Financing Business Activity

Chapter 9

  • Businesses need finance to:
    start a business (start-up capital)
    avoid insolvency/bankruptcy
  • Capital expenditure: the money spent on fixed assets which will last more than a year
  • Revenue expenditure: the money spent on day-to-day expenses which do not involve the purchase of a long term asset

Sources of Finance

  • Internal: the money which is obtained from within the business itself
  • External: venues for obtaining funds that come from outside an organization

Internal Finance

1. Retained Profit

  • The profit kept in the business after the owners have taken their share of the profits
  • It does not have to be repaid
  • However
  • A new business will not yet have any retained profits
  • The profits may be too low to finance the expenses
  • Withholding profits results in less payment to the owners

2. Sales of Existing Assets:

  • Those assets which are no longer required by the business
  • Better use of the capital tied up in the business
  • However
  • It may take time to sell these assets
  • New businesses may not be able to benefit from this

3. Running Down Stocks to Raise Cash:

  • Reduces opportunity cost and storage of high stock
  • Must be done carefully to avoid disappointing customers

4. Owner’s Savings:

  • Owner investing personal money into unincorporated business
  • Quickly available
  • No interest is paid
  • However
  • Savings may be too low
  • Increases risk taken by owner

External Finance

  • Short term: up to 3 years
  • Medium term: 3-10 years
  • Long term: 10+ years

Short-Term Finance

1. Overdrafts:

  • The bank gives the business the right to overdraw its bank account
  • Very flexible form of borrowing
  • Interest is only paid on the amount overdrawn
  • Cheaper than loans
  • However
  • Interest rates are variable
  • The bank can ask for repayment at any time

2. Trade Credit:

  • When a business delays paying its suppliers
  • Interest-free loan
  • However
  • The supplier may refuse to supply or give discounts

3. Factoring of Debts:

  • Debt factors are specialist agencies that ‘buy’ the debt of a firm for immediate cash
  • Immediate cash is made available
  • The risk is of the debt factor’s
  • However
  • The firm does not receive 100% of the value of its debt

Medium-Term Finance

1. Bank Loans:

  • Quick to arrange
  • Can be for varying lengths of time
  • Can be offered low rates of interest
  • However
  • Security is required
  • Will have to be repaid eventually with interest
  • Smaller companies may not get low interest rate

2. Hire Purchase:

  • Allows a business to buy a fixed asset over a long period of time with monthly payments including an interest rate
  • Firm does not have to pay a large sum of money at once
  • However
  • A cash deposit must be paid at the start
  • Interest payments may be quite high

3. Leasing:

  • Allows a firm to use an asset without having to purchase it
  • Firm does not have to pay a large sum of money at once
  • Care and maintenance of the asset is carried out by the leasing company
  • However
  • The total cost will be higher than that of purchasing the asset

Long-Term Finance

1. Issue of Shares [Equity Finance]:

  • Permanent capital which does not have to be repaid
  • No interest payments
  • However
  • Dividends are paid after tax
  • Only available to limited companies
  • Balance of ownership may be threatened

2. Long-Term Loans & Debt Finance:

  • When a firm raises money selling bonds, bills, or notes
  • Interest is paid before tax
  • Interest must be paid every year but dividends do not
  • Must be repaid (not permanent)
  • Secured against particular assets

[see loans for advantages and disadvantages]

3. Selling Debentures:

  • Long-term loan certificates issued by limited companies
  • Very long-term finance
  • However
  • They must be repaid with interest

4. Grants and Subsidies:

  • Do not have to be repaid
  • However
  • There are always strings attached

How Choice of Finance is Made

  • Purpose
  • Time-Period
  • Amount Needed
  • Status and Size of Company
  • Control
  • Risk and Gearing

[Gearing is a measure of risk. It is the proportion of total capital raised from long-term loans]

When Will Banks Lend and Shareholders Invest?

  • Financial information is provided about the firm’s trading record and forecasts about its future:
    business plan
    cash flow forecast
    forecasted profit and loss account
    gearing ratios
    reason behind the loan
    future prospects
  • Comparison of dividends with other companies
  • Variation of company’s share price
  • Forecast shows solvency
  • Experience of people in the business and how convincing they are

Business Plans

  • A document containing the business objectives and important details about the operations and finance of the firm
  • It must contain:
    Type of Business
    Market aimed for
    Market research
    H/R plan
    Details of senior staff
    Production details
    Business cost
    Main equipment
    Forecasted profit
    Cash flow
    Finance/ Sources of Finance


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