans, debentures, debt factoring, micro-finance, grants/subsidies, crowdfunding.
  • Alternative finance:
    • Micro-finance targets entrepreneurship among the poor; examples include Grameen Bank.
    • Crowdfunding tests market viability and can raise large sums but requires strong planning and publicity.
  • Short-term finance examples: overdraft, trade credit, factoring.
  • Long-term finance examples: bank loans, hire purchase, leasing, sale and leaseback, debentures, shares/rights issues.
  • Gearing (risk): ext{Gearing}= rac{ ext{Long-term debt}}{ ext{Total capital}}; high gearing (> 0.50.5) indicates higher risk and often tighter lending.
  • Banks and shareholders: lenders want cash flow forecasts, profit forecasts, existing debt details, security; shareholders look for rising share price, high dividends, growth potential, and reputation.
  • Case analyses: determine whether internal vs external finance is appropriate based on timing, amount, control, and risk.

Quick Glossary

  • Start-up capital, Working capital, CapEx, OpEx, Retained profits, Share issue, Debentures, Factoring, Micro-finance, Crowdfunding, Gearing, Rights issue, Leases, Hire purchase.

References and Data Points (Illustrative)

  • Global crowdfunding raised ≈ US$34.3extbillionUS\$34.3 ext{ billion} in 2015; World Bank forecast: up to US$90extbillionUS\$90 ext{ billion} by 2020 (some analysts expect even earlier peak).
  • Crowdfunding constraint: if target is not fully raised, funds promised must be repaid; platforms charge a percentage fee of the raised amount.
  • Example figures: Star Citizen crowdfunding ≈ US$148extmillionUS\$148 ext{ million}; Godrej Properties raised over US$90extmillionUS\$90 ext{ million}; share ownership before/after issue: 84% → 73%.
  • Gearing threshold: typically considered high if > 50% of capital is debt; expressed as ext{Gearing} > 0.5.