CH 15: Business Finance

Why businesses need finance

Startup: In ini%al stages, a business needs start-up finance. This includes finance to pay for
assets that the business needs to begin trading e.g., a premises, machinery, wages for labour. It
is hard for businesses to procure start-up finance as entrepreneurs o=en do not have enough
finance on their own and investors are reluctant to risk their money for an untested business.

Growth: When businesses grow, they o=en expand to other regions. This requires finance to
purchase non-current assets such as new premises, equipment. The business will also have to
pay for the recruitment and wages of more staff such as delivery riders, factory workers etc.

Survival: Businesses need finance to survive at the beginning to cover costs and pay off
debtors. When facing an economic crisis, businesses need finance to pay off liabili%es while
protec%ng assets.

Short-term vs. Long term sources of finance

Short-term finance is used for day-to-day expenses such as paying suppliers, bills and wages.
Need for short-term finance may be because of sudden decrease in sales, increase in price of
raw materials or poor cash flow. It is expected to be paid back within 12 months.

Long-term finance is used for long-term expansion plans which require purchase of non-current
assets such as buildings or equipment. It is paid over a period of more than a year.

Internal sources of finance are procured from within the business.

External sources of finance are arranged from outside the business.

Sources of Finance available to business

The decision of which source of finance to obtain will largely depend on the dura%on for which
the capital is being raised for. There are three categories of sources of finance based on that.
Internal source

1. Retained earnings: Profit saved by the business from previous years’ trading for internal
growth. No interest had to be paid, does no add to liabili%es. However, reduc%on of
dividends, relies on business’s profitability.

2. Sale of assets: An asset sale happens when you sell or transfer the assets of your company,
rather than shares or stock. These assets can be tangible (eg machinery and inventory) or
intangible (eg intellectual property). In an asset sale, you can typically choose what you
want to sell. Does not have to be repaid, no interest payments quick method. Business
loses asset forever.

3. ReducIon in Working capital: In short, working capital is the money available to meet your
current, short-term obliga%ons. To make sure your working capital works for you, you'll
need to calculate your current levels, project your future needs and consider ways to make
sure you always have enough cash. Permanent and fast way to raise finance. Customers
may switch to a business which offers more credit %me.
External sources

1. Bank loans: Capital borrowed fro banks at fixed interest rates, collateral may not be
necessary, less costly than overdra=. However, high interest rates, collateral may be
needed if amount is large, not accessible to small or new businesses.

2. Sales and leaseback: Business can con%nue using asset and also retain capital from its
sell. Business now has to make payments for something it used for free.

3. Share capital: Capital raised by selling shares to new / exis%ng owners. Permanent
finance, large sum can be procured. Ownership of business dilated, reduc%on of
dividends.

4. Venture capital: Capital taken from investors. May be repayable only if business is
profitable, last resort for business without trading history or collateral. However, profits
may have to be shared with investor, investor may want business to move in specific
direc%on.

5. Government loans: Financial support provided by the state to assist businesses. Grants do
not have to be repaid, lower repayments than bank loan. However, strict terms may be
a\ached to loan, e.g., how business can spend the funding.

6. Microfinance: Loans specially deisgned for small and new businesses. Beneficial for small
businesses with no collateral and trading history. However, amount may be very small.

7. Crowd funding: Raising small amounts from a large popula%on by promo%ng the idea
publicly. Large amounts may be raised, beneficial for entrepreneurs with good business
ideas but no finance. However, investors may expect discounts when product is launched.

8. OverdraN: Bank agrees to a business borrowing up to an agreed limit as and when

required. High interest because short-term finance is required, must be paid back shortly.

9. Trade credit: Asking for an extended %me to pay back from the creditors. Easier to plan
sales, for the be\erment of cash flow.

10. Debt Factoring: Selling of claims over trade receivables to a debt factor in exchange for
immediate liquidity – only a propor%on of the value of the debts will be received as cash.
 Receivables sold to a factoring company, a certain percentage of receivable recovered by
the original owner

Note: Short-term finance is used up and paid back within a year and mostly used to pay for
bills and other day-to-day expenses. Long-term finance is used up and paid back over a period
of more than a year and used for purchasing non-current assets for expansion.

The difference between cash and profit

• Profit is defined as revenue minus all the expenses of a business during a certain period.
Even if a business is profitable, it may not have sufficient cash.

• The business may offer long credit periods to customers. This means that the cash
generated from sales will not flow into the business un%l customers have paid for the goods
or services. In the mean%me, the business will need cash to cover its expenses such as
paying suppliers or workers.

• Some businesses hold a large inventory, resul%ng in much of the cash being %ed up in stock
which cannot be u%lised elsewhere.

• The purchase of non-current assets such as machinery may help in e.g., produc%on of goods
and services and therefore eventually bring cash into the business. However, ini%ally this will
put a strain on a business’s cash as non-current assets require large sums of finance.

• If a profitable business does not have sufficient cash to cover its bills, it may become
insolvent and fail.

Business failure
LiquidaIon
When an incorporated business i.e., a company is judged to be insolvent, its assets will be sold
off for cash. This process is known as liquida%on. The personal assets of owners will be
protected as they have limited liability.
Bankruptcy
The owners of an unincorporated business such as sole traders have unlimited liability. In this
case, the business is declared legally bankrupt when it’s unable to se\le its debts. The assets of
the business including the private possessions of the owners are sold off to pay back creditors.
Compulsory liquidaIon
This occurs when a creditor seeks order of court to have the assets of the company sold off in
order to get paid. The court appoints a receiver who takes over the insolvent company and
arranges for creditors to be paid back.

Voluntary liquidaIon
This occurs when the owners of the company realise the weak financial posi%on of the business
or want to re%re but are unable to sell the business.

AdministraIon
Some businesses enter administra%on and receive protec%on from immediate liquida%on. An
administrator is appointed who a\empts to protect shareholders’ interests and keep the
business running. However, if the business is unable to con%nue trading, it will enter liquida%on.

Working capital
Working capital is the amount available to a business to pay for its day-to-day expenses such as
bills and raw [Link] working capital is derived from the statement of financial posi%on
with the formula:

[working capital = current assets - current liabiliIes]

This amount is highly important for any business as if the business is unable to pay its bills, it
may become insolvent and cease trading.

Working capital can also be a source of short-term finance for a business if current assets
con%nually exceed current liabili%es. This can occur if:

• The business manages its trade receivables in a way that its paid on %me.
• The business manages its trade payable in a way that payment is delayed as much as
possible.
• Not too high of an inventory is held to prevent cash from being %ed up in stocks.
Capital expenditure vs Revenue expenditure

Capital expenditure is spending on mainly non-current assets with long-term use such as
machinery. This includes expenditure on start-up and expansion. This spending is essen%al to
generate sales and profit in the long-term e.g., more equipment will increase produc%on of
goods. Capital expenditure is a part of the statement of financial posi%on.

Revenue expenditure is spending on mainly current assets that are used up in a short period of
%me e.g., raw materials. This also includes expenditure on bills and wages which are essen%al to
pay in order to con%nue trading ac%vi%es. Revenue expenditure is shown on the income
statement.

Business ownership and sources of finance

Sole trader: Sole traders may find it difficult to procure finance. Banks may be unwilling to lend
to sole traders due to lack of collateral. Lenders are reluctant to invest into the business as it
they have doubts over its development and growth. Thus, sole traders are likely to use their
personal finance, government loans that support small businesses and micro-finance.

Private limited company: The business can sell shares to close friends or family to raise finance,
however it is o=en difficult to find suitable shareholders. Introducing new shareholders also
leads to reduced control and lesser dividends for exis%ng shareholders. Shareholders may
disagree over the source of finance to be used. Banks and lenders may be more willing to invest
into a company as the element of risk is lesser.

Partnership: Introducing a new partner for capital will reduce exis%ng partner’s share of profit
and may lead to disagreement. No shares can be sold and conver%ng a partnership into a
private limited company is a legally extensive and costly procedure. Partners may use their
savings, bank loans or government loans.

Public limited company: The business can sell shares to close friends or family to raise finance,
however it is o=en difficult to find suitable shareholders. Introducing new shareholders also
leads to reduced control and lesser dividends for exis%ng shareholders. Shareholders may
disagree over the source of finance to be used. Banks and lenders may be more willing to invest
into a company as the element of risk is lesser.
Factors to be considered making source of finance decision

When making judgements on the most appropriate source, managers will have to take into
account a range of factors rela%ng to the business’s internal posi%on and the business
environment in which it is trading.

• Is the busines profitable? If so, it may be able to use retained profits as a source of finance
or at least be able to provide evidence to banks and other creditors that it can repay loans.
Alterna%vely, it may have assets that it can sell, and lease back, or simply sell.

• The business’s reputaIon. A reputa%on as a reliable and popular business may also enable
its managers to persuade suppliers to offer increased trade credit which can fund short-
term needs for finance. Equally, such a reputa%on will assist a business in nego%a%ng loans,
possibly at favorable rates of interest, or in persuading shareholders to purchase the
company’s shares.

• Its legal structure. This will play a role in making the decision on the appropriateness of
sources of finance. Thus, only companies will be able to elect to use share capital as a
source to fund start-ups or expansions.

• The business environment. The environment in which the business is trading will also
shape the decision. If sales in a market are growing the business may be more able to
finance the repayments on a loan as its revenues should increase in the future. On the
other hand, if interest rates are high, making loan capital a rela%vely expensive source of
finance, businesses may seek alterna%ve sources

• Opportunity cost. A decision to use a par%cular source of finance may have a cost in terms
of what has to be given up as a consequence of the decision. For example, a decision to use
sale and leaseback as a source of finance may appear a low-cost op%on. However, this
source of finance will commit the company to paying each month or year for the asset that
has been sold. Similarly, using retained profits for reinvestment into the company entails an
opportunity cost which can be measured in terms of the reduc%on in the amount of profits
that can be paid to shareholders (these are known as dividends)

• Flexibility. Some sources of finance are highly flexible and can be adapted to meet a
business’s precise needs. The most obvious example is an overdra=. This source of finance
allows a business to overspend its current account or not according to its needs (but
subject to an overall limit). Thus, a business can use its overdra= only when it is necessary
and can avoid any interest charges at %mes when its finances are stronger. This flexibility
has a cost however: overdra=s are an expensive source of finance
 Glossary

1. Startup Capital: the capital needed by an entrepreneur to set up a business. Example: Bank
loans and crowd funding

2. Working capital: the capital needed to pay for raw materials, day-to-day running costs and
credit offered to customers. In accoun%ng terms working capital = current assets – current
liabili%es.
Example: Bills for fuel and raw materials, wages and business rates.

3. Capital expenditure: the purchase of assets that are expected to last for more than one year,
such as building and machinery.

4. Revenue expenditure: spending on all costs and assets other than fixed assets and includes
wages and salaries and materials bought for stock.

5. Liquidity: the ability of a firm to be able to pay its short-term debts.

6. LiquidaIon: when a firm cease trading and its assets are sold for cash to pay suppliers and
other creditors.

7. OverdraN: bank agrees to a business borrowing up to an agreed limit as and when required.

8. Factoring: selling of claims over trade receivables to a debt factor in exchange for immediate
liquidity – only a propor%on of the value of the debts will be received as cash.

9. Hire purchase: an asset is sold to a company that agrees to pay fixed repayments over an
agreed %me period – the asset belongs to the company.

10. Leasing: obtaining the use of equipment or vehicles and paying a rental or leasing charge
over a fixed period, this avoids the need for the business to raise long-term capital to buy the
asset; ownership remains with the leasing company.

11. Equity finance: permanent finance raised by companies through the sale of shares.
12. Long-term loans: loans that do not have to be repaid for at least one year. Example:
debentures issued by the company.

13. Long-term bonds or debentures: bonds issued by companies to raise debt finance, o=en
with a fixed rate of interest.

14. Rights issue: exis%ng shareholders are given the right to buy addi%onal shares at a
discounted price.

15. Venture capital: risk capital invested in business start-ups or expanding small businesses
that have good profit poten%al but do not find it easy to gain finance from other sources.
Example: Specialist organiza%ons or wealthy individuals.

16. Microfinance: providing financial services for poor and low-income customers who do not
have access to banking services, such as loans and overdra=s offered by tradi%onal commercial
banks.
Example: Many business entrepreneurs in Bangladesh and other Asian countries have received
microfinance to help start their businesses. In some of these countries, more than 75% of
successful applicants for microfinance are women.

17. Crowd funding: the use of small amounts of capital from a large number of individuals to
finance a new business venture.
Example: Small and medium-sized businesses.

18. Business plan: a detailed document giving evidence about a new or exis%ng business, and
that aims to convince external lenders and investors to extend finance to the business.
 MulIple choice quesIon

1 Working capital is defined as:

a) the capital required to start up a business
b) the capital needed to purchase buildings and machinery
c) the capital needed to pay for raw materials, day-to-day running costs and credit offered to
customers
d) all forms of finance

2 The liquidity of a business refers to:

a) its ability to pay short-term debts
b) its ability to repay long-term finance
c) its ability to make profit
d) its ability to raise finance

3 Which one of the following is not an example of internal finance?

a) retained profits
b) sale of assets
c) sale of shares
d) reduc%ons in working capital

4.A disadvantage of relying on internal finance is that:

a) there is an increase in the liabili%es or debts of the business.
b) there is a risk of loss of control by the original owners.
c) there is a high direct cost to the business.
d) it will limit the availability of finance for expansion
[Link] one of the following is primarily a short-term source
of finance?
a) mortgage
b) bank loan
c) hire purchase
d) overdra=

[Link] factoring involves:

a) selling claims on debtors to a third party
b) insis%ng that debtors se\le their debts in cash
c) extending credit to customers
d) paying o! the debts of the business

7 Which one of the following is an example of equity finance?

a) sale of debentures
b) sale of shares
c) overdra=
d) bank loan

8. An entrepreneur planning to start a new business is short of funds. One of the most likely
sources of finance for the new venture is:
a) long-term bank loan
b) crowd funding
c) sale of shares
d) sale and lease-back of assets
 Sample answers
2015 June 13 B6 (a)
An internaIonal chain of coffee shops is planning to expand into a new country.
Discuss the factors that could affect the decision on how to finance this
investment [20 marks]
Interna%onal expansion, although organic, requires big and long-term sources of finance to source
capital requirements to operate in another country. Since the coffee shops will need long-term finance
for regular cash - flow first of their very feasible source of finance will be retained profits. Since this chain
of coffee shops is interna%onal, it might just have. enough finance to finance the opening of new shops
which make up for an internal source. To avoid any direct costs to the business or an increase in
liabili%es, a second internal source of finance would be reduc%ons in working capital by for instance
selling addi%onal franchises or closing less profitable branches.
However, before expanding to a new country, the chain needs to consider, whether the government of
the country offers any incen%ves for new business and if yes, what are the second they need to consider
what are the interest rates when op%ng for debt- finance. If the company plans to conserve addi%onal
profits and not in a posi%on to sell any of its assets, it needs to rely on external and long-term sources of
finance first of which Is a long-term loan, however, these might become very expensive in a period of
using interest rates. Second great way to -raise large sums of money would be the sale of debentures. by
This also results in no loss of ownership, however, becomes a liability as the investors need to be paid off
a=er the limited company, a huge sum of money can be raised by the sale of shares which result in a loss
of ownership but since it is permanent capital, it never has to be repaid hence no increase un liabili%es
this or to finance is known as equity finance. All the factors. which period, amount required, cost of
finance, the legal structure of the business, size of exis%ng borrowing, and flexibility of finance need to
be considered before op%ng for any source of finance.

Q. Explain the difference between revenue expenditure and capital expenditure.

[5 marks]
Capital expenditure is the purchase of assets that are long. Las%ng i. e more than a year or so which
might include the buying or capital equipment (machinery), however, revenue expenditure accounts for
all current - assets purchased which include wage salaries and materials bought for stock. However, both
will be recorded differently. Revenue expenditure is recorded on the income statement which states the
profit and expenditure for a single year

Q. Define the term start-up capital. [2 marks]

Start-up capital is the ini%al capital used to inject into the business to start opera%ons/produc%ons for
e.g., capital required for buying machinery, premises, etc.
Q. Briefly explain two sources of start-up capital. [3 marks]
Two sources of start-up capital are crowdfunding and microfinance. Crowdfunding refers to the business
idea being put up on a crowdfunding website where many inventors pool in sums of money un%l the
specified target is reached. All these many investors are then paid back with interest or given a share in
the business. microfinance however refers to the lending of money from small banks to poor
entrepreneurs who do not have access to loans to addi%onal banks. These loans however must be paid
back

Q. Define the term 'retained profit'. [2 marks]

Retained profits are the profits incurred y a business during a specific period of %me which are then used
as a source of finance for the upcoming year. This source of finance isn't available for start-ups

Q. Briefly explain two external sources of finance that could be used to fund the
capital expenditure of a partnership. [3 marks]
A partnership is a form of an unincorporated business it has access to limited sources of finance, unlike
corpora%ons. one external source of finance that could be used by a partnership is grants: These may be
given by specialist. agencies or the government with condi%ons a\ached. If these condi%ons are fulfilled,
the grant no longer have to be paid back. This reduces the risk of unlimited liability in case of a business
failure: Second sources available are [Link] long-term loans by banks. This however requires a
trading history for a business and might involve difficul%es in acquiring one.

Q. Explain the importance of the business of disInguishing between revenue

expenditure and capital expenditure. [5 marks]
Revenue expenditure account for all payment of assets within one year or less however capital
expenditure is the purchase. of assets expected to last for more than a year. Its dis%nc%on is important
as capital expenditure is recorded in balance sheet while revenue expenditure is recorded in the income
statement. Secondly, CE is incurred to acquire fixed assets for opera%on i . e. needs long term sources of
finance whereas revenue expenditure is incurred on day - to day conduct of business i.e.. accounts for
the cash flow and needs short term sources of finance. Thirdly, capital expenditure increases the earning
capacity of the business while RE is Incurred to maintain the earning capacity.

Q. Explain the difference between ' cash' and ' profit. [2 marks]
Cash is the liquid money need to run day-to-day affairs of the business without which cashflow is
hindered and the business can decline. Profit however is the money made on a single product or overall,
that is le= a=er all the expenses have been paid. A business can survive some lime w /D profit but not
cash

Q. Define the concept of liquidity. [2 marks]

liquidity is a business ability to pay its short-term debts. It is affected by the amount of business working
capital, without which a business will be forced into Liquida%on.

Q. Explain how a manufacturing company could finance its expansion [8 marks]

To choose appropriate source of finance, the current financial standing of the business needs to be
considered i.e., whether there are enough retained profits, However, this might put further pressure on
the business if a huge amount is required depending on the size of expansion and machinery required.
External sources need to be heavily relied on instead of internal sources for e.g., a great Source could be
equity finance if it's a public limited company however it would result in a loss of ownership. Second
source could be long-term loans from banks as it would be easier to obtain as the company is already
established. third source could be hire purchase or leasing for equipment for expansion depending on
whether the equipment is to be owned or not.

Q. Explain how a public limited company might finance a large capital

investment project. [5 marks]
The amount of finance and its source must appropriately be chosen keeping in mind the amount
required and whether it is for the short or long -term. However, for large capital investment, requires
long-term finance: The biggest source of finance that exists for a public limited company is the
availability of equity finance; e. sale of share ex. A huge number of shares could be sold however this
might result in a loss of ownership. Another source could be debentures where investment is raised by
other forms or local people in exchange for a cer%ficate for a limited %me period a=er which they are
repaid with interest.
 Chapter 15
Year Session Paper Section Q Part Marks Question Unit Chapter
Analyse the benefits of using internal sources of finance for business
2022 March 12 B 5 a 8 5 2
growth.
Discuss the most appropriate source of finance for a private limited
2022 June 11 B 7 b 12 5 2
company to purchase an additional factory.
2021 November 12 A 2 a 2 Define the term ‘overdraft’. 5 2
2021 November 12 A 2 b 3 Explain two reasons why a business might use an overdraft. 5 2
Explain the advantages to a manufacturing business of using sale and
2021 June 11 A 3 a 5 5 2
leaseback of non-current assets as a source of finance.
Analyse the benefits for a business of an overdraft as a source of
2021 November 11 B 5 a 8 5 2
finance.
2021 November 12 B 7 a 8 Analyse the advantages for a business of debt factoring. 5 2
Discuss the most important factors for a venture capitalist to consider
2021 November 12 B 7 b 12 when deciding whether to provide growth capital for a computer games 5 2
retailer.
Analyse the benefits to an entrepreneur of using micro-finance as a
2021 June 13 B 7 a 8 5 2
source of start-up capital.
2020 November 11 A 2 a 2 Define the term ‘venture capital’ 5 2
2020 November 11 A 2 b 3 Explain two ways that venture capitalists might help a business 5 2
Explain the difficulties that a small business start-up might have when
2020 June 12 A 3 a 5 5 2
trying to obtain finance from an external source.
Analyse the disadvantages to a business of using debt factoring to improve
2020 June 12 B 5 a 8 5 2
its cash flow.
Analyse the possible problems that a new business might experience
2020 June 13 B 5 a 8 5 2
when trying to raise finance.
2019 June 11 A 2 a 2 Define the term ‘retained earnings’. 5 2
Briefly explain the distinction between short-term and long-term sources
2019 June 11 A 2 b 3 5 2
of business finance.
Analyse the advantages of crowd funding as a source of finance for small
2019 June 12 B 5 a 8 5 2
businesses
Analyse the external sources of finance a multinational car manufacturer
2019 June 13 B 7 a 8 5 2
may use to finance the production of a new electric car.
2018 November 11 A 1 a 2 Define the term ‘crowd funding’. 5 2
2018 November 11 A 1 b 3 Briefly explain two advantages of crowd funding for a new business. 5 2
2018 November 13 A 2 a 2 Define the term ‘debt factoring’. 5 2
Briefly explain two disadvantages of using debt factoring to improve the
2018 November 13 A 2 b 3 5 2
cash flow of a business.
Explain how a large manufacturing business could finance investment in
2018 November 12 A 3 a 5 5 2
new machinery.
Briefly explain two reasons why a bank might refuse to lend money to an
2018 June 12 A 4 b 3 5 2
entrepreneur.
Analyse the advantages of venture capital as a source of finance for a
2018 June 13 B 5 a 8 5 2
small business.
Analyse the advantages and disadvantages for a new business of using
2018 November 11 B 7 a 8 5 2
an overdraft to help manage its cash flow
Discuss the factors that directors of a large pharmaceutical company
2018 March 12 B 7 b 12 5 2
should consider when choosing how to finance growth.
2017 June 12 A 2 a 2 Define the term ‘debt factoring’. 5 2
Briefly explain how leasing might be used by a business to improve cash
2017 June 12 A 2 b 3 5 2
flow.
2017 November 12 A 2 a 2 Define the term 'retained earnings’. 5 2
2017 November 11 A 4 a 2 Define the term ‘micro-finance’. 5 2
2017 November 11 A 4 b 3 Briefly explain two advantages of micro-finance for an entrepreneur. 5 2
2017 June 13 A 4 a 2 Define the term ‘share capital’ 5 2
Briefly explain one advantage and one disadvantage of grants as a
2017 June 13 A 4 b 3 5 2
source of business finance.
2016 June 13 A 4 b 3 Briefly explain two sources of start-up capital 5 2
Discuss the benefits and drawbacks to a business of using only internal
2016 June 12 B 5 b 12 5 2
sources of finance to fund expansion.
Analyse the advantages of crowd funding as a source of finance for a
2016 November 13 B 7 a 8 5 2
small business
 Chapter 14
Year Session Paper Section Q Part Marks Question Unit Chapter
Explain why a business manager needs to understand the difference
2022 June 12 A 3 a 5 5 1
between capital expenditure and revenue expenditure.
Explain the effects on a business of having a high level of working
2021 March 12 A 3 a 5 5 1
capital.
2021 June 12 A 3 a 5 Explain the importance of working capital to a new business. 5 1
2018 June 12 A 4 a 2 Define the term ‘capital expenditure’. 5 1
2016 November 11 A 4 a 2 Define the term ‘working capital’. 5 1
Briefly explain two reasons why the effective management of working
2016 November 11 A 4 b 3 5 1
capital is important for all businesses
2016 June 13 A 4 a 2 Define the term ‘start-up capital’. 5 1
Analyse the importance for a business of distinguishing between
2016 June 12 B 5 a 8 5 1
revenue expenditure and capital expenditure.
Explain how better management of trade receivables and trade
2020 March 13 A 3 a 5 5 1&3
payables can improve cash flow