Scribd Logo
Upload

Welcome to Scribd!

  • Business Finance

    Uploaded by

    sana
    43 views13 pages
    Professional practices

    Copyright

    © © All Rights Reserved

    Available Formats

    PDF or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    Report this Document
    Professional practices

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    43 views13 pages

    Business Finance

    Uploaded by

    sana
    Professional practices

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    of 13
    Tar arecee lars! Flame al day 4 Introduction This section introduces the importance of the management of finance, the keeping of accounts and the analysis of them, and the assessment of business financial performance. The key issues of financial management, the value of financial statements and the measurement of financial performance are all explained and developed. Central to the role of finance and accounting is an 93 understanding of how information produced, analysed and applied can be used by businesses to create value and measure whether financial objectives have been met. Eu Scanned with CamScann afthis chapter, you will be able to; ” py busines activity requires erence between capital and erature andthe diferent needs fo o create a theimporance OF working capital to a mio tiscanbemanaged diferent sources eance, barhinternal and external ance of long, medium- and \eSSES - BOTH NEED FINANCE differences between Haldia Ltd (HPL) and the six Khadki villagers jld private water wells. However, there = they are both situated in India have a need for finance. HPLis a large has operated at a loss for several years. It ineed for finance to prevent the business Finance proposals include converting es reduicing interest payments) and shares to existing shareholders (a rights option was chosen and 520 million dat 25.10 Rupees each. dki villagers needed finance to dig water dhave a social benefit as well as being Although poor, they each saved onth fora year. Although their request 00 Rupees was rejected by a commercial had no collateral (they had no 'ves), they were successful in '2 microfinance bank. The interest They repaid the loan within two since returned to borrow bigger ‘even deeper wells. Without this would not have been started. 3 Business finance ne This chapter covers syllabus, ‘Yeetions AS Level §.1 and 8.2. Introduction Business activity cannot take place without finance - or the means of purchasing the materials and assets before the production of a good or service can take place, Finance decisions are some ofthe most important that managers have totake. Inadequate or inappropriate finance can lead to business failure —in fact, shortage of liquid funds is the main a reason for businesses failing, The range and choice of finance sources are extensive and skilled managers willbe able to match accurately the needs of their business for particular types of finance with the sources available. Selecting an inappropriate source of finance can prove to be expensive for a business or could even lead to a loss of control by the original owners. Why business activity requires finance Finance is required for many business activities. Here is a Uistafiust some of the main situations in which businesses will require finance: Setting up a business will require cash injections from the ‘owner(s) to purchase essential capital equipment and, possibly, premises. This is called start-up capital, ‘# Allbusinesses need to finance their working capital - the day-to-day finance needed to pay bills and expenses and to build up stocks. Scanned with CamScanner When businesses expand, further finance will be needed toineroase the capital assets held by expansion will involve higher & Expansion ean be achieved by taking Finance is then needed (o buy out the owners of the other thm, ‘= Special situations will often lead to a need for greater Finance, For example, a decline in sales, possibly as 0 result ‘of economic recession, could lead to cash needs to keep {he business stable; ora large customer could fal to pay for foods, and finance is quickly needed to pay for essential expenses, Apart from purchasing fixed assets, finance is often used {0 pay for research and development into new products or to livest in new marketing strategies, such as opening up overseas markets Some of these situations will need investment in the business for many years ~ of even permanently, Other cases will need only short-term funding = this is usually defined as being for around one year oF less. Sc Fequirements of the business are for between one and five years and this is referred to as medium-term finance, The list given above of reasons why businesses need finance is not complete = you could probably add to it yourself, The important point to note about this list is that all of these situations are rather different. In practice, this means that 'no one source or type of finance is likely to be suitable in all cases. Managers will have to decide which type and source of finance are best in each case. Before making finance decisions, itis necessary to be aware of all of the many sources of finance available to businesses, we finance Capital and revenue expenditure ‘These two types of spending will almost certainly be financed in different ways and the length of time that the money is tied up’ will be a major factor influencing the final finance choice. of stock, Without sufficient working capita be illiquid What happens in cases such as this? ithe, finance quickly ~ such asa bank loan Orit may ye into liquidation’ by ts creditors, the frm ” bef Ones ar The simple calculation for working capital is: cup less current liabilities. You will see from the sectiga Statement of financial position in Chapter 39 that reat ash int vie without these three assets, although some busines refuse to sell any products on credit so there willbe: assets are inventories, accounts receivable and o bank and the tills. Virtually no business could trade receivables. This is very rare for busneses bey, cer in size Where does the capital come from to purchase nd hold these current assets? Most businesses will obtain some of this finance in the form of current liabilities - overdrafts and creditors are the main forms. However it would be unwise to obtain all of the funds needed frm these sources. First, they may have to be repaid at very short notice, meaning the firm is again left witha liguidy problem, Second, it will leave no working capital for buying additional stocks or extending further credit to customers when required How much working capital is needed? Sufficient working capital is essential to prevent a business from becoming illiquid and unable to payits, debts. Too high a level of working capital is a disadvan! the opportunity cost of too much capital tied upin invertors Accounts receivable and idle cash is the return that 1 could earn elsewhere in the business - invested in fixed assets, perhaps, ‘The working capital requirement for any busine will depend upon the length of this ‘working cai! ycle: The longer the time period from buying mat {0 receiving payment from customers, the great Bl be the working capital needs of the business. Figu® mn ‘shows the simple cycle of a business that ee but neither asks for nor offers credit, Creditt0 Ost siven by the business will lengthen the time bef into cash, Credit received by the busine Scanned with CamScanner se be" stock bought has to be paid for pete than is received i810 increase the p : i ee 1 need itt al, To receive More credit than jg given for working capital Deas he wing capital efficiently is vi tA sis discussed in Chapter 3 f al forall ‘why businesses requi 7-418, identify: ns that are likely to need (ore than fiveyears) ns that might require finance. 2 your answer, directphone Ltd bieciphone Ltd operates a direct insurance ‘enite to motorists. As part of a recent expansion ogame, the finance director calculated that suesofstationery, such as insurance certificates, veuldhave to rise by 10% from $10,000. More iitorsts would be encouraged to use the company bybeing offered extended credit terms. This would intase trade receivables to an estimated $50,000 fmtheexisting $40,000, Cash reserves to pay out frecidents would rise to $35,000 from $30,000. Tronlycurrent liability was creditors (garages fthadnot yet been paid for accident work). This ‘Sainted to $40,000 and the director hoped to be toincrease this to $50,000. ce come from? with sources of finance for CRED/7 a SELL OW AND stoc*® Figure 28.1 The sim; this cycle takes to.co be needed ple working capital cycle - the longer Implete, the more working capital will Partnerships. Companies are able to raise finance from a wide range of sources, Its useful to classify these into: '© internal money raised from the business's own assets or from profits left in the business (ploughed-back or retained. earnings) © external money raised from sources outside the business, Another classification is also often made, that of short-, ‘medium- and long-term finance; this distinction is made clearer by considering Figure 28.2 Internal sources of finance Profits retained in the business Ifa company is trading profitably, some ofthese profits will be taken in tax by the government (corporation tax) and some is nearly always paid out to the owners or shareholders (dividends) Ifany profit remains, this is kept (retained) in the business and becomes a source of finance for future activities. CCearty, a newly formed company or one trading ata loss will rot have access to this source of finance. For other companies, retained earnings - fina liquid form ~ area very significant source of funds for expansion, Once invested back into the business, these retained earnings will ot be paid out to shareholders, so they represent permanent source of finance, of assets Seca fing earnest are no longer fully employed. These could be sok 10 will sell assets that they |. some ee fa they do not need to own. Scanned with CamScanner { | : I Redu toe | | f companies }} | Lecema —— - ‘Short term Figure 28.2 Sources of finance for limited companies In these the assets might be sold to a leasing specialist and leased back by the company. This will raise capital - but there will be an additional fixed cost in the leasing and rental payment. In 2014 the struggling cell phone manufacturer BlackBerry considered the sale of property assets to raise finance to help the business over a difficult trading period caused by its loss of market share to iPhones and Android phones. The Coca-Cola Company and its bottling partner, COFCO Coca-Cola Beverages Ltd, have continued their expansion in China with the opening of two bottling facilities in less- Geveloped central and western China - Coca-Cola finances ‘most ofits expansion from retained ea i "Medium term ‘Long term iJ || Seo Medium-term loan Bank overdraft Bank loan Creditors Factoring huge HSBC, a large international bank, recently sold its 2 billion, but will stay in the London headquarters for building and lease it back from the new owners ~ at an annual rent of $80 million, Reductions in working capital se stock levels or sell goods on When businesses incre 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. As will be sen in Chapter 31, 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 - an 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 abilities or debts ofthe 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 pate’ assets. Solely depending on internal sources of finance fo" expansion can slow down business growth, asthe pace of development will be limited by the annual profits or Scanned with CamScanner pe sold. Thus, rapidly expandin ast ependent on external sources afte" for mistake of suggesting that selling shares Soe al finance for companies. Although own the business, the company is a wena 4 refore, the shar nd, therefore, reholders are etal sources of finance sources es main sources of short-term external finance: * wkoverdrafts shakoverdratis the most flexible ofall sources of finance. ‘Sineansthat the amount raised can vary from day to day, {paving onthe particular needs of the business. The bank Aesthe business to ‘overdraw’ on its account at the bank _ etingcheques or making payments to a greater value Sathebalance in the account. This overdrawn amount ‘hull always be agreed in advance and always has a limit ‘omni which the firm should not go. Businesses may need to ‘eae he overdraft for short periods of time if customers ‘rtpayas quickly as expected or if a large delivery of be paid for. This form of finance often carries In addition, ifa bank becomes the stability of one of its customers, it can and force the firm to pay it back. This, in can lead to business failure. Debt factoring When a business sells goods on credit, creates trade ‘receivables. The longer the time allowed to pay wp. the ‘More finance the business has to find to carry on trading One option. if it is commercially unwise to insist on cash Payments, is to sell these claims om 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 th factor makes a profit. Smaller firms who sell goods on hire Purchase often sell the debt to credit-loan firms, so that the credit agreement is never with the firm but with the specialist provider. Sources of medium-term finance ‘There are two main sources of medium-term external finance: '& hire purchase and leasing = medium-term bank loan. Hire purchase and leasing ‘These methods are often used to obtain fixed assets with a medium lifespan - one to five years. Hire purchase is a form of credit for purchasing an asset over a period of time. This, avoids making a large initial cash payment to buy the asset. Leasing involves a contract with a leasing or finance company to acquire, but not necessarily to purchase, assets cover the medium term. A periodic payment is made over the life of the agreement, but the business does not have to purchase the asset at the end. This agreement allows the firm to avoid cash purchase of the asset. The risk of using Scanned with CamScanner ree unreliable or outdated equipment is reduced as the leasing company will repair and update the asset as part of the agreement. Neither hire purchase nor leasing is a cheap option, but they do improve the short-term cash-flow Position of a company compared to outright purchase of an asset for cash, Long-term finance ‘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 (also known as loan stock or: ‘corporate bonds). 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 Cut to be expensive if the loan is agreed ata 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 ifthe company cannot repay the debt. Businesses with few assets fo act as security may find it difficult to obtain loans — or ‘may be asked to pay higher rates of interest, Alternatively, in the UK, a small usines can apply to the Department of Trade and Industry for the loan to e teed loan scheme’ be part of the ‘guarant heme Ba more willing 0 endif compny his bey tM in this application because it gives the pany iy of repayment. Merchant banks are speci ty institutions. They provide advice as well MG engagingin expansion or mergertakeove pe, EIB loans €30 million for aeronautics R&D __-Afrench company specialising in high-preion screws and other fasteners for the aeronautg industry has applied for - and been grant a massive €30 million loan by the European Investment Bank. The capital will be useq aliong-term research and development proeer the group's headquarters near Pars to desinney fasteners using lighter and stronger materials p was thought that this form of finance was the beg ane to use a this time, with interest rates fling gue to the global downturn and share prices alo beng very volatile and uncertain, Investorsin shares ane understandably nervous atthe present time with uncertain share prices but also with RED projectsin particular, which can take years before the profit returned to the business, tofinance ey See any [12 marks, 15 minutes} Do you agree that loan capital was source of finance for this company for this project? Justify your answer, Long-term bonds or debentures A company wishing to raise funds will issue or sell sch bonds to interested investors. The company agrees to py 4 fixed rate of interest each year for the life of the bond, *h can be up to 25 years. The buyers may resell tothe investors if they do not wish to wait until maturity befor Setting their original investment back. Long-term loans0! debentures are usually not secured on a particular ast When they are secured, which means that the invest have the right ifthe company ceases trading to sell tht Scanned with CamScanner in repayment, the debentures are (0B yentures. Debentures can be 1898 ong: term finance ~ in a ates BT's recent gout e of issued loan stock amou fei! nted fave Convertible debentures can (ifthe ei be converted ito shares ater ie z, and this means that the ee ine company es never have to pay the debenture beck ‘he 8 pores ~ eauity finance by sue shares when they pees ey ate first wot ania fased will Be used to purchase THe Chapter 2 explained the essential ss ees Newen private and public limited companies, ge organisations ate able to sel further shares we Am tei authorised share capital - ig ihe aditional permanent finance, This apita is tobe repaid unless the company is completely asa result of ceasing to trade. Private limited nis can sel further shares to existing shareholders, Fevthe advantage of not changing the control or nahi ofthe company ~ as long as all shareholders eres inthe same proportion to those already owned, ves ofa private limited company can also decide to ‘go i¢ and obtain the necessary authority to sell shares to 1 ier public. This would obviously have the potential syse much more capital than from just the existing durcolders - but with the risk of some loss of control to ‘eew shareholders. Inthe UK, this can be done in two ways and these are ‘uetypical for many countrie: 1 oatzinalistng on the Alternative Investment Market (AIM), chs that part of the Stock Exchange concerned with snallrcompanies that want to raise only limited amounts dladdtional capital. The strict requirements fora full Stock Eachange listing are relaxed. 1 Apply fora full listing on the Stock Exchange by satisfying. Shecrteria ofa) selling at least £50,000 worth of shares and | Whavinga satisfactory trading record to give investors. ___teconfidence in the security of their investment. This ‘eof shares can be undertaken in two main ways: '* Publicissue by prospectus: This advertises the Company and its share sale to the public and invites 0 apply for the new shares. This is expensive, as Prospectus has to be prepared and issued. The share Ssveisoften underwritten or guaranteed by a merchant fe anaittich charges forits services 2 placing of shares with institutional ‘without the expense of a full public issue: ‘company has gained pic status, itis still possible aise further capital by selling additional shares. ‘done by means of a rights issue of shares. By no in barn ittoducing new shareholders, the ownership ofthe reat oats Mt change and the company raises capital relatively cheaply as no pul jic promotion or advertisiny ofthe share off one oo — is necessary. Howe ‘creases the supply of shares to Ply of shares tot! short-term effect is often to reduce t +. as the rights issue stock exchange, the he existing share price, ‘which i unlikely to give existing shareholders too much Confidence in the business ifthe share price falls too sharply Debt or equity capital - an evaluation ‘Which method of long-term finance should a company choose? There is no easy answer to this question. And, as seen above, some businesses will use both debt and equity finance for very large projects Debt finance has the following advantages: '= Aso shares are sold, the ownership of the company does not change or is not ‘diluted! by the issue of additional shares, ‘& Loans will be repaid eventually (apart from convertible debentures), so there is no permanent increase in the \iabilties 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 taxis deducted, while dividends on shares have to be paid from profits after tax. 1m The gearing of the company increases and this gives shareholders the chance of higher returns in the future. This. pointis dealt with more fully in Chapter 35. Equity capital has the following advantages: 1m Itnever has to be repaid; itis 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 ‘There are many agencies that are prepared, under certain circumstances, to grant funds to businesses. The two ‘major sources in most European countries are the central government and the European Union. Usually grants from these two bodies are given to small businesses or those expanding in developing regions of the country. Grants often come with conditions attached, such as location and the number of jobs to be created, but if these conditions are met, grants do not have to be repaid, Scanned with CamScanner —aEES”__ i KOOVS lists on AIM online fashion retailer Koovs has stock Exchange AIM. Koovs sucessfully atthe ntl pli oe oro) thine million. Koovsis the first Indian busines a in November 2011, There are 62 Indian businesses, combined value of £90 billion listed in London 2¢18 and the main stock exchange market. bukun Adeb2¥°, Head of Primary Markets, India atthe London Stock Exchange Group said “We welcome Koovs to our marke! ‘ondon been listed on L ion sully raised £22 million siness at £36 Peacocks to go public Peacocks, the discount clothing and housewareretale, has ssued its prospectus tothe public. The company s ‘going public to raise £42 million (after expenses) to fund further expansion and to repay outstanding debt. The managing director believes that there are great benefits in replacing debt finance with equity or share finance. Rights issue from Australian company Australian fertiliser maker Incitec Pivot Ltd plans to raise A117 billion through a rights issue of shares. Some of (28 marks, 40 minutes] 1 Why have indian companies such as Koovs decided tojoin AIM ratherthan the main Stock Exchange? [4] 2. Whyhhas the management of Koovs decided not to sell more than 50% ofthe shares in the company? [2] 3. Peacocks decided to issue shares by prospectus to the general public. Why do you think this method of selling shares was selected? (4) Venture capital ‘Small companies that are not listed onthe Stock Exchange ~ ‘unquoted companies’ - can gain long-term investment funds from venture capitalists These are specialist organisations, or sometimes wealthy individuals, who ate prepared to lend rsk capital to, or purchase share in, for Indian companies o focus on affordable Weste, the capital will be used for long-term issue is being offered at AS2. to the company's latest tra issue is likely to re inthe short term. The company hi tripling of annual profits, reflecting takeover and high fertiliser p ce the market 4 What did the managing director of Peacocks mean when he said that there were advantagesin sling shares to repay debt? What are the advantages of repaying debts? ® 5. Why do you think incitec Pivot decided tousea rights issue of shares to raise capital? 4 6 Evaluate whether a shareholder in Incitec Pot should buy the rights issue of shares being ofered. I business start-ups or small to medium-sized businesestit ‘might find it difficult to raise capital from other sures: “This could be because of risks to the business. These iS sould come from the new technology that the compat * dealing in or the complex research itis planning, in ¥®* other providers of finance are not prepared to get ial Venture capitalists take great risks and could lose alll money ~ but the rewards can be great. The value of cet high-tech’ businesses has grown rapidly and mas "©" financed, at least in part, by venture capitalist. Ves capitalists generally expect a share of the futur a. a sizeable stake in the business in return for their Scanned with CamScanner ace for unincorporated businesses na fina rs and partnerships were referred to in Chapt et? a distinctions bet ca jiythe main d }etween company fin: st rorporated business finance will he made nx ad rorated businesses ~ sole traders and int ie ah ae ela a owners of these businesses will have access to f rafts, loans and credit fro1 fete overdral d credit from suppliers, They me prow from family and friends, use the savings and sama byte owners il, if a sole trader wishes to fps take on pariners oie farther capt Nahas been made clear earlier in the book, any owner sine iD orporated business runs the risk of all property owned ifthe firm fails, Lenders ae often esi tant to len snd partnerships tend to be, unless the sand partnership to be, unless the owners give \d to smaller businesses, which is what sole der vena guarantees, supported by their own assets, should thea Grants are a spntofmost governments assistance to small businesses 0 TOPTIP when answering case study questions, you should analyse at type of legal structure the business has and what Sources of finance are available to it. Microfinance Thsapproach to providing small capital sums to int source of finance entrepreneurs is now a very importa a developing, relatively low-income countries. In 1974, Muhammad Yunus, an economics lecturer US827 toa group of very

    You might also like