1.3 - Putting a Business Idea Into Practice

Topic overview 

In this topic students need to continue to relate the concepts to the contexts in which an enterprise and  an entrepreneur will be operating. They must be aware how business implementation can be affected  by the local and national business environment and how this might impact on a small business. Students  must be aware of this sections relationship with the other areas in this theme and how again, this may  impact on business decision-making. 

Business aims and objectives 

What motivates someone to become an entrepreneur?   

For many people this will be money.  The chance to earn significant profits, buy a yacht, take numerous  holidays, buy designer goods and send the kids to the best private schools. 

Money and personal wealth may well however, not be the real motivation. Evidence suggests that there  are many more reasons why someone wants to start a business.  

Every business starts small.  However, if the entrepreneur takes some calculated risks, shows a lot of  determination and has some luck, a start-up business can become very large, profitable and valuable.  However, not every entrepreneur wants to build a big business and earn a fortune. 

The objectives when starting a business can be broadly split into two categories: financial objectives and non-financial objectives.

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The purpose of business aims and objectives 

Aims and objectives provide a direction for any business. Without clear objectives, a business may  provide goods and services that are not appropriate to why the business was set up. This may result in  the business not being successful. Having objectives just written down however, is not enough to  ensure business success. In order for objectives to be effective, they must be implemented and  monitored over time. Some of the benefits to a business of having clear objectives are as follows:  

Financial objectives 

• Survival – over half of new businesses fail within five years and many new businesses do not  survive much beyond their launch. Often entrepreneurs discover that their business idea was  not as good as they originally thought and therefore the business cannot run profitably or it runs  out of cash. Changes in the business environment also may make it harder for a business to be  successful. The first priority of a business is therefore always to survive. 

• Profit – making profit is the main objective for most businesses. This is the reward to the  entrepreneur for their hard work and the risks undertaken, often with their own money. Ideally,  the profit earned is sufficient to provide the entrepreneur with enough income to live on. Profits  may also be kept in the business to allow it to expand or develop further. Other objectives  businesses may have which are linked to profit maximisation are increasing revenue, the  amount made from sales, or decreasing costs. 

• Another financial objective is financial security or personal wealth. Working for someone else  might mean the loss of a securely paid job, which means the entrepreneur would have no 

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financial security. Some entrepreneurs have a longer term objective.  They aim to build a  valuable business that can substantially increase their future wealth. They could be aiming to  build up the business and sell it, or make it so it will provide a substantial future income for  them, with no risk to them of being made redundant! 

• Sales maximisation/market share – some businesses will be more concerned with increasing  their sales and therefore their market share. They may accept lower profits in the short term, in  order to increase sales.  

Non-financial objectives 

Although most businesses will be focussed on financial objectives, there are many other priorities that  will exist for new and small businesses. Providing a high quality service will be particularly important for  a new business. Looking after its customers and its employees would also be an objective for many  small businesses.  

In many cases, non-financial objectives will link to or be consistent with financial objectives, but not  always as sometimes even for a small business quality might conflict with profit. Therefore when  businesses set and use objectives, they will prioritise the areas which are most important to their organisation and the owners. 

Here are some of the non-financial motives that are often quoted by entrepreneurs: 

• Social objectives such as benefiting the environment 

• More control over working life – want to choose what kind of work is done; the need for greater  independence is a major motivator 

• A more flexible and convenient work schedule, including being able to work from or close to  home; this motive is an important reason behind the many home-based business start-ups • Skills are being wasted and their potential is not being fulfilled 

• Escaping an uninteresting job or career 

• Pursuing an interest or hobby that they enjoy 

• Want to be the boss, as they are fed up with being told what to do 

• Want the feeling of personal satisfaction from building up a business 

• Fed up with working in a business hierarchy or a bureaucratic organisation, where there are lots  of rules; people with entrepreneurial characteristics often feel stifled working with and for  others! 

• Major change in personal circumstances for example redundancy, divorce, illness, bereavement 

Different aims and objectives 

Different businesses will have different aims and objectives. This is particularly the case with small  businesses, where every entrepreneur is likely to have different motives for starting up their own  business. For example: 

Entrepreneur 1: has recently been made redundant from a large building firm. He would like to turn his  skills and experience into building maintenance in his local area. He wants varied work and enough  money to live off, but does not want to build up the business or travel far. 

Entrepreneur 2: has a new business idea for a web application for finding places for a good night out.  The idea is proving very popular in the local trials. The entrepreneur wants to develop this application  and sell it all over the world in order to make a lot of profit. 

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Business objectives will also be affected by the external environment which firms operate within. A  small low cost hairdresser may have direct competition in one area, indirect competition from an  expensive hairdressing national brand in another area and no competition at all in a further area. The  objectives of such a small business will be different because of the situation it finds itself in.   

Business revenues, costs and profits 

In order for a business to calculate its profit (or loss) it needs to work out its total costs and total  revenue.  

Costs are the spending that a business has to undertake in order to make goods and provide services.  Every business has costs, but they vary in terms of their type and amount. For a new business,  estimating what the likely costs are going to be is often very difficult.  

Successful businesses place great importance on costs. In most cases they want to ensure they are kept  as low as possible. There are many reasons for this including: 

• Increases in costs reduce the possible profits that the business can make 

• They are the main cause of cash-flow problems in a small business 

• They will change as the output or activity of a business changes 

Costs can be divided into two types: fixed and variable  

Fixed costs 

Fixed costs do not change as output varies.  In other words, they are fixed even if output moves up or  down from period to period. 

Examples of fixed costs include: 

• Rent and council tax 

• Salaries 

• Marketing, for example advertising, market research 

• Insurance 

• Interest repayments 

• Leased equipment charges 

It is worth remembering that just because a cost is classified as “fixed”, it does not mean that the cost  will stay the same forever. A fixed cost can change over time. For example, the rent of an office or  shop may stay the same for 5 years.  However, the rent may change (up or down) when the rental  agreement is renegotiated when due. The important point about a cost, like rent, being “fixed” is that it  has to be paid, whatever the level of sales achieved. 

Fixed costs are particularly important when it comes to calculating the break even output of a business.   The higher the level of fixed costs in a business, the higher the output needed to cover these costs and  break even. 

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Variable costs 

Variable costs change when output changes. In other words the higher the output, the higher the  variable costs.  

Variable costs tend to be those relating directly to the production or sale of a product.  Good examples  include: 

• Raw materials and bought-in stocks and components 

• Wages based on hours worked or amount produced 

• Marketing costs based on sales  

• Agent and other commissions 

Total variable costs can be calculated by a simple formula:  

Total costs 

The total costs of a business can be calculated by simply adding together the variable costs, at different  levels of output, to the firm’s fixed costs. The formula therefore is: 

Example: 

Graham’s van repair business is a small business that has the following costs and sales output for  March: 

To calculate the total costs for the business, start with the variable costs. These equal £75 per unit x 100  jobs = £7,500 

Fixed costs = £500 (garage rent and rates) + £1,500 (salaries) + £100 (advertising) + £400 (other fixed  costs) = £2,500 

Therefore the total costs for Graham’s business equal £7,500 (total variable costs) + £2,500 (total fixed costs) = £10,000  

As output increases the total costs will not increase as fast. This is because the fixed costs will stay the  same. This means that a business may have lower average costs of production as it grows.

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Revenue and Profit 

Revenue 

Revenue is the money the business receives from its sales. This can be represented simply using the  formula: 

In practice, most businesses sell more than one different product and have more than one selling price,  which makes the calculation more complicated. However, the method remains the same. 

In the above example, if Graham charges £100 for each job that he completes, his revenue will equal:  £100 (selling price per unit) x 100 (quantity sold) = £10,000. 

Is Graham’s business making a profit?  

Profit 

Having calculated the total costs and the total revenue for a business, it can now work out its profit.  Profit is the financial return or reward that the owners of a business aim to achieve to reward them for  the risk that they take. It will measure the success of that investment. 

Profit is also an important signal to other providers of finance to a business.  Banks, suppliers and other  lenders are more likely to provide finance to a business that can demonstrate that it makes a profit, or is  likely to do so in the near future, and that it can pay debts as they fall due. 

Profit is also an important source of finance for a business.  Profits earned, which are kept in the  business and are not distributed to the owners via dividends or other payments, are known as retained  profits. Retained profits are an important source of finance for any business, but especially start-up or  small businesses.  The moment a product is sold for more than it cost to produce, then a profit is earned  which can be reinvested 

Profit can be measured and calculated by the following formula: 

Here is an example which illustrates the formula in action:

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Whatever the result, profit, loss or breaking even a business will always need to review its performance  and look at how it might be improved. Can costs be decreased? How? And by when? Can revenue be  increased? Should the price stay the same? Can more be sold? Is there a need for further investment to  decrease costs or increase revenue? 

Interest  

As well as the costs involved in running a business, a business owner may also have to pay interest, if  the business needed to borrow money in the form of a loan or mortgage when it was set up. The  business may also arrange an overdraft with the bank, which will also involve the payment of interest.  Interest will therefore form part of the firm’s total costs. The amount needed to be paid may vary if  interest rates change. This is however, dependent on the terms of the loan/mortgage/overdraft, which  would have been agreed with the bank and the business owner, when the specific source of finance was  first taken out.  

The following formula can be used to calculate the interest rate on a loan as a percentage: 

Example: 

If a new business start-up borrowed £50,000 but repaid £60,000 in total, the interest percentage would  be:   £60,000 - £50,000   x   100 =   20% 

               £50,000

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Break even  

A business will calculate its break-even point in order for it to have an idea of how much it will need to  produce to survive. Break-even is the point where total revenue is equal to total costs, which means the  business is not making a profit or a loss. Through calculating break even, a business knows how many  units it will need to produce and sell in order to start making a profit.  

This information can be represented on a break even diagram or graph and will show the potential  profit or loss that could be made at different levels of output, as revenue and costs change.  

Break even diagram for Business A: 

Break even point

Variable  

costs 

Margin of safety 

This break even diagram shows that fixed costs are drawn as a straight line, which is the case because  they do not change with output. The total cost line is also shown, instead of the variable cost line on its  own, as the total cost line takes into account both fixed and variable costs. The total cost line starts at  the same point as fixed costs, as even if the business is making no output, fixed costs still need to be  paid. At zero output however, variable costs are zero resulting in fixed costs and total costs being the  same value. The revenue line is lastly drawn, which starts at zero and goes up diagonally. This is because  as the business makes and sells more, it will gain more revenue.  

In this example, Business A’s break-even point is 10,000 units, the point where total costs and total  revenue cross. This means that if the business manages to produce and sell this amount of output, it will  not be making a profit or a loss.   

Margin of safety 

Business A can also calculate the margin of safety from the break-even diagram. This is the difference  between its current level of output/sales and the break-even point. If Business A was currently selling or  producing 15,000 units, its margin of safety would be 15,000 (current level of output) – 10,000 (break even point) = 5,000 units. Business A would want the margin of safety to be as high as possible, as this  shows how much output or sales could fall before it hits its break-even point and then after this, the  business would be making a loss. 

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A reminder of the formula for margin of safety is shown here: 

Calculating profit and loss from the break-even chart 

A business can determine the amount of predicted profit or loss level it expects to make at different  levels of output from the break-even diagram. As already discussed, profit is calculated by deducting  total costs from total revenue.  From reviewing the break-even diagram for Business B (on the next  page)  it can be seen, at an output level of 80 units, the business is making £160 revenue and its total  costs equate to £140. If we subtract the total costs from the total revenue the profit at this level of  output equals:  £160 - £140 = £20. 

It is clear the business is making a profit at this level  of output, as the firm’s break-even point is 60 units  (the point where total revenue = total costs) and as the business is operating at 80 units, a higher  output level than the break-even point, then the business must be making a profit. 

However, if the business is operating below the break-even point of 60 units, the business will be  making a loss. Looking again at the break even chart for Business B and assuming the business is  producing 20 units, the value of total costs at this level of output is £80 and the total revenue figure is  £40. Remember that profit = total revenue – total costs, so in this case, the business is making a loss as:  £40 - £80 = (£40). 

This method of calculating profit/loss for a business can be applied to any level of output for a business  that has produced a break even diagram. However, the difficulty is that sometimes values are difficult to  read from the diagram and therefore if a business relied on this method only of calculating profit,  inaccurate figures may be calculated and therefore used in decision making. For example, looking again  at the break even chart for Business B, can the profit or loss be accurately worked out, purely from  reading the graph, if the firm was operating at an output level of 55 units? 

Monthly break even chart for Business B: 

180 

160 

140 

_{Costs / Revenues} £ 

120 

Break even  

100 

point

80 

60 

40 

20 

0 

0 10 20 30 40 50 60 70 80 

Number of Units  

Fixed costs Total Costs Sales Revenue 

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The impact of changes in revenue and costs on the break-even point 

As well as calculating profit and loss and identifying the break-even point, the break-even diagram can  also be used to help business owners with decision making and “what if” scenarios. By changing one or  more variables in the break-even diagram, business owners, or business decision-makers, can then  assess the impact of this change on the break-even point. This will allow worst and best case situations  to be prepared for by the business. Some examples are included here to illustrate this further. 

Example 1: Break even diagram to show the impact on the break-even point of an increase in selling  price 

250 

200 

_{Costs/revenue £}s 

150 100 50 

0 

New break even point 

Original break  even point

0 10 20 30 40 50 60 70 80 Number of units 

Revenue (1)  Revenue (2) Fixed costs  Total costs 

In the above situation, a business’s selling price has increased from £2 to £3. This has resulted in the  amount needed to be sold to break even (the break-even output) decreasing from 60 units to 30 units.  In this case, the business may then conduct some research to see if customers would be willing to pay  the increased selling price or whether demand would drop significantly, as even though the break point  has lowered, in this case it would take the business a significantly longer time to reach this point due to  a drop in demand. 

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Example 2: Break even diagram to show the impact on the break-even point of an increase in fixed  costs 

_{Costs/revenue £}s 

New break 

160 

^{even point} Original break  

140 

even point

120 

100 

80 

60 

40 

20 

0 

0 10 20 30 40 50 60 70 80 Number of units 

Revenue Fixed costs (1)  Fixed costs (2) Total costs (1) Total costs (2) 

In this case, the fixed costs of the business have increased from £60 to £70. This has increased the total  costs which has resulted in the amount needed to be sold to break even (the break-even output)  increasing from 60 units to 70 units. In the case, if the business anticipates that its fixed costs are going  to rise, which would ultimately make it harder to break even and therefore become profitable, it may  look for different ways to become more efficient to lower costs, to overcome this change. 

Calculating break even using the formula 

Rather than drawing a break even diagram to calculate the break-even point each time, a quicker and  more efficient method of calculating break-even is to use the formulae. The break-even formulae are  shown in the box: 

Break even output using the formula 

In order to calculate the break-even output using the formula, three variables are required. These are  fixed costs, sales price and variable cost per unit. 

In example 2, the original fixed costs of the business were £60. 

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The current variable cost per unit is £1. Variable costs are not drawn directly onto the break-even chart.  However, this value can still be calculated if total costs and fixed costs are known and the formula here  is used: 

From reviewing the chart, at an easy to read point, i.e. 10 units, the original total costs were £70 and  the original total fixed costs were £60. Total variable costs at this level of output therefore = £70 - £60 =  £10. 

To calculate the variable cost per unit, the number of units just needs to be divided into this amount =  £10/10 = £1. 

In order to calculate the sales price or the selling price per unit, a similar method can be applied. At an  easy to read point i.e. 10 units, the total sales revenue = £20. To calculate the sales price or selling price  per unit, the number of units just needs to be divided into this amount = £20/10 = £2. 

We now have all the variables required to calculate the break-even output level using the formula as  shown: 

Break even output =           fixed cost =    £60    = 60 units (sales price – variable cost) £2 - £1 

This being the same answer as obtained from the break-even chart. 

Break-even point in costs/revenue using the formula 

We will use example 2 again to illustrate how to calculate the break-even point in costs/revenue. A  reminder of the formula is: 

The original break-even point in units = 60 units x £2 (sales price) = £120. This again shows the same  value on the “y” axis for costs/revenue in £s as the break-even diagram, at the break-even point. 

The benefit of using break even analysis to a business 

🗹 Break-even is a very useful business tool, as it can quickly illustrate what happens to a firm’s  profits at different output levels. This can help a business with decision-making about cost levels  and selling prices. 

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🗹 A business could create a series of break-even diagrams to illustrate the impact on the break even point if one of the variables on the graph changed. This is called “what if” analysis. 

Break even does however have limitations: 

🗷 It assumes that the average price that goods sell at will stay the same.  

🗷 It gives the impression that just because products are produced that they will be sold at the  average price.  

🗷 It can become very complicated to a business which sells many different products. 🗷 It assumes that variable costs are proportional to output, whereas they may get cheaper as  output rises or more expensive if workers have to be paid overtime.  

🗷 It may mean that the business focuses on breaking even rather than making a profit! Cash and cash-flow 

Cash-flow describes the movement of cash into and out of a business. It is not the same as profit. Many  profitable businesses fail because they do not have enough cash to pay their bills. This is because profit  is recorded straight after a sale, whereas cash is recorded when it is either spent or received by the  business. If a business offers trade credit to a customer for example, of 30 days, then the sale and  therefore profit is documented when the goods are taken by the customer, but the cash will not be  recorded until payment i.e. the cash is received 30 days later! 

In business, cash is always on the move… 

• Cash-flows into the bank account when customers pay for their sales, when a loan is received  from the bank, interest is received or when assets are sold 

• Cash-flows out of the bank account when suppliers are paid, employee wages and salaries are  paid, interest is paid to the bank and so on… 

You need to be able to distinguish between: 

• Cash inflows: movements of cash into a business 

• Cash outflows: movements of cash out of the business 

The difference between the cash inflows and cash outflows during a specific period, for example a  week or a month is known as the “net cash-flow”. 

The challenge for any business, particularly new businesses, is to manage its net cash-flow successfully,  so that the business does not run out of money. 

Main types of cash inflow and outflow 

The main types of cash-flow can be summarised as follows:

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Why businesses suffer cash-flow problems 

Start-up and small businesses are especially vulnerable to cash-flow problems. The reasons for this can  be divided into two types: 

• not enough money coming into the business fast enough  

• too much money going out of the business too quickly 

In addition, if a business does have cash-flow problems then new businesses or businesses facing  financial difficulties will often not have reserves of retained profits to see them through until things  improve. If a business runs out of cash and is not able to obtain new finance, it will become insolvent. 

If a business has a positive cash-flow it will build up cash reserves. This can be saved in case of future  problems or used for future investment. 

The cash-flow forecast 

The cash-flow forecast predicts the net cash-flows of the business over a future period. It can be used to  identify likely cash-flow problems and help avoid or solve them. 

The forecast estimates what the cash inflows into the bank account and outflows out of the bank  account will be.   The result of the cash-flow forecast is also an estimate of the bank balance at the end  of each period covered (normally this is for each month). An example of a simple cash-flow forecast is  shown below:

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As can be seen from the table, the closing balance becomes the opening balance for the next month.  This is then added to the net cash-flow for that month, which may be a positive (April) or negative  (May), in order to calculate the closing balance for that month. The closing balance each month might  be a surplus, which means the business has a positive cash balance at the end of the month, or a deficit,  which means that the business has a negative cash balance at the end of the month (often indicated by  brackets, as in May).  

Looking at this cash-flow forecast a little more carefully, it shows that the business will start the period,  i.e. January, with a cash surplus or opening balance of £250,000. During the first three months, the net  cash-flow is negative, as it is predicted that there will be more cash outflows than inflows, which will  reduce the closing balance surplus to £50,000 in March. In April and June, the cash outflows are  estimated to reduce considerably making them less than the cash inflows, resulting in a surplus in the  closing balance in those two months.  In May again, the outflows are predicted to be higher than the  cash inflows. The opening balance, of £100, is not enough to cover this increase and therefore the  business is forecasted to go into a deficit of £50,000. 

Businesses must carefully monitor when the business is forecast to experience a deficit, as this  highlights the business may run out of cash! 

To recap the key formulae for cash-flow forecasts are: 

Why the cash-flow forecast is so important 

A business uses a cash-flow forecast to: 

• Identify potential shortfalls in cash balances in advance – think of the cash-flow forecast as an  “early warning system”.  This is the most important reason for a cash-flow forecast and enables  the business to take action, so that it does not experience any cash-flow issues, which can  ultimately prevent the business from trading and becoming insolvent

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• Makes sure that the business can afford to pay suppliers and employees - suppliers which do  not get paid will soon stop supplying the business; it is even worse if employees are not paid on  time, as in this case there would be no-one to either produce the goods or provide customers  with the level of service that they demand 

• Spot problems with customer payments – preparing the forecast encourages the business to  look at how quickly customers are paying their debts. This is only an issue in some businesses  and not all. For example, most retailers take most of their sales in cash/credit cards at the point  of sale i.e. at the time of purchase 

• Compare actual figures to forecast figures – this allows management to spot if there are any  potential issues and take appropriate action, for example if there are significant differences  between the forecasted figures and the actual figures, a business owner would need to arrange  appropriate sources of finance to cover any shortfalls in cash 

• External stakeholders, such as banks, may require a regular forecast - certainly if the business  has a bank loan, the bank will want to look at the business cash-flow compared to its forecast at  regular intervals, to ensure that the business will continue to make its repayments  

Main causes of cash-flow problems 

A cash-flow problem arises when a business struggles to pay its debts as they become due. When cash flow is consistently negative and the business uses up its cash balances, then the problem becomes  serious. The main causes of cash-flow problems are:

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Edexcel GCSE Business (9-1) Course Companion 

Sources of business finance 

A start-up or existing small business will need finance. They will need it for various reasons, short term  and long term. There are different sources of finance available and the actual source chosen by a  business will depend on the amount and reason the finance is required, as well as the circumstances  and the type of legal status the business has. 

The challenge of raising money 

Often the hardest part of starting a business is raising the money to get going.  

An entrepreneur might have a great business idea and clear plan for how to exploit a market  opportunity.  However, unless sufficient finance can be raised, the entrepreneur will struggle to make  the most of the opportunity. 

Raising finance for a start-up requires careful planning.  The entrepreneur needs to decide: 

• How much finance is required? Raising finance is hard work and expensive – a start-up business  should avoid having to go through the process too often! 

• When and for how long the finance is needed?  A useful distinction can be made between long term and short-term finance 

• What security (if any) can be provided? This will affect the ability of the business to raise a bank  or other loan where the lender requires some security (or “collateral”) 

• Whether the entrepreneur is prepared to give up some control (ownership) of the start-up in  return for investment 

• Whether the cost of the finance, for example the interest charged, is justified The finance needs of a start-up should also take account of these key areas: 

• Set-up costs: the costs that are incurred before the business starts to trade 

• Getting ready to produce: the fixed or long term assets that the business needs before it can  begin to trade, such as machinery, equipment, vehicles etc 

• Working capital: money required for the day to day operation of the business. Money will be  needed by the business to buy the stocks required by the business, such as raw materials, and  allowance should be made for amounts that will be owed by customers once sales begin, if the  business chooses to offer its customers trade credit 

• Growth and development: in the future the business may wish to grow and expand and  therefore will need to invest in extra capacity, for example in extra space to produce more products  

Finance to cover different periods 

An important consideration when obtaining finance for a business is when and for how long the finance  is needed.   A useful distinction can be made between long-term and short-term sources of finance.  The  table summarises the main examples and uses of each category:

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Edexcel GCSE Business (9-1) Course Companion 

Short-term sources of business finance: 

Trade credit 

This is used by many businesses as a short-term source of finance. Trade credit essentially means that a  firm’s suppliers will allow it to have the goods and pay for them at a later date.  

🗹 This can give time for the business to use the goods and sell its products before it pays the  suppliers, which will improve its cash-flow position.  

🗷 If the bills are not paid on time however, this can lead to the business getting a bad reputation  and losing future credit arrangements with the supplier.  

🗷 It can also be particularly difficult for new start-up businesses to negotiate trade credit with  suppliers, as there is a risk that the business will fail and suppliers may end up not getting paid! 

Bank overdraft 

Businesses of all sizes use bank overdrafts as a means of finance.  As a business gets bigger, it often  finds that its overdraft facility also needs to grow.  That is because an overdraft is essentially a short term source of finance that is available to help fund the day-to-day payments required by a business. It  allows the business to withdraw funds from its account that are not there, up to an agreed maximum  limit, and is only used when the business requires additional, temporary amounts of money. 

🗹 The big advantage of a bank overdraft is its flexibility. If a business experiences a short-term  shortage of cash or an unexpected cost, then it can be paid by using some of the overdraft  facility.  Interest is only paid on the amount used. 

🗷 The main downside of an overdraft is that it is repayable to the bank at any time. A business may  have an overdraft facility of £100,000 i.e. it can owe the bank up to that amount, but the bank may lower or even withdraw that facility at any time.  This happened to numerous businesses  with bank overdrafts during the credit crunch of 2007-8, many of whom were relying on their  overdraft to stay in business.  

🗷 The other drawback of an overdraft is that they usually have high levels of interest attached to  them, making them an expensive form of finance when they are used. 

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Edexcel GCSE Business (9-1) Course Companion 

Long-term sources of business finance: 

Personal savings 

An entrepreneur will often invest personal cash balances into a start-up. This can be personal savings  from the bank or building society.  This can also be in the form of providing assets for the business, for  example using an own car, or it can be as simple as working for nothing! By using this source of finance,  the entrepreneur is providing a strong signal, to other potential investors and the bank, of his/her  commitment to the business venture.   

🗹 This is a cheap form of finance that is readily available.  

🗹 Investing personal savings maximises the control the entrepreneur keeps over the business.   🗹 The amount that is available may be limited, resulting in this being used with other sources of  finance to fund the business. 

Loans  

These might be from friends and family or from financial institutions, such as a bank.  Friends and family: 

Friends and family who are supportive of the business idea may be willing to provide money either  directly to the entrepreneur or into the business.   

🗹 This can be quick and cheap to arrange (certainly compared with a bank loan). 🗹 The interest and repayment terms may be more flexible than a bank loan.   

🗷 However, borrowing in this way can add to the stress faced by an entrepreneur, particularly if  the business gets into difficulties, as it can cause disagreements. 

🗷 The amount available may be limited, resulting in this being combined with other sources of  finance. 

Bank loan: 

A bank loan is an amount of money borrowed for a set period with an agreed repayment schedule. The  repayment amount will depend on the size and duration of the loan and the rate of interest.  This is a  common source of finance that a small or new business would choose. However, bank loans tend to be  more readily available for well-established and growing businesses, rather than start-up businesses.   The reason for this is risk – banks prefer to loan to successful businesses, which makes them more likely  to be able to repay the loan and interest. 

If a bank loan can be obtained then there are several advantages for a start-up or an established small  business: 

🗹 The business is guaranteed the money for a certain period - generally three to ten years (unless  it breaks the loan conditions). 

🗹 Loans can be matched to the lifetime of the equipment or other assets the loan is being used for 🗹 While interest must be paid on the loan, there is no need to provide the bank with a share in the  business, so no control is lost. 

🗹 Interest rates may be fixed for the term, making it easier to forecast interest payments and  cash-flow. 

🗹 Repayments are made in instalments, resulting in the business having access to substantial  amounts of cash that does not need to be paid back all in one-go.  

There are also some disadvantages of a bank loan:

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Edexcel GCSE Business (9-1) Course Companion 

🗷 Time consuming - a new business would need to produce a detailed business plan to show to  the bank in order to secure the loan, which would take up time and resource; however it could  be argued in the long-run, that this careful planning would help the business to have a greater  chance of success in the future. 

🗷 Security - normally has to be given to the bank on some of the assets of the business.  The bank  will have control over these assets if the business fails. 

🗷 Lack of flexibility - a small business might take a loan out for £50,000 but finds it only needed  £30,000.  That means that interest is being paid on £20,000 of loan that it does not need. 🗷 Interest – interest must be paid on the loan amount, which increases the costs of the business. 

Venture capital 

Venture capitalists often invest in small businesses.  Venture capital can be gained from professional  investors or companies who typically invest between £10,000 to £750,000.   

Venture capitalists tend to have made their money by setting up and selling their own business – in  other words they have proven entrepreneurial expertise. The advantages and disadvantage of this  source of finance are: 

🗹 Venture capitalists often make their own skills, experience and contacts available to the firm. 🗹 They have access to large amounts of funds. 

🗷 The venture capital company or investor will usually want a share of the business and of the  profits, which can result in some loss of control over the firm for the entrepreneur, which he/she  may not want to give up. 

Obtaining venture capital is quite different from raising debt or a loan from a lender, such as a bank.  Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the success  or failure of the business. By contrast, venture capital is often invested in exchange for a stake in the  company where the return will be dependent on the growth and profitability of the business. 

Not every business is suitable for investment by a venture capitalist.  Such investors prefer to invest in  small entrepreneurial businesses which are aiming (and have the potential) for sales and profit growth.  As a rough guide unless a business can offer the prospect of significant turnover growth within five  years, it is unlikely to be of interest to a venture capital firm. 

Share capital 

Small or new businesses that are set up as a private limited company can raise finance by selling shares in the company.  There are many advantages to a business of raising finance through share issues: 

🗹 Large sums of money can be raised. 

🗹 Capital does not have to be repaid. 

🗹 There is no interest – dividend payments can be missed if profits are low. 

There are however some disadvantages including: 

🗷 Possible loss of control if the original owners sell more than 50% of the total shares. 🗷 Need to satisfy shareholders expectations of dividends and share price growth. 

Retained profit 

This is a very important source of finance for an existing small business, but is clearly not suitable for a  new business, as they are yet to build up reserves of profit!

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Edexcel GCSE Business (9-1) Course Companion 

The idea is simple.  When a business has worked out its profits, the owners or shareholders can decide  whether to take the profits for themselves or reinvest the profits back into in the business.   

Retained profits have several major advantages: 

🗹 They are cheap, as no interest has to be paid on them. 

🗹 They are very flexible – the business owners have complete control over how they are  reinvested and what proportion is kept, rather than paid as dividends. 

🗹 They do not dilute or reduce the ownership of the organisation, so for companies there is no  increased risk of a takeover. 

There are, however, also some disadvantages: 

🗷 If a business needs some temporary finance because it is facing difficulties, then it is unlikely to  have any profits that it can use. 

🗷 Growth may be slow if it is dependent on retained profits, as profits may not be high enough to  finance the growth quickly. 

Crowdfunding 

Crowdfunding is a recent way of small businesses or projects raising money from outside investors,  often through the internet or a crowd funding platform such as www.kickstarter.com or  www.crowdfunder.co.uk 

A proposal is publicised and the aim is that a large number of small investors will be attracted from all  over the world. The investors will generally be in sympathy with the aims of the project or the cause for  which the funds are being raised. 

There are some advantages to a business of using crowdfunding to secure finance: 

🗹 It provides cheap investment when other sources of external finance may not be available. 🗹 If the project is interesting or newsworthy it might attract good publicity, which will help the  business in becoming successful. 

🗹 The business may create a web blog or use social media to keep investors informed, which might  provide ongoing finance. 

🗹 Investors may have experience or skills that they can offer the business. 

There will however be drawbacks: 

🗷 Investors will need to be offered a return; this might be free use of the good or service  produced, or a share in the profits. Some schemes will also provide shares, which therefore  dilutes the control of the original owners of the business.  

🗷 There is a risk that there will be a limit to the amount of money investors are willing to use in  this way.

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