QuizGecko Finance 5.1 PDF

Why Businesses need Finance All businesses need finance to get started, allow them to grow and fund their continuing activity Businesses often call the money needed to start and operate \'capital\' Diagram: explaining why a business needs finance The finance department manages the finances and e...

Why Businesses need Finance All businesses need finance to get started, allow them to grow and fund their continuing activity Businesses often call the money needed to start and operate \'capital\' Diagram: explaining why a business needs finance The finance department manages the finances and ensures that the business is able to remain liquid The finance department manages the finances and ensures that the business is able to remain liquid Starting a business Start-up capital is the finance needed by a new business to pay for fixed assets and current assets before it can begin trading A business usually estimates the amount of start-up capital they need in the business plan Many small new businesses will get a start-up loan to cover these initial costs Expanding a business As a business grows more finance may be needed for capital expenditure It may require more equipment, buildings, IT infrastructure or vehicles which will allow the business to increase output If a business wants to grow by developing a new product, it will need to spend large amounts of capital on research and development (R&D) E.g. Apple\'s annual research and development expenses for 2023 were \$29.915 Billion, a 13.96% increase from 2022 as they are investing heavily in Artificial Intelligence (AI) and innovation of new products Working capital Finance is required for working capital which is spending on raw materials or or wages or utilities Having a steady flow of working capital is essential to keep the business operational Without working capital, the business would be unable to cover its day to day expenses It may suffer cash-flow problems which could lead to business failure The Distinction Between Short and Long-term Finance Short-term financial needs Short-term finance is used to help a business maintain a positive cashflow, for example: To get through periods when cash flow is poor for seasonal reasons, e.g. a rainy summer for an ice cream seller To help bridge the gap when a large customer payment is delayed, leaving the business without enough money to pay its bills that month To provide extra cash to pay for the manufacturing required to meet sudden or unexpected changes in customer orders, e.g. A small craft business selling via Etsy may use an overdraft to buy more stock of beads and threads due to a sudden surge in demand Long-term financial needs Long-term finance is usually used to buy fixed assets Fixed assets are purchased to be used for a long period of time and tend to be more expensive Long-term finance is used for expansion, e.g. a toothpaste factory installs a new production facility that costs over £1 million. This is a very large investment, but it will allow the business to increase output, efficiency and its product range Alternative Sources of Finance In recent years new forms of business funding have become available to business and can provide the funding required Two of the most common are crowdfunding and microfinance An Explanation of Crowdfunding and Microfinance Source Explanation Advantage Disadvantage Crowdfunding Crowdfunding allows businesses to access finance provided by a large number of small investors on online platforms such as Kickstarter These funds are voluntary 'donations' and don't have to be return or paid a dividend E.g. Flow Hive is a beekeeping system that was successfully funded on Indiegogo in 2015. The campaign raised \$12.2 million from 38,470 backers The Business has to reach a target amount before any funds are released i.e they will not receive any funds even if they are just a few hundred £s short by the selected funding date Investors are often attracted by incentives such as a sample or early access to a product Businesses need to provide a persuasive business plan to convince individuals to invest in their product, as they will be competing with many other projects online Microfinance Small-scale financial support for small start-up businesses in less developed countries Finance is available for people looking to start or expand small businesses, e.g. loans and insurance Some institutions are specifically aimed at women to help them to become more self-sufficient Provides access to credit for people who would not normally have access to it, allowing them to start or expand their businesses and increase their income The financial institutions are social enterprises and can provide advice and guidance over the long term Only small loan amounts may be offered, which may limit the choice of start-up options for the new business owner Business owners may get into excessive debt if they have access to loans from more than one microfinance institution and little experience of a new start-up Internal Sources of Finance An internal source of finance is money that comes from within a business such as owners capital, retained profit and money generated from selling assets An external source of finance is money that is introduced into the business from outside such as a loan or share capital Internal sources of finance Owner's capital: personal savings Personal savings are a key source of funds when a business starts up Owners may introduce their savings or another lump sum, e.g. money received following a redundancy Owners may invest more as the business grows or if there is a specific need, e.g. a short-term cash flow problem Retained profit The profit that has been generated in previous years and not distributed to owners is reinvested back into the business This is a cheap source of finance, as it does not involve borrowing and associated interest and arrangement fees The opportunity cost of investing the money back into the business is that shareholders do not receive extra profit for their investment Sale of assets Selling business assets which are no longer required (e.g. machinery, land, buildings) generates finance A sale and leaseback arrangement may be made if a business wants to continue to use an asset but needs cash The business sells an asset (most likely a building) for which it receives cash The business then rents the premises from the new owners E.g. In early 2023, Sainsbury's announced that it was in talks to sell the prime retail property for £500 million, which will then be leased back to them by the new owners, LXi Reit Sale of stock Stock may be sold at reduced prices in order to raise additional finance This reduces the opportunity cost and storage cost of high inventory levels It must be done carefully to avoid disappointing customers if stock runs low E.g. A clothing retail business holds a January sale to get rid of old stock and make space for new Spring stock Managing working capital A business can also generate additional finance internally by managing its working capital more effectively They can negotiate extended payment terms with suppliers They can incentivise customers to pay more promptly for credit purchases Evaluating the use of Internal Finance Advantages Disadvantages Internal finance is often free (e.g. it does not involve the payment of interest or charges) It does not involve third parties who may want to influence business decisions Internal finance can often be organised quickly and without significant paperwork Businesses that may fail credit checks (necessary for a bank loan) can access internal finance sources more easily There is a significant opportunity cost involved in the use of internal finance e.g. once retained profit has been used it is not available for other purposes Internal finance may not be sufficient to meet the needs of the business Using an internal finance method is rarely as tax-efficient as many external methods e.g. loan repayments may be treated as a business cost and offset against tax External Sources of Finance In some cases, a business may not be able to fulfil its needs with internal sources of finance Some projects or investments may require a significant amount of finance External sources, such as loans or issuing shares, can provide the necessary funds for these expensive projects Diagram: external sources of finance External sources of finance include borrowing, such as loans and bank overdrafts, share capital, grants and contemporary methods such as crowdfunding External sources of finance include borrowing, such as loans and bank overdrafts, share capital, grants and contemporary methods such as crowdfunding The implications of the different types of external finance need to be carefully considered Interest and fees to arrange finance can vary significantly between financial providers The percentage of company ownership required in exchange for finance depends on how much risk investors are willing to take The length of time allowed to repay borrowings or achieve investment targets also varies External Sources of Finance Source Explanation Bank overdraft An arrangement for business current account holders to spend more money than it has in their account Overdraft users are typically charged interest at a daily rate Using an overdraft for a long period can be expensive compared to other methods Bank loan A sum of money is borrowed from the bank and repaid (with interest) over a specific period of time Loans can be short-term or long-term Banks must approve the loan application Loans must be repaid with interest Hire purchase/leasing Instead of purchasing and owning assets outright businesses can opt to lease or use hire purchase agreements A business acquires equipment such as machinery or vehicles, spreading the cost of its use over time This is not a method to raise capital but allows the business use of an asset they would otherwise need to purchase Businesses commonly use these arrangements for equipment such as company cars (leasing) or photocopiers (hire purchase) Share issue/debentures A company can raise finance by selling shares on the stock market This can raise large amounts of capital but requires a business to follow strict regulations A rights issue allows existing shareholders the right to buy new shares in the business to raise further finance Shares in private limited companies may be sold to venture capitalists or angel investors Venture capitalists may provide guidance and expertise as part of the arrangement Debentures are long-term loan certificates issued by limited companies Debentures must be repaid with interest to lenders Debt factoring Businesses can sell their accounts receivable (invoices) to a third party at a discount The third party pays the business immediately, which means that cash is received immediately Customers then pay the third party over the agreed time frame (possibly several months) Trade credit Where a business has an agreement to delay paying its suppliers for a period of 30, 60 or 90 days This helps to improve the cash position of the business Grants and subsidies These are sums of money provided to the business by governments and some outside agencies They do not usually have to be repaid The money is often provided with certain conditions attached, such as the business must locate in a particular area in order to create jobs Businesses also access finance through the use of credit cards or charge cards These are particularly useful as a means to allow employees to make small purchases that are centrally paid Interest charges can be high so use is carefully monitored\| Short-Term Sources of Finance Short-term sources of finance will be needed to meet unexpected costs or to pay bills and suppliers These are likely to be relatively small amounts and are rarely needed beyond a year Longer-term sources of finance will be needed to fund the purchase of non-current assets such as buildings and other types of capital equipment These are likely to be large sums that may be required for a significant period of time Diagram: short and long-term sources of finance The purpose of the finance will ultimately determine if the business chooses a short, or long-term source The purpose of the finance will ultimately determine if the business chooses a short, or long-term source Evaluating Short-term Sources of Finance Source Advantages Disadvantages Overdrafts A limit is agreed and interest is charged only when a business 'goes overdrawn' Offers significant flexibility and aids cash flow An overdraft may be called in if the bank is concerned about a business\'s ability to repay what it owes Interest on overdrafts tends to be higher than on other loans Trade credit Trade credit is usually interest-free A business can increase its stock without having to immediately pay for it, which can significantly enable positive cash flow if the stock is sold before payment becomes due Suppliers may prioritise delivery to customers who have the shortest repayment dates Cash needs to be carefully managed to ensure the business has the money available to pay its suppliers on the agreed date Debt factoring Debt factoring provides a source of Immediate cash to the business The business does not have to handle the debt collection themselves The third-party debt company will keep a percentage of the debts collected as reward The business does not get paid the total value of their debts Long-term Sources of Finance Long-term finance is available for more than a year and can be paid back over a long period of time Many forms of long-term finance appear as non-current liabilities in the balance sheet Evaluating Long-term Sources of Finance Source Advantages Disadvantages Bank loans Bank loans are usually unsecured and are typically repaid over two to ten years Interest rates are fixed for the term of the loan so repayments are made in equal instalments, which helps with business planning Interest is payable and the business assets are at risk if the business does not make repayments as planned Hire Purchase The firms does not need to spend a large sum of money to acquire and use an asset A deposit is usually payable before the asset is delivered Interest charges can make the overall cost higher that buying an asset outright Leasing The business does not own the asset during the period of the lease and so is not responsible for maintenance or repair costs Leasing is usually more expensive in the long run than buying an asset Share Issue Large amounts of money can be quickly raised from wealthy investors Shareholders who buy a large number of shares may also bring and share expertise, which can be beneficial to the business Shareholders are the owners of shares and they are entitled to a share of the company's profit when dividends are declared Shareholders usually have a vote at a company's Annual General Meeting (AGM) where they can have a say in the composition of the Board of Directors Debentures Can be used to raise very long-term finance, e.g. over 30 years Unlike share capital, debenture holders have no share in the company itself Interest and the loan itself has to be repaid Factors to Consider when Choosing a Source of Finance There are many factors that managers must consider before deciding upon the type and source of finance required They may need to use more than one source of finance at the same time Diagram: factors affecting the suitable choice of finance Several factors affect the suitability of the choice of finance such as the timescale, the cost, the purpose, the legal structure of the business, the willingness to relinquish control, and the level of existing debt The level of existing debt may be so high that a business will rather sell shares than borrow more An Explanation of the Factors Affecting the Choice of Finance Factor to Consider Explanation What is the purpose of obtaining finance? Fixed assets are most likely to need a long-term source of finance, such as a bank loan Day-to-day costs such as rent and wages could be covered by a short-term overdraft How long is the finance required for and when can it be paid back? Overdrafts are a short term option to help a firm who needs a smaller amount of finance urgently Mortgages can be paid back over many years How much finance is needed? Large amounts of capital can be raised through the issue of shares to family and friends, or through a flotation on a stock exchange Smaller sums may be accessed through business credit cards or overdrafts What is the legal structure of the business? Businesses which are already Public Limited Companies can issue shares or debentures Sole traders often rely on owners\' capital How much risk is involved? Businesses with existing loans may have high gearing and pay high rates of interest as they are seen as risky Leasing involves little risk as assets can be returned if finance costs are not paid How much control and ownership does the company want to keep? If limited companies issue too many shares, the current owners may lose some control of the business Borrowing retains control, though interest is payable Reducing the risk of being unable to raise finance This risk of not being able to raise the finance can be reduced in several ways Bank loans will most likely be approved when A business presents a convincing business plan including a cash-flow statement, and income statement for the last time period Existing sources of external finance are minimal and being managed effectively A business has collateral to reduce risk to the bank Investment from shareholders will most likely happen when The share price is improving Dividends are generous The company has good profit potential and is planning to grow Alternative investments are less attractive Recommending an Appropriate Source of Finance Finance managers frequently have to make recommendations to their CEOs about the most suitable form of financing to use The most suitable form is determined by conducting an analysis using the questions in the table above Example 1 A very successful private limited company manufactures and sells wooden tables and chairs. It has been running for 15 years and has an excellent reputation. It has previously reinvested profits to fund expansion. It now needs more finance to fund growth into new markets Key considerations The business is a limited company, so selling shares to family and friends is an option to raise a limited amount With 15 years of success, it is less of a risk than a new start-up, so a bank loan could be obtained The scenario indicates that reinvesting profits will not be enough to finance growth plans Recommendation A bank loan could be easy to obtain due to business success over the last 15 years. Repayments are spread over several years and interest must be paid The business could issue new shares to existing shareholders, which may increase their investment due to business success as family and friends may want to be part of its exciting growth plans The decision will depend upon how much control and ownership the business owner may lose by issuing more shares Most finance managers would recommend obtaining a bank loan, as this is often preferable to losing ownership and a share of future profits Example 2 A retail store selling fashion trainers has sold large quantities of stock since an influencer promoted the store on TikTok and Instagram. It needs to quickly replenish its stock. The sole trader, Toby, is considering using his existing overdraft or trade credit Key considerations New stock is needed quickly so the existing overdraft facility on his bank account could be an instant source of finance Trade credit means he would not have to pay for stock straight away, which would avoid cashflow problems as stock can be sold before payment to the supplier is due Recommendation An overdraft is a short-term source of finance and Toby will have to pay interest on the amount that he uses Trade credit would ease financial pressure as stock is replenished and he may receive a discount when he sets up the agreement Most finance managers would recommend to Toby that he first seek trade credit. If he is unable to secure that, then he should consider using his overdraft facility Examiner Tips and Tricks Which is the best source of finance for this business? This is a very common question in the exam Be prepared to analyse the advantages and disadvantages of the main sources of finance and give a justified recommendation. Consider the type of business ownership; for example, only a public limited company can sell shares on the stock exchange