The Need for Business Finance
Business finance is the money needed by a business to start, operate, maintain and grow its activities.
→ Businesses need finance at different stages of their development.
→ The amount and type of finance required depends on the purpose, size and circumstances of the business.
Main Reasons Why Businesses Need Finance
Start-up Capital
Start-up capital is the money needed to set up a new business.
→ A new business may need finance to pay for:
→ land or premises
→ machinery and equipment
→ furniture
→ vehicles
→ initial inventory
→ advertising
→ licences and registration
→ employee wages
→ other start-up costs
Example:
→ A person starting a bakery may need finance to rent a shop, buy ovens and equipment, purchase ingredients and pay employees before the business begins generating enough revenue.
Capital for Expansion and Growth
→ A successful business may need additional finance to expand.
→ Finance could be used to:
→ open new branches
→ purchase more machinery
→ increase production
→ enter new markets
→ develop new products
→ employ more workers
Example:
→ A restaurant that is consistently operating at full capacity may need finance to open another branch.
Replacing Existing Non-Current Assets
Non-current assets are assets that a business expects to use for more than one year.
→ Examples include:
→ machinery
→ buildings
→ vehicles
→ computers
→ production equipment
→ These assets eventually become old, damaged or inefficient and may need to be replaced.
Example:
→ A delivery business may need finance to replace old delivery vans.
Investing in New Technology
→ Businesses may need finance to purchase new technology to improve efficiency, reduce costs or develop new products.
Examples:
→ automated production machinery
→ computers and software
→ online ordering systems
→ robots
→ digital payment systems
→ Although technology may require a large initial investment, it may reduce costs or increase productivity in the future.
Working Capital
Working capital is the money available to a business to pay for its day-to-day operating expenses.
A simple formula is:
Working Capital = Current Assets − Current Liabilities
Current assets include:
→ cash
→ inventory
→ trade receivables
Current liabilities include:
→ trade payables
→ short-term debts
→ other amounts due within a short period
Why Working Capital Is Important
→ Businesses need working capital to pay for everyday expenses before receiving money from customers.
Example:
A business may need to:
→ pay employees this week
→ pay suppliers this month
→ pay electricity and rent
→ buy inventory
But customers may not pay for their purchases until several weeks later.
→ The business therefore needs enough working capital to continue operating while waiting for customer payments.
Problems Caused by Insufficient Working Capital
→ Difficulty paying suppliers
→ Delayed payment of wages or bills
→ Difficulty purchasing inventory
→ Damage to relationships with suppliers
→ Risk of insolvency
→ Inability to take advantage of business opportunities
Too Much Working Capital
→ Holding excessive cash or inventory can also be inefficient.
→ Money tied up in inventory or unused cash could have been used for investment or expansion.
Short-Term and Long-Term Finance Needs
Short-Term Finance
Short-term finance is finance needed for a relatively short period, usually less than one year.
→ It is often used to support working capital.
Examples:
→ paying suppliers
→ purchasing inventory
→ paying wages
→ covering temporary cash shortages
Common sources:
→ bank overdraft
→ trade credit
Long-Term Finance
Long-term finance is finance needed for more than one year.
→ It is usually used for major investments and long-term business activities.
Examples:
→ buying buildings
→ purchasing expensive machinery
→ business expansion
→ opening new branches
→ investing in new technology
Common sources:
→ bank loans
→ share capital
→ retained profit
→ venture capital
→ leasing
Internal Sources of Finance
Internal finance comes from within the business or from its existing resources.
Owners’ Investment
→ Owners put their own money into the business.
→ This is an important source of finance for many start-ups.
Advantages
→ No interest has to be paid.
→ No repayment is normally required.
→ The business does not have to borrow from a bank.
Disadvantages
→ The amount available may be limited.
→ Owners risk losing their money if the business fails.
→ Owners may not have enough personal savings to finance large projects.
Retained Profit
Retained profit is profit kept in the business rather than distributed to the owners or shareholders.
→ It can be used to finance expansion, new equipment or other investments.
Advantages
→ No interest has to be paid.
→ No borrowing is required.
→ No loss of control to outside investors.
Disadvantages
→ A new business may not have retained profit.
→ A business making low profits will have less available.
→ Shareholders may prefer profits to be distributed as dividends.
Sale of Unwanted Assets
→ A business can sell assets that it no longer needs to raise finance.
Example:
→ A business replaces old vehicles and sells the old vehicles to raise money.
Advantages
→ No borrowing is required.
→ No interest has to be paid.
→ Can turn unused assets into cash.
Disadvantages
→ The asset can no longer be used.
→ The amount raised may be relatively small.
→ The asset may have a low resale value.
Working Capital
→ Some of the business’s available working capital may be used to finance business needs.
→ However, using too much working capital for long-term investment could leave the business unable to pay its short-term expenses.
External Sources of Finance
External finance comes from outside the business.
Share Capital
Share capital is money raised by a company by issuing shares to investors.
→ Investors provide money in return for ownership of part of the company.
Advantages
→ Large amounts can potentially be raised.
→ There is no fixed repayment date for share capital.
→ No interest is normally paid on ordinary shares.
Disadvantages
→ Ownership may be diluted.
→ Existing owners may lose some control.
→ Profits may need to be distributed as dividends.
→ It is generally available to companies rather than sole traders.
Venture Capital
Venture capital is finance provided by investors to businesses with high growth potential, often in return for part ownership.
Advantages
→ Can provide substantial finance.
→ Investors may provide business knowledge and experience.
→ Useful for businesses with strong growth potential.
Disadvantages
→ Owners may have to give up part of the business.
→ Some control may be lost.
→ Investors may expect high returns.
Bank Overdraft
A bank overdraft allows a business to withdraw more money from its bank account than it currently has, up to an agreed limit.
→ It is mainly useful for short-term cash-flow problems.
Advantages
→ Flexible.
→ The business generally pays interest only on the amount actually used.
→ Useful for temporary cash shortages.
Disadvantages
→ Interest rates can be high.
→ The bank can reduce or withdraw the overdraft facility.
→ Not usually suitable for financing long-term investments.
Leasing
Leasing allows a business to use an asset without buying it outright by making regular payments to the owner of the asset.
Example:
→ A business leases vehicles or machinery and pays a monthly amount.
Advantages
→ Lower initial cash requirement.
→ The business can use modern equipment.
→ Useful when the business cannot afford to purchase the asset.
Disadvantages
→ Total payments over the lease period may be high.
→ The business does not normally own the asset.
→ The lease may involve contractual restrictions.
Hire Purchase
Hire purchase allows a business to use an asset while making regular payments and usually become the owner after all payments have been made.
Advantages
→ The business can obtain an asset without paying the full price immediately.
→ Useful for expensive machinery and vehicles.
→ The asset can be used to generate revenue while being paid for.
Disadvantages
→ Interest increases the total cost.
→ Regular payments must be made.
→ The asset may be repossessed if payments are not made.
Bank Loan
A bank loan is money borrowed from a bank that is repaid over an agreed period, usually with interest.
Advantages
→ Can provide a large amount of finance.
→ Suitable for long-term investments.
→ Repayments can often be planned in advance.
Disadvantages
→ Interest increases the cost of finance.
→ Regular repayments must be made.
→ The bank may require security.
→ A business with existing loans may find it difficult to borrow more.
Trade Credit
Trade credit allows a business to buy goods or materials from suppliers and pay for them at a later date.
Example:
→ A retailer receives inventory today but pays the supplier 30 days later.
Advantages
→ Helps the business manage working capital.
→ No immediate cash payment is required.
→ Usually easy for an established business with good supplier relationships.
Disadvantages
→ Suppliers may charge higher prices.
→ The business may lose discounts for early payment.
→ Failure to pay on time can damage supplier relationships.
Government Grants
A government grant is money provided by the government to support businesses or specific activities.
→ Grants may be available for areas such as:
→ business start-ups
→ employment
→ regional development
→ technology
→ training
→ environmental investment
Advantages
→ Usually does not have to be repaid if conditions are met.
→ Can reduce the amount of borrowing required.
Disadvantages
→ Businesses may have to meet strict conditions.
→ The application process can be time-consuming.
→ Grants may not be available for every business or purpose.
Crowdfunding
Crowdfunding involves raising relatively small amounts of money from a large number of people, usually through an online platform.
→ People may contribute because they believe in the business idea or want a product or other benefit.
Advantages
→ Can raise finance without relying entirely on banks.
→ Can create publicity for a new product or business.
→ Can demonstrate whether customers are interested in an idea.
Disadvantages
→ There is no guarantee that the required amount will be raised.
→ Preparing and promoting the campaign takes time.
→ The business idea becomes publicly visible.
Internal vs External Finance
| Internal Finance | External Finance |
|---|---|
| Comes from within the business or existing owners | Comes from outside the business |
| Owners’ investment | Bank loan |
| Retained profit | Bank overdraft |
| Sale of unwanted assets | Share capital |
| Working capital | Venture capital |
| Usually less dependence on lenders | Can provide larger amounts |
| May be limited | May involve interest, repayment or loss of ownership |
Choosing a Source of Finance
A business should consider several factors before selecting a source of finance.
Size of the Business
→ A small business may have limited access to share capital or venture capital.
→ A large company may be able to raise substantial finance by issuing shares.
Legal Form of the Business
→ Sole traders cannot issue shares to the public.
→ Companies may be able to raise finance through share capital.
→ The legal structure therefore affects the sources available.
Amount Required
→ A small amount may be obtained through an overdraft or trade credit.
→ A large expansion may require a bank loan, retained profit, venture capital or share capital.
Length of Time
→ Short-term needs may be financed through an overdraft or trade credit.
→ Long-term investment may require a bank loan, retained profit or share capital.
Existing Loans
→ A business with large existing debts may find it difficult to obtain additional borrowing.
→ Further borrowing could also increase interest and repayment commitments.
Cost of Finance
→ The business should consider:
→ interest
→ arrangement fees
→ dividends
→ leasing costs
→ other charges
→ The cheapest source is not always the most appropriate if it does not meet the business’s requirements.
Purpose of the Finance
→ The purpose of the finance is one of the most important factors.
Example:
→ A temporary cash-flow shortage → bank overdraft
→ Buying expensive machinery → bank loan, hire purchase or leasing
→ Starting a high-growth technology business → venture capital
→ Financing expansion using existing profits → retained profit
→ Buying inventory and paying suppliers later → trade credit
Selecting the Most Appropriate Source
The best source depends on the specific situation of the business.
Example 1: Temporary Cash Shortage
A retailer needs $20,000 for two months because it has to pay suppliers before receiving payment from customers.
→ A bank overdraft may be suitable because the finance is needed only for a short period and the business expects to receive cash from customers soon.
Example 2: Buying New Machinery
A manufacturer needs $500,000 to purchase machinery that will be used for several years.
→ A bank loan or hire purchase may be appropriate because the finance is required for a long-term investment.
Example 3: New Technology Start-up
A new technology business has an innovative product but little retained profit and limited assets.
→ Venture capital may be suitable because investors can provide substantial finance to a business with high growth potential.
→ However, the owners may have to give up part ownership and some control.
Example 4: Established Profitable Business
A business has substantial retained profit and wants to open a new branch.
→ Retained profit may be appropriate because the business can finance the expansion without paying interest or giving ownership to external investors.
Making a Finance Decision
When recommending a source of finance, consider:
→ How much money is needed?
→ How quickly is it needed?
→ How long is it needed for?
→ What is the purpose of the finance?
→ Can the business afford repayments?
→ What is the total cost?
→ Will ownership or control be affected?
→ Does the business already have loans?
→ What sources are available given the legal form and size of the business?
A good finance decision matches the source of finance with the purpose, amount, time period and financial position of the business.