Financing Business Activity: Why Does A New Business Need Finance?

AL WADI INTERNATIONAL SCHOOL
NOTES
IGCSE BUSINESS STUDIES
FINANCING BUSINESS ACTIVITY

Why does a new business need finance?
To purchase of plant & machinery, office equipment etc.
To rent or buy premises and offices (example the first 3 months
rent may need to be paid in advance)
Essential business services such as insurance
The purchase of stocks of raw materials and components to allow
production to start
The wages and salaries of the first employees to join the business
(who may be needed before any goods or services are actually
sold)
To provide financial cover whilst the business waits for customers
to pay
Definition to learn:
Start up capital: is the finance needed by a new business to pay for
essential fixed and current assets before it can begin trading.
Definitions to learn:

NOTES
Capital Expenditure: It is the money spent on buying the fixed

assets, which last for more than one year. E.g. Furniture this is
recorded on the balance sheet as fixed assets.
Revenue Expenditure: It is the money spent on day-to-day running
of the business. E.g. Rent. This is recorded on the profit & loss
account as an expense.
SOURCES OF FINANCE
These types of finance can be split into:
Internal or external
Short-term, medium-term, or long term

NOTES
Internal finance: this is money which is obtained from with

in the business itself.
Retained profits:
This is profit kept in the business after the
owners have taken their share of the profits. It is often called

ploughed back profit.
Advantages
Retained profits does not have to be repaid
Disadvantages
A new business will not yet have any retained profits.

NOTES
Many small firms could find that their profits are too low to finance
the expansion needed.
Keeping more profits in the business reduces payments to owners,
for example dividend to share holders.
Sale of existing assets:
Existing assets that could be sold
are those assets which are no longer required by the business. For
example, redundant buildings or surplus equipment.
Advantages
This makes better use of the capital tied up in the business.
Disadvantage
It may take some time to sell these assets.
This source of finance is not available for new business as they
have no surplus assets to sell.
Running down stocks to raise cash

Advantage
This reduces the opportunity cost and storage cost of high
stock levels.
Disadvantage
It must be done carefully to avoid disappointing customers if not
enough goods are kept to stock

NOTES
Owners savings
Advantages
It should be available to the firm quickly
No interest is paid
Disadvantages
Savings may be too low
It increases the risk taken by the owners.
External finance comes from individuals or organisations that

do not trade directly with the business example, banks.
Issue of shares:
This source of finance is only possible for
limited companies
Advantages
This is a permanent source of capital which would not have to
be repaid to share holders.
No interest has to be paid.
Disadvantages
Dividends will be expected by the share holders.
The ownership of the company could change hands.
Bank loans
Advantages
Usually quick to arrange, can be for varying length of time.

NOTES
Large companies are often offered lower rates of interest by

banks if they borrow large sums.
Disadvantages
A bank loan will have to be repaid eventually and interest must be
paid
Security or collateral is usually required.
Debentures:
These are long term loan certificates issued by
limited companies. Debentures are documents given to people or

institutions who lend money to companies. It will tell them when he
can expect to be repaid and how much interest he can expect to
receive until then. Debenture holders are lenders to a company and
not owners.
Advantage
Debentures can be used to raise very long term finance, for
example 25 years.
Disadvantages
As with loans these must be repaid and interest must be paid.
Factoring of debts:
Debt factors are specialist agencies that
buy the debts of firms for immediate cash. They may offer 90percent
of an existing debt. The debtor will then pay the factor and the 10
percent represents the Factors profit.
Advantages
Immediate cash is made available

NOTES
The risk of collecting the debt becomes the Factors.
Disadvantage
The firm does not receive 100 percent of the value of its debts.
Grants and subsidies from outside agencies

Outside agencies include, for example, the government.
Advantage
These grants and subsidies usually do not have to be repaid.
Disadvantage
They are often given with strings attached for example the firm
must locate in a particular area.
SHORT, MEDIUM AND LONG TERM FINANCES

Short-term finances
This provides the working capital needed by businesses for day-today operations.
Overdrafts: These are arranged by a bank. The banks give the
businesses the right to overdraw more money from the bank account
than is currently in it.
Advantages

NOTES
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 loans.
Disadvantages
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. They

are given period of credit, normally around 30-60 days. By trying to
extend this period they can improve their short-term finance position.
Advantage
It is almost an interest free loan to the business for the length
of time that payment is delayed for.

NOTES
Trade credit is an important source of finance for nearly all

businesses since it is effectively a free source of finance.
Disadvantage
The supplier may refuse to give discounts or even refuse to supply
any more goods if payment is not made quickly.
Factoring of debts
See page 4 under external finance
Medium-term finance
This is finance which is available for between three and five years.
Bank loans
These are 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.
Advantage
The firm does not have to find a large cash sum to purchase
the asset.
Disadvantages
A cash deposit is paid at the start of the period.
Interest payments can be quite high.

NOTES
Leasing
Leasing is like renting a piece of equipment or machinery. The
business pays a regular amount for a period of time, but the item
belongs to the leasing company.
Advantages of leasing
Cheaper in the short run than buying a piece of equipment
outright
If technology is changing quickly or equipment wears out
quickly it can be regularly updated or replaced.
Cash flow management easier because of regular payments
Disadvantage of leasing
More expensive in the long run, because the leasing company
charges fees, which makes the total cost greater than the
original cost.
Long term finance

This is finance which is available for more than ten years.
Long term loans

Advantage
o Interest is paid before tax as expense.
Disadvantage
They must be repaid, as they are not permanent capital
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NOTES
They are often secured against particular assets.
Issue of shares
Refer to external finance
Issue of debentures
Refer to external finance
In getting funds, businesses need to consider the
following factors.
Amount of money required the amount of capital required
can range from just a few dollars to pay an outstanding bill to a
huge investment in a new factory. When a business requires a
large sum of money, it will have to borrow from a large financial
institution or ask shareholders to provide more share capital.
The cost of borrowing the cost of finance is normally

measured in terms of extra money that needs to be paid to secure
the initial amount the typical cost is the interest that has to be
paid on the borrowed amount.
The amount of risk involved in the project the more risk

the lender is taking, the more interest payment they will expect.
Some forms of borrowing, such as from a Credit card company,
can be very expensive.
Permanent or temporary a good entrepreneur will judge

whether the finance needed is for a long-term project or short term
and therefore decide what type of finance they wish to use.
11

NOTES
Gearing measures the proportion of loan capital to the share

capital. A business is said to be highly geared if the loan capital is
more than the share capital and the business is at risk
Factors to be considered by bank managers before

giving loans to businesses:
The forecasts of its repaying capacity and its due dates
The projected / forecasted Profit and Loss Account and Balance
Sheet
The Cash Flow projections
The utilization plan of the loan amount
The image and experience of the business in its field of activity
The security given for the loan
Reason for fall in share prices

Share prices reflect current and prospective profitability along with
future prospects.
Falling share price reflects markets doubts about future health of the
company.
Could be a bear market (a market in which the share prices are low)
General economic atmosphere: At other times (during boom) the
government takes steps to reduce the level of spending. In this

case, lower profits are expected and share prices fall.
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NOTES
Political factors may also be important. The prospect of a change
of government often makes the stock exchange very unstable. The

assassination of a foreign political leader has a similar effect.
Reasons for increase in share prices

1. The company has announced a good dividend, the demand for its
shares increases and hence the price of its shares will increase.
2. The company is likely to be successful in the future perhaps
because it developed a new product. This could increase the price of
its shares as demanders of shares expect larger profit and higher
dividends in the future.
3. Sometimes the government does all it can to persuade people to
spend money (economic growth). This will normally mean a period of
rising profits, and many investors will instruct their stockbrokers to
buy shares, causing a general rise in share prices.
Business Plan
A business plan sets out how a business is going to achieve its aims
and objectives.
13

NOTES
A business plan will probably contain the following elements:

Statement of aims and objectives
Description of market the business is selling to
Main competitors (how will they respond to a new competitor?)
Production and sales forecasts
Equipment needed
Distribution plan for how to get product to customers
Past Paper Questions

14

NOTES
Year
Nov 2009
May 2008
Nov 2007
May 2007
Nov 2006
Nov 2004
Nov 2003
May 2003
May 2002
Nov 2001
Paper 1
Q1d
Paper 2
Q1b
Q1a,
Q4a,
Q1b,
Q2b
Q2(d)
Q2a(iii),c
Q1b,c,
Q1a,Q5b,
Q6,
Q4b,
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AL WADI INTERNATIONAL SCHOOL

IGCSE BUSINESS STUDIES