26 - Business Finance

Question 0

What is start up capital?

Answer 0

This is the capital needed by an entrepreneur to set up a business

Question 1

What is the importance of finance to a firm?

Answer 1

Finance is important to a firm because:
-Setting up a business will require cash injections from the owners to finance the business needs such as land and labour. This is called the startup capital

• All businesses would need to finance their working capital in order to pay for the day to day expenses e.g paying bills, wages and restocking
• When businesses expand, they require further finance to increase capital assets, this involves higher working capital needs
• Expansion can be achieved by taking over other firms, finance will np be needed for this

Question 2

What is working capital?

Answer 2

This is the finance needed for a firm to pay its day to day costs, such as paying bills, restocking and paying wages

-Working capital = current assets - current liabilities

Question 3

What is capital expenditure?

Answer 3

This is expenditure on assets that are expected to last more than one year, such as property and machinery

-This is recorded on the balance sheet

Question 4

What is revenue expenditure?

Answer 4

This is expenditure on all costs and assets other than fixed assets. It includes wages, salaries and stock

-This is recorded on the income statement

Question 5

What is liquidity?

Answer 5

This is a firm ability to pay its short term debts as they fall due

Question 6

What is liquidation?

Answer 6

This is when a firm stops production and it’s assets are sold in order to pay the debt to its creditors

Question 7

Why is it important to maintain sufficient levels of working capital?

Answer 7

• Sufficient working capital is essential to keep the firm liquid and ensure that they can pay short term debts
• Too much working capital is a disadvantage because of the opportunity cost of too much capital tied up as stock, the money could be invested elsewhere, where it can earn interest

Key point
*The working capital requirements of a firm would depend on the length of it’s working capital cycle. The longer the time period from buying raw materials to receiving payments from consumers, the greater the working capital needs of the firm

Question 8

What are internal sources of finance?

Answer 8

This is internal finance raised from the businesses own assets or from retained profit

Question 9

What are external sources of finance?

Answer 9

This is finance raised from sources that are outside of the business

Question 10

What are the internal sources of finance?

Answer 10

• Retained profits, This is the profit that is ploughed back into the business, it is only available for firms that are trading profitably.
• This is unavailable for newly formed businesses as they would not be trading profitably
• This money would not be paid to shareholders, therefore limited companies should be cautious of the amount of profit that is retained
• Sale of assets, This is when a redundant asset is sold in order to increase a firms cash.
• The asset can the be leased back if needed
• This would usually be unavailable to small firms as they normally struggle to make high profits
• The asset may be required in the future for expansion
• Reducing working capital, This is when a firm reduces it’s current assets in order to increase cash levels
• It can be done when a firm buys less stock in order to save cash
• This is risky because the firm could become illiquid

Key points

• These sources of finance have no direct cost to the business. However if an asset is leased back, there will be additional costs
• Internal sources don’t increase liabilities or debts to the business
• There’s no risk of dilution of control however, it’s not available to all companies

Question 11

What are the short term sources of finance?

Answer 11

• Bank overdrafts, this is a short term source of finance from the bank
• This is the most flexible source of finance
• It can only be used in the short term due to high interest rates
• Trade credit, this is delaying the payment of bills for goods or services
• This can be done by delaying to pay creditors, the cash can be used on other investments
• This can damage a firms relationship with its creditors
• Debt factoring, The claims from credit sales are sold to a debt factoring company
• The value of the credit sales isn’t met, therefore the firm receives less money
• If the debtors are approached by the factoring company, it could suggest that the firm is in financial trouble

Question 12

What is an overdraft?

Answer 12

This is when a bank agrees to lend a business money up to an agreed limit as and when required

-This comes with high interest

Question 13

What is factoring/debt factoring?

Answer 13

Selling of claims over debtors to a debt factoring company in exchange for immediate liquidity. The firm wouldn’t gain the full value of their claims, therefore money is lost in the long term

Question 15

What is leasing?

Answer 15

This is when a firm obtains the use of an asset over a fixed period of time

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

Question 16

What is hire purchase?

Answer 16

This is when a firm pays fixed payments overtime in order to cover the cost of an asset. Once the cost has been covered, the firm gains ownership of the asset

Question 17

What are the long term sources of finance?

Answer 17

• Long term loans, these are loans that don’t have to be repaid for at least one year
• Firms would need collateral in order to access these with reasonable rates of interest
• Banks would be more willing to allow loans to successful firms as they are more likely to pay back the debt
• Longterm bonds/Debentures, A bond issued by companies to raise debt finance, often with a fixed rate of interest
• The company agrees to pay affixed rate of interest for the life of the bond, which can be up to 25years
• Issue share, shares are sold to raise capital, only available to limited companies
• This capital is paid back in the form of dividends
• There is a dilution of ownership as shareholders are also owners

Question 18

What is a long term load?

Answer 18

Loans that don’t have to be repaid for at least one year

Question 19

What is equity finance?

Answer 19

Permanent finance raised by companies through the sale of shares

Question 20

What is a long term bond/Debendture?

Answer 20

This is a bond issued by companies to raise debt finance, often with a fixed rate of interest

Question 21

What is a rights issue?

Answer 21

When an existing shareholder is given the right to buy additional shares at a discounted price

Question 22

What is venture capital?

Answer 22

This is the risk capital invested in business start ups or on the expansion of small businesses

-These small firms usually have good profit potential but don’t find it easy to gain finance through their sources

Question 23

What is a business plan?

Answer 23

This is a detailed business document giving evidence about a new or existing business, it aims to convince external lenders and investors to invests into the business

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-It gives the owner and managers a clear plan of action to guide their actions and decisions

-It forces the owners to think long and hard over the future of the firm and possibly plan for future weaknesses or risks

Question 24

What factors influence the choice of the sources of finance?

Answer 24

• Amount required, High cost expenditures, such as capital equipment would most likely require long term sources of finance
• Smaller sums would require short term sources
• Cost, The interest rates influence the choice made as it could make a source of finance expensive to use
• Obtaining finance always comes with a cost! even internal finance comes with opportunity cost.
• legal structure, this can determine which sources of finance are
• Sole trader don’t usually have the option of bank loans
• Only limited companies can raise share capital
• Desire to retain control, loss of control is a consequence of issuing shares
• If the owners would like to retain ownership of the firm, then they should avoid issuing shares

-Flexibility, if a firm wants a flexible loan, they should look towards short term sources of finance as long term sources are inflexible

Question 26

What are the medium term sources of finance?

Answer 26

• Hire purchase, an asset is paid for over a set period of time until the debt has been payed off and ownership is gained
• This avoids large capital expenditure
• This involves a contract and the individual doesn’t gain ownership until the debt has need paid
• Leasing, this is when a contract is signed for a firm to acquire but not own an asset over a certain period of time. A periodic payment is made over the life of the contract
• This doesn’t involve ownership of any kind
• This avoids large capital expenditure