Financing business activity

= jn it w ill exp lain : S w+iy businesses need finance S e different sources of finance a v a ila b le to business S -o w m anagers choose betw een differen t sources. s end of the unit you should be ab le to: li ~=<ognise the differen t reasons w h y businesses need finance Z : cssify different sources of raising finance betw een internal and e xtern a l and :-r-riod of tim e 1 : -slyse the ad van tag es and disadvantages of d ifferent sources of finance Z : slyse a firm's need fo r funds and m a k e a choice betw een the a v a ila b le sources Z <ake decisions on w h e th e r finance should be m ade a v a ila b le to a business from ff- = view p o in t o f shareholders, banks and other institutions.

W h y do businesses need finance?

What is finance? Finance is money. We all need money to purchase the goods and services we require. We need money to buy everyday goods, like food, but we also need money, or finance, to pay rent or to buy a house or other expensive things. Businesses need finance too. Without money they could not pay wages, buy materials or pay for assets. Here are three examples of why businesses need money.

Starting up a business
When an individual plans to start their own business, they should consider all of the assets they will need to buy in order to start trading. From studying Unit 7 you should now have a clear idea of what fixed assets are and why new businesses will need to purchase some of these. In addition, the owner of the firm will need to obtain finance to purchase current assets, for example stocks, before goods can be sold to the first customers. The finance needed to launch a new business is often called s t a r t - u p
C A P IT A L .

M in rH o n to learn:
rO P ^A i is the *eeded by a new to pay for fixed and current it can begin

Expanding an existing business

The owners of a successful business will often take a decision to expand it in order to increase profits. Additional fixed assets could be purchased - such as buildings and machinery. Another business could be purchased through a take-over. In both cases, it will probably be necessary to increase the firms working capital in order to finance additional stocks and debtors. 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.

128 FINANCING BUSINESS ACTIVITY

A business in difficulties
Finance may also be needed by businesses that are not doing so well. Fcr example, a loss-making business may need to purchase new machinery :r order to become more efficient. In another case, a firm with negative cii i flow may need finance to cover short-term expenses. It is often very difficult for either loss-making businesses or those with negative cash f (see Unit 8) to raise essential finance.
D e fin itio n s to le a rn :
C apital
expenditure

is

money spent on fixed assets which w ill last for more than one year. Revenue
expenditure

In all three cases above, businesses may need finance to pay for either C A P IT A L E X P E N D IT U R E or R E V E N U E E X P E N D IT U R E . It is important to understand the difference. Capital expenditure is money spent on fixed assets which will last f :: I more than one year. These are needed at the start of a business anc it expands. Revenue expenditure is money spent on day-to-day expenses whicr do not involve the purchase of a long-term asset, for example wag; and rent.

is

money spent on day-to-day expenses which do not involve the purchase of a long-term asset, for example wages and rent.

Revision summary: financial needs of business

revenue expenditure capital expenc '

difficulty

Activity 9 . 1: cose study task

Look at the list below of expenses for a sports centre and tick whether you consider them to :e revenue expenditure or capital expenditure.
Revenue exp en d itu re
Purchase of building W ater rates Staff wages O ffice computer Gym equipment M aintenance of equipment

C apital exp en d itu re

Sources o f finance 129

Activity 9.2: case study task

ii^ch has decided to leave his job to set up his own taxi business. F ''fake a list of the likely set-up costs of this business for its first month of operation. cate which of these costs are revenue expenditure and which are capital expenditure, a i your answer.

Sources of finance
As there are so many different sources of finance, it is common to split them up, or classify them, into different groups. The two most common ways of doing this are to define whether the finance is: internal or external short-term, medium-term or long-term.

Internal finance
This is money which is obtained from within the business itself. The most common examples of internal finance are: Retained profit Those profits kept in the business after the owners have taken their share of the profits. These are often called ploughed back profits, and have the following advantage and disadvantage. a Retained profit does not have to be repaid unlike, for example, a loan. A new business will not yet have any retained profits and many firms could find that their profits are too low to finance the expansion needed. Sale o f existing assets Those assets which are no longer required by the business, for example, redundant buildings or surplus equipment. Q This makes better use of the capital tied up in the business. It may take some time to sell these assets and this source is not available for new businesses as they have no surplus assets to sell. Running down stocks to raise cash. This reduces the opportunity cost and storage cost of high stock levels. It must be done carefully to avoid disappointing customers if not enough goods are kept in stock. Owners savings A sole trader or members of a partnership can put more of their savings into their unincorporated businesses. As we saw in Unit 3, the owners of these firms are not separate from their businesses and therefore such finance is called internal. It should be available to the firm quickly and no interest is paid. Savings may be too low and it increases the risk taken by the owners.

130 FINANCING BUSINESS ACTIVITY

Revision summary: internal sources of finance

retained profits sale of surplus assets

INTERNAL SOURCES OF FINANCE

selling stocks - reducing stock levels

sole trader or partne" owners' savings

Activity 9.3: cose study task

W ally Shah needs advice on sources of finance before going ahead with his plan (Activity 9 1 Explain to him why: a) b) c) retained profits are not, to start with, a possible source of finance his savings will be likely to be an important source of funds selling off stocks is never likely to be an available source of finance to his taxi business.

External finance
This is money obtained from individuals or institutions outside of ~ business. The most common forms o f external finance are: Issue o f shares (only possible for limited companies). This is a permanent source of capital which would not have repaid to shareholders. No interest has to be paid. Dividends will be expected by the shareholders and the owr of the company could change hands. Bank loans. ,-I2 Usually quick to arrange and can be for varying lengths of c r : Large companies are often offered low rates of interest by t*irs they borrow large sums. A bank loan will have to be repaid eventually and interest mur. paid. Security or collateral is usually required. For example, a bJ may insist that it has the right to sell some o f the firms propert i it fails to pay interest or does not repay the loan. A sole trader ir. .1 have to put his or her own house up as security on a bank loan. Selling debentures These are long-term loan certificates issued by limited companies. Q Debentures can be used to raise very long-term finance, for example, 25 years. As with loans, these must be repaid and interest must be paid. Factoring o f debts Debt factors are specialist agencies that buy the debts o f firms for immediate cash. They may offer 90 per cent o f an existing debt. The debtor will then pay the factor and the 10 per cent represents the factors profit.

Short-, medium- and long-term finance 131

Immediate cash is made available and the risk of collecting the debt becomes the factors. G The firm does not receive 100 per cent of the value of its debts. Grants and subsidies from outside agencies, for example, the government. Q These usually do not have to be repaid. They are often given with strings attached, for example, the firm must locate in a particular area.

Revision summary: external sources of finance

bank loans sale of shares - limited companies debentures

sell debts to debt factor

grants and subsidies from government

Activity 9.4: cose study task

'.~ y Shah's taxi business has now been operating for two years. He wants to expand by buying another taxi and employing two drivers on a shift system. a) Explain to W ally the benefits of using the business profits to buy the taxi rather than taking out a oank loan. In what circumstances would you advise W ally to take out a bank loan to expand his business?

b)

Short-, medium- and long-term finance

Short-term finance
This provides the working capital needed by businesses for day-to-day operations. It is finance which is needed for up to three years. Shortages of cash in the short-term can be overcome in three main ways: Overdrafts These are arranged by a bank. ; Q The bank gives the business the right to overdraw its bank account, i.e. spend more money from the account than is currentiy in it. The firm could use this finance to pay wages or suppliers but, obviously, it cannot do this indefinitely^The overdraft will vary each month with the needs of the business - it is said to be a flexible form of borrowing. Interest will be paid only on the amount overdrawn. Overdrafts can turn out to be cheaper than loaiW

132 FINANCING BUSINESS ACTIVITY

Interest rates are variable, unlike most loans which have fixed 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. It is almost an interest-free loan to the business for the length of time that payment is delaved for. The supplier may refuse to give discounts or even refuse to supply any more goods if payment is not made quickly. Factoring o f debts See page 130 under External finance.

Medium-term finance
This is finance which is available for between three and ten years. It is usually needed to purchase machinery and vehicles, which often have useful lives for this period. The three most common sources of medium-term finance are: Bank loans Payable over a fixed period of time. The advantages and disadvantages of these have already been considered under External finance. Hire purchase This allows a business to buy a fixed asset over a long period of time with monthly payments which include an interest charge The firm does not have to find a large cash sum to purchase the asset. Q A cash deposit is paid at the start of the period. Interest payments can be quite high. Leasing Leasing an asset allows the firm to use an asset but it does no: have 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 fixed assets for cash and lease them back from a leasing company. This is called sale and leaseback. The firm 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. The total cost of the leasing charges will be higher than purchasir. the asset.

Long-term finance
This is finance which is available for more than ten years. Usually this money would be used to purchase long-term fixed assets to update or expand the business or to finance a take-over of another firm. The main sources of long-term finance are: Issue o f shares As we have seen already, this option is available only : limited companies. (See Unit 3 for details of how sole traders and partnerships can convert to limited company status.) Shares are often referred to as equities - therefore the sale of sha:.-- sometimes called equity finance.

Short-, medium-and long-term finance 133

Private limited companies can raise more capital by selling shares privately to family, friends or business contacts. The more shares sold in this way, the weaker may be the control of the people who started the company, as all shareholders have the right to vote at AGMs. 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 pics 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. A share issue provides perm anent capital which does not have to be repaid. There are no interest payments. Dividends are paid after tax whereas interest on loans is paid before tax is deducted. The balance o f ownership can be affected by a large share issue. Long-term loans or debt finance Loans differ from share capital in the following ways: - interest is paid before tax as an expense - interest must be paid every year but dividends do not have to be paid if, for example, the firm has made a loss - they must be repaid as they are not permanent capital - they are often secured against particular assets. The advantages and disadvantages o f loans have already been mentioned under External finance. Debentures See page 130 under External finance.

Revision summary: For how long is the finance required?

overdrafts from bank debt factoring trade creditors delay paying suppliers

Short term

PERIOD FINANCE IS REQUIRED FOR

leasing

Medium term

loans

hire purchase

loans

Long term

debentures

sale of shares

rights issue

new issue

134 FINANCING BUSINESS ACTIVITY

Activity 9.5
Consider all of the following sources of finance. Copy out the table and tick the relevant column for each source. Are these short-, medium- or long-term sources of finance?
Source o f finance
Overdraft Debentures Issue of shares Three^/ear bank loan Trade credit Hire purchase

Short-term

M ed iu m -term

Long-term

Activity 9.6
Consider all of these different reasons for a private limited company needing finance. Copy out the table and fill in the gaps with: a) b) what you consider could be the most suitable source of finance the reason for your choice.
Most suitable source Reason fo r choice

N eed for finance

Planned take-over of another business Temporary increase in stocks over the summer Purchase of new car for the Chief Executive Research and development of new product - to come on the market in four years time Cost of building modern factory requiring much less land than the present one

How the choice of finance is made in business

We now know the main types o f finance available to firms. What factors do managers consider before deciding where to obtain finance from?

Purpose and time period

What is the finance to be spent on? Is it to be used to pay for fixed asset: or is it needed to pay for a short-term cash flow crisis? The general rule is to match the source of finance to the use that wit be made of it.

H o w the c h o ic e o f fin a n c e is m a d e in business

135

If the use is long term, for example the purchase of a fixed asset, the source should be long-term. If the use is short term, for example the purchase of additional stocks to cover a busy period, the source should be short-term. Think about the disadvantages of buying additional stocks which will only be needed for a few months, with a long-term bank loan. Can you see why this would be unwise? What source of finance would be suitable for this?

Amount needed
Different sources will be used depending on the amount of money needed.

Status and size

Companies, especially public limited companies, have a greater choice of sources of finance. Issuing shares or debentures is not an option for sole traders and partnerships.

Case study example

I f a company needs $5,000 to repair a van, a new issue of shares would be the wrong choice. This is because the issue of shares is complicated and would take a long time - the firm wants the van repaired now! Also, the cost of arranging a share issue would be much more than the $5,000 raised. What source of finance could this business use instead? If the same company wanted to take over another company and offered $5 million, a new share issue would be much more likely - the cost of arranging for the new shares to be sold would be much less than the $5 million raised. These businesses, if they wish to expand, may have to depend on the savings of their owners - personal capital. They also often have the disadvantage of having to pay higher interest rates to banks for loans than large and well established companies.

Control
Owners of businesses may lose control of that business if they ask other people to invest into their firm.

Risk and gearing

A further point about loan capital is that it will raise the gearing of the business - and this is a common measure of risk that the managers are taking. The gearing of a business measures the proportion of total capital raised from long-term loans. I f this proportion is very high - say more than 50 per cent - the business is said to be highly geared. It is being financed more from loans than from shareholders. This is said to be a risky way of financing a business.

140 FINANCING BUSINESS ACTIVITY

Activity 9.9: case study task

Joe Dagglio has $ 1 5 ,0 0 0 in savings. He wants to buy shares in public limited companies because he has heard that he could earn dividends and make a capital gain if the shares rise in price. He has received details of a pic that is arranging a new issue of shares. The company wishes to expand. He makes a note of the following information. a) b) The current share price is $5 but it has been as high as $7. The average value of shares on the Stock Exchange has risen over the last year. The gearing ratio of the company is 55 per cent. Interest rates are likely to rise in the next month or so. The company is offering high dividends to its existing shareholders. Considering all of the risks and possible gains, advise Joe whether he should buy these shares or not. W hat other information would you find helpful in advising Joe?

This example helps to show that shareholders and those hoping to become shareholders have many factors to consider before buying shares in a company. Fortunes can be won or lost on the Stock Exchange and people like Joe will want to try to make sure that they do not turn out to be one of the losers!

Revision summary: finance from banks and shareholders

Is a cash flow forecast available? Is a business plan available? Is a forecasted profit an account available?

WILL BANKS LEND?

W h y is the loan needed?

W ill the loan be secured?

W hat is the gearing ra-':

Are the future prospects for the company good?

How do company dividends comc with those from other companies?

WILL SHAREHOLDERS INVEST?

How has the company's share price varied?

e gearing rcr

Revision questions

141

Revision

questions
10 The directors of a company are planning to install a new computer system in the office. The computers are expected to last about three years. They will cost $60,000. Three methods of finance are being considered: - leasing without purchasing at the end - long-term bank loan - new share issue. Advise the directors on the most suitable method of finance. Give reasons for your answer. [6] 11 Explain how the sources of finance available for a limited company are different to those available for a sole trader. [5] 12 What is a business plan?

1 Explain Wo reasons why the owners of a new business will need finance to set it up. [4] 2 What is the difference between revenue and capital expenditure? [3] 3 What is the difference between internal and external business finance? [3]
4

State two methods of raising finance internally and list one advantage of each method.

[4]

' Explain the difference between short- and long-term sources of finance. [3] 6 State two methods of raising short-term finance externally and list one advantage of each method. [4] *7 Explain the advantages to a business of an overdraft as opposed to a bank loan. [4] 5 hen a company issues more shares this is Termed p erm a n en t capital - explain this rerm. [2] * 9 Exolain three advantages a bank loan may * , have over a share issue for a company. [6]

[2 ]

13 Explain Wo benefits to a firm of preparing a business plan. [4] 14 Give three examples of information contained in a business plan. Explain, for each one, why a bank manager would consider this information important. [6] 15 Explain Wo factors that an investor would consider before deciding whether to invest in a company. [4]

ROM (see details on page x) provides further tests, activities and Case study work on the rrered in this unit.