BUSINESS FINANCE

Finance is money. We all need money to purchase the goods and services we require – everyday goods,
like food, but also more expensive items such as a house or car. Businesses need finance too – and this is
often called ‘capital’. Without finance, businesses could not pay wages, buy materials or pay for assets.

REASONS WHY BUSINESSES NEED FINANCE

1. Starting up a business: When an entrepreneur plans to start their own business, they should
think about all of the buildings, land and equipment they will need to buy in order to start
trading. These are usually called non-current (fixed) assets. Nearly all new businesses will need
to purchase some of these. In addition, the owner of the firm will need to obtain finance to
purchase other assets such as inventories before goods can be sold to the first customers. The
finance needed to launch a new business is often called start-up capital.
2. Expanding an existing business: The owners of a successful business will often take a decision to
expand it in order to increase profits. Additional non-current (fixed) assets could be purchased –
such as larger buildings and more machinery. Another business could be purchased through a
takeover. Other types of expansion include developing new products to reach new markets. This
form of growth could require substantial amounts of finance for research and development.
3. Additional working capital: Working capital is often described as the ‘life blood’ of a business. It
is finance that is constantly needed by firms to pay for all their day-to-day activities. They have
to pay wages, pay for raw materials, pay electricity bills and so on. The money available to them
to do this is known as the firm’s working capital. It is vital to a business to have sufficient
working capital to meet all its requirements. Many businesses have stopped trading, not
because they were unprofitable, but because they suffered from shortages of working capital.
So, the third major business need for finance is often to raise additional working capital. In all
three cases above, businesses may need finance to pay for either capital expenditure or
revenue expenditure. Capital expenditure is money spent on non-current assets, such as
buildings, which will last for more than one year. These assets are needed at the start of a
business and as it expands. Revenue expenditure is money spent on day-to-day expenses, for
example, wages or rent.

Sources of finance
There are many different sources of finance available. It is common to split them up, or classify
them, into different groups. The two most common ways of doing this are:
1. internal
2. External sources of finance

1. Internal finance is obtained from within the business itself. They include
A. Retained
B. Profit: Profit kept in the business after owners have been given their share of the profit.
Firms can invest this profit back in the businesses.
ADVANTAGES OF RETAINED PROFIT
i. Does not have to be repaid, unlike, a loan
ii. No interest has to be paid

DISADVANTAGES OF RETAINED PROFIT

 i. A new business will not have retained profit
ii. Profits may be too low to finance
iii. Keeping more profits in the business reduces payments to owners, for example,
dividends to shareholders who might invest in other businesses instead.

C. SALE OF EXISTING ASSETS: Assets that the business doesn’t need anymore, for example,
unused buildings or spare equipment can be sold to raise finance. Existing assets that could
be sold are those items of value which are no longer required by the business, for example,
redundant buildings or surplus equipment.
ADVANTAGES OF SALE OF EXISTING ASSETS
i. Makes better use of capital tied up in the business
ii. Does not become debt for the business, unlike a loan.

DISADVANTAGES OF SALE OF EXISTING ASSETS

i. Surplus assets will not be available with new businesses
ii. Takes time to sell the asset and the expected amount may not be gained for the
asset

D. SALE OF INVENTORIES: sell of finished goods or unwanted components in inventory.

ADVANTAGES OF SALE OF INVENTORY
i. Reduces costs of inventory holding
DISADVANTAGES OF SALE OF INVENTORY
ii. If not enough inventory is kept, unexpected increase demand form customers cannot
be fulfilled
E. OWNER’S SAVINGS: For a sole trader and partnership, since they’re unincorporated (owners
and business is not separate), any finance the owner directly invests from his own saving will
be internal finance.
ADVANTAGES OF OWNER’S SAVINGS
i. Will be available to the firm quickly
ii. No interest has to be paid.
DISADVANTAGES OF OWNER’S SAVINGS
i. Increases the risk taken by the owners

2. EXTERNAL SOURCE. This is finance obtained from sources outside of the business

External fin
ance is obtained from sources outside of the business.
A. Issue of share: This source of finance is only for limited companies.
Advantage:
 A permanent source of capital, no need to repay the money to shareholders
no interest has to be paid
Disadvantages:

 Dividends have to be paid to the shareholders

 If many shares are bought, the ownership of the business will change hands. (The ownership is
decided by who has the highest percentage of shares in the company)
B. Bank loans: A bank loan is a sum of money obtained from a bank which must be repaid and on
which interest is payable.
Advantages:

 Quick to arrange a loan.

 Can be for varying lengths of time.
 Large companies can get very low rates of interest on their loans.
Disadvantages:

 Need to pay interest on the loan periodically

 It has to be repaid after a specified length of time
 Need to give the bank a collateral security (the bank will ask for some valued asset, usually some
part of the business, as a security they can use if at all the business cannot repay the loan in the
future. For a sole trader, his house might be collateral. So there is a risk of losing highly valuable
assets)
C. Debenture issues: debentures are long-term loan certificates issued by companies. Like shares,
debentures will be issued, people will buy them and the business can raise money. But this
finance acts as a loan- it will have to be repaid after a specified period of time and interest will
have to be paid for it as well.
Advantage:
 Can be used to raise very long-term finance,  for example, 25 years
Disadvantage:
 Interest has to be paid and it has to be repaid
D. Debt factoring: a debtor is a person who owes the business money for the goods they have
bought from the business. Debt factors are specialist agents that can collect all the business’
debts from debtors.
Advantages:
 Immediate cash is available to the business
 Business doesn’t have to handle the debt collecting
Disadvantage:
 The debt factor will get a percent of the debts collected as reward. Thus, the business doesn’t get all
of their debts
E. Grants and subsidies: government agencies and other external sources can give the business a
grant or subsidy
Advantage:
 Do not have to be repaid, is free
Disadvantage:
 There are usually certain conditions to fulfil to get a grant. Example, to locate in a particular under-
developed area.
ALTERNATIVE SOURCES OF CAPITAL.
The sources of finance that have been explained so far are very widely used by existing businesses or
start-up businesses with a detailed business plan supported by owners’ capital. In recent years, other
sources of capital have become available to very small business start-ups, especially in developing
economies, and to start-ups that carry significant risk, which can make sources of capital difficult to
obtain.

A. Micro-finance
In many low-income developing countries, traditional commercial banks have been very unwilling to
lend to poor people – even if they wanted the finance to set up an enterprise. Banks did not lend
because:
 The size of the loans required by poor customers: perhaps a few dollars – meant that the bank
could not make a profit from the loans.
 The poorer groups in society often have no asset to act as ‘security’ for loans – banks are
usually not prepared to take risks by lending without some form of security (assets they can sell
if the borrower cannot repay).
Specialist institutions have been set up in most developing countries to meet the financial
needs of poor people especially poor entrepreneurs. The most famous of these is the Grameen
Bank in Bangladesh. These institutions, including postal savings banks, finance cooperatives,
credit unions and development banks, focus on lending small sums of money to people – hence
the term micro-finance or micro-credit.
B. Crowdfunding
Crowdfunding is funding a project or venture by raising money from a large number of people who each
contribute a relatively small amount, typically via the internet.
This idea of raising finance for new business start-ups by encouraging a large number of people to each
invest small amounts has been used for many years. However, it has only become very popular since the
widespread use of the internet. This allows entrepreneurs to contact millions of potential investors
around the globe, usually by using ‘crowdfunding platforms’ such as Kickstarter, Rocket Hub and
FundAnything. It is a source which is not suitable for raising very small sums.
Crowdfunding is claimed to have these benefits:
 No initial fees are payable to the crowdfunding platform. Instead, if the finance required is
raised, the platform will charge a percentage fee of this amount.
 Allows the public’s reaction to the new business venture to be tested. If people are not
prepared to invest, it probably is not a very good business idea.
 Can be a fast way to raise substantial sums.
 Often used by entrepreneurs when other ‘traditional’ sources are not available.
Disadvantages of Crowdfunding
 Crowdfunding platforms may reject an entrepreneur’s proposal if it is not well thought out.
 If the total amount required is not raised, the finance that has been promised will have to be
repaid.
 Media interest and publicity need to be generated to increase the chance of success.
 Publicising the new business idea or product on the crowdfunding platform could allow
competitors to ‘steal’ the idea and reach the market first with a similar product.
 SHORT-TERM AND LONG TERM SOURCES OF FINANCE

Short term finance provides the working capital needed by businesses for day-to-day operations
Short-term finance is used to help a business maintain a positive cash flow. For example, it can
be used to:

 get through periods when cash flow is poor for seasonal reasons, eg during a rainy summer for
an ice cream seller
 bridge the gap when a large payment is delayed, leaving the business without enough money
to pay its bills
 provide extra cash to pay for the manufacturing required to meet sudden or unexpected
changes in customer orders

short term sources of finance includes:

Overdrafts
Overdrafts are one of the most common forms of finance arranged by banks. However, they
should be used carefully and only in emergencies as they can become expensive due to the high
interest rates charged by banks. The bank gives the business the right to ‘overdraw’ its bank account
(that is, spend more money than is currently in the account).

Common features of a bank overdraft include:

 variable interest rates - the cost of borrowing money will change when the interest rate
changes
 flexibility - a business uses its overdraft only when it needs to, therefore the business will only
pay interest when the overdraft is used. The overdraft will vary each month with the needs of the
business – it is said to be a ‘flexible’ form of borrowing.
 the bank can demand full payment - banks can demand full repayment of an overdraft
within 24 hours.

However:

 Interest rates are variable, unlike most loans which have fixed interest rates.
 The bank can ask for the overdraft to be repaid at very short notice.

Trade credit
This is when a business delays paying its suppliers, which leaves the business in a better cash position.
Trade credit must be agreed with a supplier and forms a credit agreement with them. This source
of finance allows a business to obtain raw materials and stock but pay for them at a later date.
The payment is usually made once the business has had an opportunity to convert the raw
materials and stock into products, sell them to its own customers, and receive payment.

Common terms and conditions of a credit agreement include:

 credit limit - the maximum amount of credit available to the business
 credit period - the length of time the business has to pay what is owed, usually 30, 60 or 90
days
 frequency of payment - how often payment is required, usually monthly
 method of payment - the way in which the business makes payment (eg bank transfer, cheque
or card payment)
 retrospective discount - a discount given when the business has purchased a certain amount
of stock or raw materials.

Factoring of debts
A debtor is a customer who owes a business money for goods bought. Debt factors are specialist agencies
that ‘buy’ the claims on debtors of businesses for immediate cash. For example, a debt factor may offer
90 per cent of an existing debt. The debtor will then pay the factor and the 10 per cent represents the
factor’s profit – when the factor collects payment from the debtor.

a. Immediate cash is made available to the business.

b. The risk of collecting the debt becomes the factors and not the business’s.
c. However, the business does not receive 100 per cent of the value of its debts.
Long-term finance

This is finance which is available for more than a year and sometimes for very many years. Usually this
money would be used to purchase long-term fixed assets, to update or expand the business, or to
finance a takeover of another business. The main sources of long-term finance are as follows:

Bank loan
A bank loan is money lent to an individual or business that is paid off with interest over an
agreed period of time. Usually this rate of interest is fixed. This means that the business knows in
advance what the cost of borrowing will be and what monthly repayments will be required. This
allows the business to plan ahead.

To get a bank loan, a business must apply to a bank. The bank then carries out credit checks to
see the financial history and reliability of the applicant. The bank may require the business to
secure its assets against the loan. This means that if the business is unable to repay the loan, the
bank can demand the sale of the assets to raise money to pay back the loan. If a business does not
have enough assets, a bank may require a guarantor to repay the loan if the business does not
make its repayments on time.

Hire purchase
This allows a business to buy a non-current (fixed) asset over a long period of time with monthly
payments which include an interest charge. The business does not have to find a large cash sum to
purchase the asset. However a cash deposit is paid at the start of the period and Interest payments can
be quite high.

Leasing
Leasing an asset allows the business to use the asset without having to purchase it. Monthly leasing
payments are made. The business could decide to purchase the asset at the end of the leasing period.
Some businesses decide to sell off some non-current (fixed) assets for cash and lease them back from a
leasing company. This is called sale and leaseback. The business does not have to find a large cash sum
to purchase the asset to start with. The care and maintenance of the asset are carried out by the leasing
company. However, the total cost of the leasing charges will be higher than purchasing the asset.

Issue of share
Shares are often referred to as equities – therefore the sale of shares is sometimes called equity
finance. Public limited companies have the ability to sell a large number of shares to the general public.
These new issues, as they are called, can raise very large sums of money but can be expensive to
organise and advertise. A rights issue of new shares is a very common way for public limited companies
to raise additional capital. This gives existing shareholders the right to buy new shares in proportion to
their current holding. This avoids the problem of new shareholders changing the balance of ownership.
 Factors that affect choice of source of finance
 Purpose: if a fixed asset is to be bought, hire purchase or leasing will be appropriate, but if finance is
needed to pay off rents and wages, debt factoring, overdrafts will be used.
 Time-period: for long-term uses of finance, loans, debenture and share issues are used, but for a short
period, overdrafts are more suitable.
 Amount needed: for large amounts, loans and share issues can be used. For smaller amounts,
overdrafts, sale of assets, debt factoring will be used.
 Legal form and size: only a limited company can issue shares and debentures. Small firms have limited
sourced of finances available to choose from
 Control: if limited companies issue too many shares, the current owners may lose control of the
business. They need to decide whether they would risk losing control for business expansion.
 Risk- gearing: if business has existing loans, borrowing more capital can increase gearing- risk of the
business- as high interests have to be paid even when there is no profit, loans and debentures need to
be repaid etc. Banks and shareholders will be reluctant to invest in risky businesses.

CASH FLOWS

Cash is a liquid asset. This means that it is immediately available for spending on goods and
services. Cash doesn’t just mean the physical money a business has in notes and coins. It also
refers to cash in the bank – in other words, money that is available in the business’ bank
accounts.

The management of cash is very important as cash allows a business to pay its bills. The main
cash payments a business makes include:
 payments to suppliers
 payments to employees
 overheads, such as rent, electricity and telephone bills
When a business has just a few large customers and they fail to pay on time, the business’ cash
flow position is badly affected because the business does not have money it was expecting to
have. This can lead to the business having financial difficulties and even failing.

A business can arrange credit terms with its suppliers, in order to pay for raw materials or stock
at a later date. Credit arrangements can also allow customers to pay for products or services
within 30, 60 or 90 days. If a business allows its customers credit terms, it is a sensible option to
also negotiate longer credit terms with its suppliers.

Preventing business failure

Failing to manage cash and cash flow can cause business failure. Even if a business has many
customers, it can still have negative cash flow.

There are two instances when a business can suffer cash flow problems:

 at start-up, when large amounts of money need to be invested to get the business started,
for example to pay for equipment, initial stock, rent, insurance, hiring, training and staff costs
 during rapid growth, when the business needs to grow quickly but cannot keep up with the
cash being paid out, for example, if the business needs to find larger premises and invest in
making them ready to move into
If a business has customers who are not paying what they owe, this means that the business
may be unable to pay its own bills and may become insolvent.

Businesses need positive cash flow to reduce the risk of failure and insolvency. Three possible
steps to get out of negative cash flow are:

 negotiate an overdraft facility
 keep costs under control
 keep cash coming into the business by arranging sensible credit arrangements with suppliers
and customers, and having fewer customers who pay for products and services on credit.

The cash flow of a business is the cash inflows and outflows over a period of time.

Cash inflows are the sums of money received by a business during a period of time while cash outflow

How can cash flow into a business (cash inflow)?

Here are five of the most common ways:

A. The sale of products for cash.

B. Payments made by debtors – debtors are customers who have already purchased
products from the business but did not pay for them at the time.
C. Borrowing money from an external source – this will lead to cash flowing into the
business (it will have to be repaid eventually).
D. The sale of assets of the business, for example, unwanted property.
E. Investors, for example, shareholders in the case of companies, putting more money into
the business.

How can cash flow out of a business (cash outflow)?

Here are five of the most common ways:

A. Purchasing goods or materials for cash.

B. Paying wages, salaries and other expenses in cash.
C. Purchasing non-current (fixed) assets.
D. Repaying loans.
E. By paying creditors of the business – other firms which supplied items to the
business but were not paid immediately

The difference between cash and profit

Not all cash paid into a business is profit. A business must pay its costs from the money that
comes into it. Once all costs have been deducted from all revenue, the amount that is left is the
business’ profit.

Profit is usually calculated on an annual basis. However, calculating it monthly can help a

business by showing that it is solvent and indicating whether it will be able to achieve its profit
target

Calculating and interpreting cash flow forecasts

Cash flow is the movement of money in and out of a business over a period of time.
 Cash flow forecasting involves predicting the future flow of cash in and out of a business’ bank
accounts. A cash flow forecast will usually be for a 12-month period. Forecasting cash inflows
and outflows is important, especially for three types of business:

 new businesses
 fast-growing businesses
 businesses with unpredictable sales patterns, for example seasonal businesses (eg an ice cream
van)
A cash flow forecast allows a business to plan for the future. It can therefore assist the business
in making important decisions, such as:
 employing more staff
 opening a new branch
 investing in a new business
 rewarding the owners for their success
Cash flow forecasting can also help a business to identify the risks of negative cash flow.

Calculating and monitoring cash flow

Creating a cash flow forecast for a new business can be difficult, as the business will have no
previous figures to help it estimate its future cash inflows and outflows. This will require the
entrepreneur to make some guesses. They will also need to monitor the business’ cash flow
carefully to see whether their estimates were realistic, and make changes if not.

An established business can compare its actual cash flow with its cash flow forecast to monitor
whether it is achieving its targets. It can then make changes if necessary.

Calculating cash flow involves finding or estimating figures for the following:

 cash inflows - all of the money coming into the business, which can be separated into
different categories, for example sales, rent received and loans
 cash outflows - all of the money moving out of the business to pay for its costs, for example
suppliers, employees and overheads

Net cash flow

Net cash flow is the difference between all cash inflows and all cash outflows of a business:

net cash flow = cash inflows – cash outflows

Cash flow forecast example:

Opening and closing balance

Opening balance
The opening balance is the amount of money a business starts with at the beginning of
the reporting period, usually the first day of the month:

opening balance = closing balance of the previous period

If there is no previous period, then the opening balance will be zero.

For example:

closing balance for January = £5,650

therefore

opening balance for February = £5,650

Closing balance
The closing balance is the amount of money the business has at the end of the reporting
period, usually the last day of the month:

closing balance = net cash flow + opening balance

For example:

net cash flow = £2,550

opening balance = £5,650

£2,550 + £5,650 = £8,200

therefore

closing balance = £8,200