BUSINESS FINANCE – NEEDS & SOURCES

Main Responsibilities of the Finance Department:

• Record all financial transactions (e.g. payments to suppliers, revenue from customers).
• Prepare final accounts (statement of profit or loss, statement of financial position).
• Produce accounting information for internal use by managers.
• Forecast cash flows to ensure the business can meet future obligations.
• Make financial decisions (e.g. choosing suitable sources of finance).

Main Reasons Businesses Need Finance

Starting up a business • To buy non-current (fixed) assets like buildings and equipment.
• To purchase initial inventories before generating sales.
• Known as start-up capital.
Expanding an existing • To buy new assets (e.g. larger buildings, more equipment).
business • To fund takeovers
• To develop new products (research and development) and markets
• To finance new technology
Additional working • To cover daily operational costs like wages, rent, and utility bills.
capital • Essential to avoid business failure due to cash shortages.

Types of Expenditure

Capital expenditure: Revenue expenditure:

Money spent on non-current (fixed) assets which Money spent on day-to day expenses which do not
will last for more than one year. (e.g. equipment, involve the purchase of a long-term asset, for example,
buildings) wages, rent, raw materials.

Internal sources of Finance - these are funds generated from within the business.

Retained Profit ✔ Profit kept in the business after payment of dividends – immediately available for use
✔ No repayment or interest required

✖ Not available for new businesses or non-profit-making businesses

✖ Keeping more profits to be used as internal finance will reduce owner’s share of profit/
shareholders’ dividends and they may resist the decision
Sale of Existing ✔ Generates cash inflow from sale of unused or surplus assets (e.g., old equipment)
Assets ✔ Does not increase debt/ liabilities

✖ Can be time-consuming and the expected amount may not be gained for the asset
✖ Not an option for new businesses
✖ The firm loses the use of the asset (may be required in future if business expands)
Sale of ✔ Lowers storage and opportunity costs (working capital no longer tied up)
Inventories
✖ Risk of stock shortages and disappointed customers
Owners’ ✔ Fast access, no interest to be paid
Savings
✖ May be insufficient
✖ Higher risk for owners, especially for business with unlimited liability
External Sources of Finance - these are funds obtained from outside the business.

External - Short-term Sources: used to finance immediate or day-to-day operations or revenue items (less
than one year)

Bank Overdraft ✔ Flexible borrowing that varies by month up to an agreed limit.

✔ Interest paid only on the overdrawn amount.

✖ High interest rates

✖ May be withdrawn by the bank at short notice
Trade Credit ✔ Delayed payment to suppliers improves cash flow

✖ Could lose supplier discounts or damage supplier relationships

✖ Start-ups and young firms may not be offered credit as they have not proven their
ability to pay
Debt Factoring ✔ Selling unpaid customer invoices (account receivable) to a factoring company for
immediate cash. Instead of waiting for customers to pay, the business receives
immediate funds from the debt factor, which then collects payment from the debtors.
✔ Avoids risks of bad debts – the debt factor will now handle following up on late
payments from debtors

✖ The factoring company keeps a percentage as a fee (business does not get 100% sales
revenue)
✖ May affect customer relations – some debt factors aggressively chase payments
✖ Not suitable for business with low profit margins

External - Long-term Sources: used to finance long-term growth or investment/ capital items (more than
one year)

Bank Loans ✔ Can raise large sums and repay over time
✔ Suitable for long-term investment (purchase of non-current assets)
✔ Large companies can get very low rates of interest on their loans (financial economies
of scale)

✖ Interest must be paid (reduces profits)

✖ Collateral may be required
Leasing ✔ Rent assets without ownership - immediate use of asset without large upfront outlay
to acquire capital/ assets (improved cash flow)
✔ Maintenance/ servicing costs handled by leasing company
✔ The leasing firm can replace the asset regularly (wear and tear)

✖ The asset is never owned

✖ Can be more expensive in the long run
Hire Purchase ✔ Spread the cost of buying an asset (in instalments – better cash flow)

✖ Ownership only after final payment

✖ Interest included in instalments (high interest) - the total cost of hire purchase is
usually higher than the price of the asset.
 Issue of Shares ✔ Large sums can be raised
(for limited ✔ No interest to pay
companies) ✔ No repayment (permanent source of finance)

✖ Dilutes ownership and control

✖ Costly and lengthy procedures to sell shares on stock exchange market
✖ Only available to companies (not sole traders)
✖ Dividends have to be paid to more shareholders
Debentures ✔ Fixed interest rate
(long-term bonds ✔ Does not dilute ownership
issued by
companies) ✖ Must be repaid at maturity with interest

Grants/Subsidies ✔ Do not need to be repaid

from
Government ✖ Often have conditions attached
✖ May be limited (available to certain types of businesses)

Alternative Sources of Capital:

Micro-finance • Small loans offered to the poor, especially in developing countries.

• Targets entrepreneurs who are often rejected by traditional banks. Traditional
banks avoid lending because:
- Loan amounts are too small to be profitable.
- Borrowers usually lack assets for loan security.

Micro-finance institutions include: Grameen Bank (Bangladesh), postal savings

banks, finance cooperatives, credit unions, development banks.

Benefits of micro finance:

• Enables entrepreneurship among low-income individuals.
• Can transform lives, generate employment, and boost local economies.

Crowdfunding • Raising money from a large number of people, usually via the internet.
• Common platforms: Kickstarter, Rocket Hub, FundAnything.
• Most suitable for raising medium to large sums, not very small amounts.

Advantages of crowdfunding: Disadvantages of crowdfunding:

• No upfront fees; platform charges a fee only • Proposal may be rejected by the crowdfunding
if funding goal is met. platform if not strong or convincing.
• Tests public interest and market demand. • If the full target is not reached, funds may need to be
• Can raise large amounts quickly. returned.
• Useful when traditional funding is • Success depends on media attention and marketing.
unavailable. • Risk of idea theft if the concept is publicised too early.
Key factors influencing the choice of Finance:

Purpose and time • To finance capital item with long-term use (e.g., buying equipment or for external
period growth e.g. takeover of another business) → long-term finance.
• Short-term need (e.g., covering cash shortages or for revenue expenditure) →
short-term finance.

Amount needed • Large sums → long-term sources (e.g., share issue).

• Small amounts → internal finance or short-term borrowing (can easily be repaid
within one year).
• Businesses avoid complex or expensive sources for minor funding needs.

Legal form and size of • Limited companies have more financing options (e.g., share/debenture issues).
business • Larger businesses have more assets to give as collateral
• Sole traders/partnerships:
- Cannot issue shares.
- Rely on personal savings and bank loans.
- May face higher interest rates due to higher risk profile (cost of borrowing
is higher)

Control Raising finance through selling shares may reduce owner control (e.g. for public
limited company, if more than 50% of shares being sold are acquired by a buyer).
Owners must decide between growth and maintaining control.

For sole trader, raising more capital through partner’s injection of savings
(converting into a partnership business) means less autonomy in decision-making.

Risk and Gearing • Loan capital increases gearing (debt-to-equity ratio).

• Highly geared businesses (over 50% debt):
- Considered risky by banks
- May struggle to get more loans
- Must pay interest regardless of profits - could face financial difficulties if
interest rates rise

When Banks are likely to lend:

The business has:
• A cash flow forecast showing the need for finance and how it will be used.
• An income statement (past performance) and forecast showing profit potential.
• Clear details of existing loans and finance sources.
• Availability of security/collateral (e.g. assets to cover the loan risk).
• A strong business plan outlining goals and how finance supports them.

Common reasons banks refuse loans:

• Weak cash flow
• Lack of security/collateral
• Poor preparation during the loan application
When Shareholders are likely to invest:
• Rising share prices of the business (means it is profitable/successful)
• High or increasing dividends (more returns to shareholders)
• Limited investment options elsewhere
• The company has a strong reputation and future growth plans