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Flashcards in 26. Business finance Deck (35):

Why business activity requires finance?

- Setting up a business will require cash injections from the owner(s) to purchase essential capital equipment and possibly premises

- All businesses will have a need to finance their working capital - the day to day finance needed to pay bills and expenses and to build up stocks

- Expansion requires further finance to increase the capital assets and often they require higher working capital needs

- A change in the environment such as economic recession, new competition leading to decline in sales result in the need for cash

- Finance is also being used to pay for research and development into new products or marketing strategies and campaigns to enter overseas marker


Why different needs for finance might mean different sources are appropriate?

Some of the situations will need investment for many years while other will need short term funding. Some might be medium term finance - between one and five years. Thus, not one source of finance is likely to be suitable in all cases


Define start-up capital

Investment required by an entrepreneur or business person to build up their business e.g. expenditure on capital equipment


Define working capital

The capital needed to pay for raw materials, day-to-day running costs and credit offered to customers Working capital = current assets - current liabilities


Define capital expenditure

Involves the purchase of assets that are expected to last for more than one year, such as building and machinery


Define revenue expenditure

Is spending on all costs and assets other than fixed assets and includes wages and salaries and materials bought for stock


Define liquidity

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


Define liquidation

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


Significance of working capital

- The lifeblood of a business

- Finance is needed to pay for everyday expenses such as the payment of wages and buying of stock

- Without sufficient working capital a business will be illiquid - unable to pay its short term debts => bank loan or liquidation


How much working capital is needed?

Too low => illiquid Too high is a disadvantage, the opportunity cost of too much capital tied up in inventories, accounts receivable and idle cash is the return that money could earn elsewhere in the business. e.g. invested in fixed assets


Working capital cycle

- Production -> sell on credit -> cash -> materials and stock (cycle repeats and goes in circle) - How much working capital is needed depends on the length of the working capital cycle - The longer the time period, the greater the working capital needs - To give more credit than is received is to increase the need for working capital - To receive more credit than is given is to reduce the need for working capital


What are the internal sources of finance?

- Profits retained in the business

- Sale of assets

- Reductions in working capital


What are the external sources of finance?

- Long term: share issue, debentures, long term loan, grants

- Medium term: leasing, hire purchase, medium-term loan

- Short term: bank overdraft, bank loan, creditors, factoring


Differences between short term and long term finance

- Short term finance: up to a period of a year, increase inventory orders, payrolls and daily supplies

- Long term finance: acquire new equipment, for R&D, ash flow enhancement and company expansion


Retained profits

After the profits has been taken in tax by the government and has been paid out to the shareholders as dividens, retained profits are remained as a source of finance for future activities


Sale of assets

Some of assets that are no longer fully employed could be sold to raise cash. In addition, some businesses will sell assets they the still intend to use but lease them


Reductions in working capital

When companies reduce assets - by reducing their working capital - capital is released and acts as a source of finance for other uses


Bank overdrafts

- Definition: bank agrees to a business borrowing up to an agreed limit as and when required

- Most flexible source of finance

- Bank allows business to overdraw on its account. This overdrawn amount should always be agreed in advance and always has a limit

- Businesses able to increase the overdraft over short periods of time

- High interest is charged

- Bank is able to call in the overdraft and forces business to pay it back


Trade credit

By delaying the payment of bills for goods and services received, the business is actually obtaining finance. Its suppliers or creditors are providing goods and services without receiving immediate payment => similar to lending money


Debt factoring

- Definition: selling of claims over debtors to a debt factor in exchange for immediate liquidity - only a proportion of the value of debts will be received as cash

- Immediate cash is obtained but not for the full amount of debt because the debt factoring company charges an amount of money for their service => to make profit



- Definition: obtaining the use of equipment or vehicles and paying a rental or leasing charge over a fixed period

- Avoids the need for business to raise long term capital to buy the asset

- Avoids risk of using unreliable or inefficient equipment

- Improve short term cash flow position of a company


Hire purchasing

- Definition: an asset is sold to a company that agrees to pay fixed repayments over an agreed time period - the asset belongs to the company

- Improve short term cash flow position

- Avoids risk of using unreliable or inefficient equipment

- Avoids making a large initial cash payment to buy the asset


Long term loans

- Loans that do not have to be repaid for at least one year

- Business has to provide security or collateral for the loan; this means the right to sell an asset to the bank if the company is unable to repay the debt


Equity finance

- Definition: permanent finance raised by companies through the sales of shares

- Can be done by 2 methods: public issue by prospectus and arranging a placing of shares with institutional investors without the expense of a full public issue

- Prospectus: advertise the company and its share sale to the public, has to be prepared and issued, often guaranteed by a merchant bank (which charges for its service) => expensive

- Institutional investors:


Define rights issue

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


Long term bonds or debentures

- Definition: bonds issued by companies to raise debt finance often with a fixed rate of interest



- Definition: Bounty, contribution, gift, or subsidy bestowed by a government or other organization for specified purposes to an eligible recipient


Venture capital

- Definition: risk capital invested in business start ups or expanding small businesses that have good profit potential but do not find it easy to gain finance from other resources


Micro finance



Factors influencing finance choice

- cost

- flexibility

- need to retain control

- the use to which it is put

- level of existing debt


Why is cost significant?

  • Obtaining finance is never free - might have an opportunity cost
  • Loans and overdrafts may become very expensive during a period of rising interest ates
  • Floatation can cost millions in fees and promotions of the share sale


Why is flexibility important?

Applies especially for firms that have seasonal patterns of sales and cash receipts


Why is the legal structure and need to retain control important?

Share issues can only be used by limited companies and only plc can sell shares to the public => current owners lose control unless rights issue is used


Why is the use to which it is put important?

  • Permanent capital may be needed for long term business expansion
  • Short term finance would be advisable to finance a short term need to increase stocks or pay creditors


Why is level of existing debt important?

The higher the existing debts of a business, the greater the risk of lending more. Might lead to loss of assets or higher interests