5.1: Business finance

Question 1

When would a business require finance? (5)

Answer 1

Setting up a business (start up capital)
For working capital
For expansion of the business
For overtaking other business as a way of expansion
For research and development

Question 2

Def. Start up capital

Answer 2

Capital needed by an entrepreneur to set up a business.

Question 3

Def. Working capital

Answer 3

Finance needed to pay for raw materials, day-to-day running costs and credit offered to costumers. Working capital = Current assets - current liabilities.

Question 3

Def. Revenue expenditure

Answer 3

Involves the spendings on all costs and assets other than fixed assets and includes wages and salaries and materials bought for inventory.

Question 4

Def. Capital expenditure

Answer 4

Involves the purchase of assets that are expected to last for more than one year, such as buildings or machinery.

Question 5

A business without sufficient working capital?

Answer 5

Is an illiquid business - unable to pay its immediate or short term debts. The business would have to raise finance quickly (such a bank loans), or it would be forced into liquidation.

Question 6

Def. liquidity

Answer 6

The ability of a firm to be able to pay its short term debts

Question 7

Def. Liquidation

Answer 7

When a firm ceases trading and its assets are sold for cash to pay suppliers and other creditors

Question 8

Disadvantages of too little or too much working capital?

Answer 8

Too little working capital => unable to pay debts
* Too much working capital => too much opportunity cost, it could have been invested elsewhere such as fixed assets.

Question 9

What is the working capital cycle?

Answer 9

Cash => Inventory => Production => Sell on credit =>

Question 10

How much working capital?

Answer 10

It depends on the length of the working capital cycle. The longer the time period from buying material to receiving payment from customers, the greater the working capital needed.

Question 11

What are the two types sources of finance?

Answer 11

Internal sources of finance: possibly from business’s own assets or from profits left in the business
External sources of finance: raised from sources outside the business

Question 11

Types of internal sources of finance (3)

Answer 11

Retained profits
Sale of assets
Reductions in working capital

Question 12

What are retained profits?

Answer 12

Any remained net profit after the dividends have been paid is invested back into the business. Once invested into the business, they will not be paid out to shareholders, so they represent a permanent source of finance.

Question 13

Def. sale of assets?

Answer 13

Assets that are no longer fully employed could be sold to raise cash.

Question 14

Reductions in working capital?

Answer 14

When companies reduce assets, such as inventory levels, by reducing their working capital, capital is released, which can act as a source of finance for other uses.

Question 15

Benefits of internal sources of finance? (2)

Answer 15

It doesn’t increase the liabilities or debts of the business
No risk of loss of control by the original owners as no shares are sold

Question 16

Limitations of internal sources of finance? (2)

Answer 16

Newly formed companies with few ‘spare’ assets cannot benefit from these sources
It can slow down business growth, as the pace of development is limited by the annual profits or assets to be sold.

Question 17

Types of external sources of finance? (3)

Answer 17

Short term sources
Sources of medium term finance
Long-term finance

Question 18

Types of external short term sources of finance? (5)

Answer 18

Bank overdrafts
Trade credit
Debt factoring
Grants
Venture capital

Question 19

Desc. bank overdrafts

Answer 19

• A bank agrees to a business borrowing up to an agreed limit as and when required.
  The most ‘flexible’, because the amount raised can vary day to day. For example the business may need to increase the overdraft for short periods of time if customers do not pay as quickly or large delivery of raw materials has to be paid for.

Question 20

Desc. trade credit

Answer 20

Obtaining finance by delaying bills of goods and services received. If suppliers or creditors are providing goods and services without immediate payment, it could be thought of as ‘lending money’.

Question 20

Desc. debt factoring

Answer 20

The selling of claims over debtors to a debt factor in exchange for immediate liquidity (cash) - only a proportion of the value of the debts will be received.

Question 21

Types of external medium term sources of finance? (2)

Answer 21

Hire purchase and leasing
* Medium term bank loan (1-5 years)

Question 21

Desc. hire purchase

Answer 21

• An assets is sold to a company that agrees to pay fixed repayments over an agreed period of time (a form of credit). The asset belongs to the company.

Question 22

Desc. leasing

Answer 22

• Obtaining the use of a fixed assets and paying charges over a fixed period of time. This avoids the need for the business to raise large finance to purchase the asset. The risk of using outdated equipment is reduced to the leasing company as they remain the ownership over it.

Question 23

Types of external long term finance? (3)

Answer 23

Long term loans from banks
Long term bonds or debentures
Equity finance

Question 24

Desc. long term loan from banks

Answer 24

Loans that do not have to be repaid for at least one year.
Can have variable or fixed interest rates
Companies borrowing from banks will provide security for the loan - the right to sell an asset is given to the bank if the loan is not repaid => businesses with few assets may find it difficult to obtain loans.

Question 25

Desc. long term bonds or debentures

Answer 25

bonds issued by companies to raise debt finance, often with a fixed rate interest
a company will sell such bond to an investor
the company will agree to pay fixed interest to keep the life of the bond (may be up to 25 years)
investors can sell the bond if they can’t wait for their investment to be paid back
They are usually not secured
When secured on an asset they will be called mortgage debentures
Convertible debentures can be converted into shares, so the company will never have to pay it back.

Question 26

Def. equity finance

Answer 26

• Permanent finance raised by companies through the sale of shares.

Question 27

How can a business go public? (2)

Answer 27

By obtaining a listing on the alternative investment market (AIM), which is a part of the Stock Exchange concerned with smaller companies that want to raise only limited amount of capital. The strict requirements for a full Stock Exchange listing are relaxed.
Apply for a full listing on the stock exchange by satisfying the criteria of (a) selling at least £50,000 worth of shares and (b) having a satisfactory trading record.

Question 28

What are the two main ways of sales of shares?

Answer 28

Publics issue by prospectus - this advertises the company and its share sale to the public and invites them to apply for the new shares. This is expensive, as the prospectus has to be prepared and issued.
Right issue of shares.

Question 29

Benefits and limitations to rights issue of shares? (2 1)

Answer 29

Benefits:
* The ownership of the business does not change
* Raise in capital rather cheaply as no advertising required.
Limitations:
* The increase in the supply of shares would reduce its share price, which would worry current shareholders.

Question 30

Def. Rights issue

Answer 30

Existing shareholders are given the right to buy additional shares at a discounted price.

Question 31

Grants (3)

Answer 31

For most european countries, grants come from the government or the European Union.
Usually given to small businesses or expanding businesses in developing regions of the country.
Grants usually come with conditions attached, such as locations or the number of jobs created. If the conditions are met, grants don’t have to be paid back.

Question 32

Def. Venture capital

Answer 32

Risk capital invested by venture capitalists (who could be specialist organisations or wealthy individuals) in business start-ups or expanding small businesses that have good profit potential but do not find it easy to gain finance from other sources. e.g in ‘high tech’ businesses.

Question 33

Def. Micro-finance

Answer 33

The providence of small capital sums to entrepreneurs by any investors to unincorporated businesses.

Question 34

Def. Business plan

Answer 34

A detailed document giving evidence about a new or existing business, and that aims to convince external lenders and investors to extend finance to the business.

Question 35

What are the factors influencing finance choices? Name no explanation (6)

Answer 35

Use to which finance is to be put
Cost
Amount required
Legal structure and desire to retain control
Size of existing borrowing
Flexibility

Question 36

Explain how the “use to which finance is to be put” affects the finance choice? (3)

Answer 36

It is very risky to borrow long term finance for short term needs
Permanent capital may be needed for long-term business expansion.
Short term finance would be advisable to finance short term needs.

Question 37

Explain how the “amount required” affects the finance choice? (2)

Answer 37

Share issues or debentures could be used to raise large capital sums
Bank overdrafts could be used to raise small capital sums

Question 37

Explain how the “cost” affects the finance choice? (2)

Answer 37

Even internal finance may have opportunity cost
* Loans may become more expensive during a period of rising interest rates

Question 37

Explain how the “size of existing borrowing” affects the finance choice?

Answer 37

• The higher the existing debts, the greater the risks of borrowing more. Banks would be more anxious to lend more.

Question 37

Explain how “legal structure and desire to retain control” affects the finance choice?

Answer 37

• If the owners want to retain control of the business, than further sales of shares are unwise. (Rights issue could be used).

Question 38

Explain how the “flexibility” affects the finance choice?

Answer 38

• When a firm has a variable need for finance, for example it has a seasonal pattern of sales, a short term form of finance would be better.