5.1.1 The Need for Finance
The first part of the unit is an introduction to the fundamentals of finance.
Shorter knowledge questions are more likely, however, make sure you have a clear understanding of the three different reasons businesses need finance, as this forms the building blocks of later more difficult questions.
| Past Paper Question Example Paper 1 (a) Identify two reasons why a business might need finance. [2] Reason 1: Reason 2: |
The main reasons why businesses need finance
1. Start Up Capital money required to set up a business and keep the business operating until it starts to break even for example: location costs, equipment, machinery, recruitment and selection costs, training costs, market research, advertising, research and development.
2. Working capital – apart from capital costs startups also need to ensure they have enough money to pay for all the bills they will have to pay, like employees’ wages, suppliers, electricity until they start to break even or make a profit.
This is called working capital and we will go into it in much more details later in this unit when we look at cash flow.
3. Capital for expansion Finally, businesses need capital for expansion. When companies start to provide a new service or product, or open in another location they will have to find finance for the new part of their business. Expansion costs may include: recruitment and selection costs, training costs, market research, advertising and research and development costs.
Understanding the difference between short-term and long-term finance needs
The first topic we look at in Unit 5 is sources of finance. Where do businesses get the capital they need to start up, expand or pay for running costs?
There are a wide choice of different sources of finance from an overdraft, to selling shares on the stock exchange. Firstly, we will look at short term and longer-term finance.
Short term capital is finance required for short periods, usually less than one year.
Often short term capital is needed when a business is short of working capital because of cash flow issues. For example, if a Toy Store has most of its sales at Christmas time, it will need additional working capital to pay its bills when toy sales are low in the rest of the year.
Long Term Capital is finance required for periods usually longer than one year.
Long term capital is normally for expensive items (or large expenditure investment) like equipment, machinery or taking over another business.
| ⭐⭐⭐Top Tip ⭐⭐⭐ Short term finance is less than one year. Long term finance longer than one year. |
In the next section we will look in more detail at the different types of finance and figure out which ones are most suitable in different situations.
5.1.2 Main Sources of Finance
In 5.1 we get into the detail of the different sources of finance available to business.
| ⭐⭐⭐Top Tip ⭐⭐⭐ There are 8 sources of finance listed on the IGCSE Business specification. You need to learn a definition for each, know which kind of businesses can access each source of finance, and in what situations each source of finance is suitable. |
Internal sources and external sources
Internal Sources of finance is funding from inside the business
Owners savings is using the owners personal money to finance the business (sole trader or partnerships only).
For small businesses with low start-up costs owners savings may be sufficient to start the business, and means the sole trader or partners don’t have to get into debt. For example, a YouTube Creator only needs a laptop, camera and microphone to start creating video content. Therefore, they may prefer to use their own funds as it means there is no need to organise a loan from the bank and repay the money with interest.
However, it may not be suitable if the business owner doesn’t have sufficient savings, or if there is a high capital cost in starting the business. Many small businesses require much more capital than a YouTube creator.
| Owner’s Savings | |
| + No debt to be repaid + No interest payments | X Many entrepreneurs may not have savings |
Retained Profit is reinvesting profits back into the business.
If a business is profitable, instead of sharing all the profits with the owners or shareholders a share of the profits can be used to reinvest in the business.
This is suitable if the business is profitable and if only a relatively small level of finance is needed.
It is isn’t suitable for startups, as they haven’t earned any profit yet.
For a large expansion retained profits will not be enough, unless the company is hugely profitable.
| Retained Profit | |
| + No debt to be repaid + No interest payments | X Business must be profitable X Owners must be willing to re-invest |
Sale of Assets is selling equipment, machinery or inventory to finance the business.
This can be highly suitable if machinery or equipment is no longer needed.
It can solve a short term finance issue if businesses can’t secure a loan from a bank or other source.
But it can often lead to further problems for the business. If a business sells its delivery truck they will have to pay another business to deliver, which will increase costs in the long term.
Furthermore, a business needs to have assets to sell off for this source of finance to be suitable.
| Sale of Assets | |
| + Suitable if asset is no longer needed + No debt or interest payments | X May lead to higher costs if the business must source alternative equipment |
External Sources of Finance is funding from outside the business and includes overdraft, loans, selling of shares, microfinance or crowdfunding.
Short-term and long-term sources with examples
Overdraft: banks allow businesses to take additional money out of their bank account up to an agreed limit.
| Overdraft | |
| + Flexible + Suitable for resolving a short term cash flow shortage | X Much higher interest than long term loans |
If a business just needs $100 to pay a supplier while awaiting customer payment for 5 days, the business only pays the interest on the $100 for each day they use the overdraft. If they don’t use the overdraft, they don’t have to pay any interest.
However, as the interest rates are higher than a long term loan, if a business is going to be overdrawn for a long period it makes more sense to get a loan from the bank or arrange another source of finance.
Trade Credit is delaying payment to suppliers for an agreed time period.
The other main form of short term finance is trade credit. Often suppliers will allow up to three months for the payment of bills. For example, a seafood restaurant may be given 30 days to pay a supplier after delivery of seafood to the restaurant.
This can be useful in raising the level of working capital and helping cash flow. For example, if the restaurant can sell the seafood before it has to pay the supplier.
| Overdraft | |
| + Interest free way to improve cash flow | X May not be accessible to many businesses |
However, trade credit will only help with cash flow, and is not suitable for longer term sources of finance. Small businesses may not be able to get trade credit from suppliers.
Loans are when banks lend a business a fixed amount for an agreed time period.
Loans are more suitable for longer time periods when the business has a large capital cost it has to finance, like new equipment or machinery.
However, if interest rates are high, loans can be costly.
| Loans | |
| + Suitable for long term finance if interest rates are not too high | X May not be available to businesses with high debts, low assets or small business |
It also depends if the bank is willing to lend the money to the business.
Often banks will require businesses to use an asset like a building to secure the loan. This means that businesses without high value assets can’t access loans.
Furthermore, if a business already has a high level of debt the bank may be unwilling to lend the business more money as there is a higher risk the business will not pay back the loan.
For sole traders and partnerships there is a higher risk of taking a loan because of unlimited liability. If the business fails the banks can take the owners’ personal possessions to pay for the loan.
Loans are usually long term, but can be short term if the loan period agreed is less than one year.
Loans and overdrafts are known as debt finance, as the business will owe the bank or lender money. The business must pay back the debt with interest.
The alternative to debt finance is equity financing: selling shares in the business to raise finance. Investors are not repaid but become owners of shares in the business and receive a share of the business profits ( dividends).
This option is open to partnerships that want to change to private limited companies or to private limited companies and public limited companies.
| Equity Finance (selling shares) | |
| + Can raise large amounts of capital that don’t have to be repaid | X Must may pay dividends and there is a loss of control to shareholders |
Essentially, business owners sell part of their company to investors. This means they can raise a high level of capital without going into debt.
However, it does mean they will lose some control over the business as the new shareholders will have a say in how the company is run. They will also have to pay a share of the profits (called dividends) to shareholders every year.
Leasing or Hire Purchase: paying a fixed amount every month for an asset.
With hire purchase a business gets ownership of the asset at the end of the repayment period.
A lease is business does not own but “rents” the asset, so at the end of the leasing period the business must return the asset.
It’s a good option for the purchase of capital equipment like machinery or equipment. The business should compare the long term cost of the lease with the interest rates a bank will charge for a loan in order to the find the most cost effective source of finance.
Grant: a sum of money given by a government or other organization for a particular purpose. Grants could be a source of finance for startups in some countries.
Alternative sources of capital
Microfinance: lending small amounts of finance to small business people who can’t access finance from another source.
This is a niche form of finance, it can be extremely helpful to small business people in developing countries but it is not suitable for other sorts of business.
Crowdfunding: raising finance by raising small amounts of money from a large number of people, usually via the Internet.
This could be useful if you are a start up which captures the imagination of individuals on crowdfunding websites like kickstarter.
It is not suitable if your business is a bit more conventional like most businesses. Crowd funding for a kebab shop, window cleaner or dentist is less likely to be successful.
The main factors considered in making the financial choice
Once we have figured out the different sources of finance we need to be aware of the different factors which influence which source of finance to choose.
Length of time: this one is pretty straightforward, short term sources of finance are for short periods only, for example, overdraft, trade credit or short term loan.
Size and Legal Form of business: Sole traders and partnerships are smaller businesses and have these options available
For very small businesses in developing countries microfinance may also be available.
Crowd funding may be available to innovative start ups.
| ⚠⚠ DANGER! ⚠⚠ Microfinance and Crowdfunding are for very specific kinds of businesses with special circumstances only. |
Larger businesses are usually incorporated and also have the opportunity to raise equity finance.
As they have more assets and usually have a large secure income they are more likely to be given bank loans, unless they already have high levels of debt.
Existing Loans: for small and large businesses, banks will look at existing loans before lending further capital. If a business already has a high level of debt it is much harder to secure a loan, as banks will be concerned that the business can repay all of the capital owed.
Recommend and justify appropriate source(s) of finance in given circumstances
So now we know the different sources of finance available and what factors to consider. We now need to able a recommend a suitable source of finance.
This is not a hugely popular 12 mark question but it could appear like this asking about possible sources of finance for a delivery van:
| Past Paper Question Example Paper 2 (b) Consider the following three ways Peter could finance a new delivery van. Recommend which would be the best way to use. Justify your answer. – Bank Loan – Crowdfunding – Owner’s Funds – Recommendation [12] |
You need to find an advantage and or disadvantage for each source of finance, in context, and then come to a final decision on the most suitable source of finance for the delivery van.
There will be clues in the case study directing you to a choice. For example, if the business already has a high level of debt it may not be able to access a loan. This will assist you in making a final decision in your evaluation.
