Business Finance Flashcards
Meaning and importance of working capital
Without sufficient working capital, a business will be illiquid and unable to pay its immediate or shortterm debts. What happens in cases such as this? Either the business raises finance quickly, for example as
a bank loan, or it may be forced into liquidation or administration by its creditors (the firms it owes
money to).
A high level of working capital can also be a disadvantage. There is an opportunity cost of having too
much capital tied up in inventories, accounts receivable and idle cash. It is likely that this money could
earn a higher return elsewhere in the business, possibly by being invested in fixed assets.
The working capital requirement for any business will depend upon the length of its working capital
cycle. The longer the time period from buying materials and paying for them to receiving payment from
customers, the greater the working capital needs of the business
Managing working capital
Inventory can be managed in the following ways:
* keeping smaller inventory levels
* using computer systems to record sales and inventory levels, and to order inventory as required
* efficient inventory control, inventory use and inventory handling so as to reduce losses through damage, wastage and shrinkage
* minimise the working capital tied up in inventories by producing only when orders have been received (just-in-time inventory ordering)
* getting goods to customers as quickly as possible to speed up payments from them.
Trade payables can be managed by:
* delaying payments to suppliers to increase the credit period
* only buying goods from suppliers who will offer credit.
Trade receivables can be managed by:
* only selling products for cash and not on credit
* reducing the credit period offered to customer
Internal sources of finance for limited companies
(retained profit that is invested back into business
Sale of unwanted assets
Sale and leaseback of non-current assets
reduce Working capital
Evaluation of internal sources of finance for limited companies
This type of capital has no direct cost to the business, although if assets are leased back once sold there
will be leasing charges. Internal finance does not increase the liabilities or debts of the business, and there
is no risk of loss of control by the original owners as no shares are sold. However, depending solely on
internal sources of finance for expansion can slow down business growth. The rate of growth will be
limited by the level of annual profits or the value of assets sold. Thus, rapidly expanding companies are
often dependent on external sources for much of their finance
Short-term external sources of finance
Bank overdrafts
* A bank overdraft is the most flexible of all sources of finance.
* The bank allows the business to overdraw on its account at
the bank by making payments up to a greater value than the balance in the account
* carries high interest charges
Trade credit
* By delaying payment to suppliers for goods or services received
Debt factoring
* Selling trade receivables
* debt factoring company’s
profits are made by discounting the debts and not paying their full value
Long-term external sources of finance
Hire purchase
Regular payments of interest and partial
repayments of the capital sum have to be made.
Leasing
Leasing can be a high-cost option, but it reduces the inconvenience of having to
repair, maintain and sell the asset. However, leasing does improve the short-term cash position of a
company compared to the outright purchase of an asset with cash.
Bank (long-term) loans
* Bank loans may be offered at either a variable or a fixed interest rate. Fixed rates provide more certainty,
but they can turn out to be expensive if the loan is agreed at a time of high interest rates
Debentures
* The company agrees to pay a fixed rate of interest each year for the life of the debenture, which
can be up to 25 years
* No collateral
security will be required over any non-current assets.
Business mortgages
Advantages of loans
- No shares are sold so ownership of the
company does not change and is not diluted by
the issue of additional shares. - Loans will be repaid eventually so there is no
permanent increase in the liabilities of the
business. - Lenders have no voting rights at the annual
general meetings. - Interest charges are an expense of the business
and are paid out before corporation tax is
deducted. Dividends on shares, however, have
to be paid from profits after tax. - The level of indebtedness (gearing) of the
company increases and this gives shareholders
the chance of higher returns in the future
Advantages of share capital
- It never has to be repaid. It is permanent
capital, unlike loans which must eventually be
repaid. - Dividends do not have to be paid every year.
Directors can decide to retain more earnings
by reducing dividend payments. In contrast,
loan interest must be paid even if the profit of
the business is low or a loss is made. - It lowers the indebtedness of the business, so
debt finance becomes a lower proportion of
total long-term finance.
Venture capital
- specialist organisations or wealthy individuals
- prepared to lend risk capital to
- Venture capitalists take great risks and could lose all of their money, but the rewards can be great.
- generally expect a share of the future profits or a sizeable stake in the business in return for their investment.
Finance for unincorporated businesses
- bank overdrafts and bank loans
-
crowd funding
websites allow an individual to promote their new business idea to many thousands – perhaps millions – of people, who may be willing to each invest a small sum, such as $10. Small businesses using crowd funding finance benefit from the capital that would otherwise have been difficult to obtain. However, they must keep accurate records of thousands of investors to pay back either interest and capital, or a share of the profits. Also, exposing a new project idea on the internet means that it could be copied by others before the entrepreneur has had a chance to start the business up. - credit from suppliers (trade payables)
- loans from family and friends
- owners’ investment
- microfinance - provides small capital sums to entrepreneurs. It is now a very important source of finance in developing, relatively low-income countries.
- taking on partners with capital to invest
Factors affecting the source of finance
1. Why finance is needed and the time period it is
needed
* It is risky and expensive to use long-term finance to pay for short-term needs. Businesses should match the sources of
finance to the length of time it is needed for.
* Permanent capital such as issues of shares may be needed for long-term business expansion or long-term research projects.
* Short-term finance would be advisable to finance a short-term need to increase inventories or pay creditors.
2. Cost
* Obtaining finance is never free – even internal finance may have an opportunity cost.
* Loans may become very costly during a period of rising interest rates.
* A Stock Exchange listing of a newly formed public limited company can cost millions of dollars in fees and promotion of the share sale.
* Once equity finance has been raised, dividends to shareholders are not tax deductible for the business, unlike loan interest.
3. Amount required
* Issues of new shares and debentures, because of administration and other costs, are generally used only for large capital sums.
* Small bank loans, overdrafts or reducing trade receivables’ payment period could be used to raise small sums.
* Retained profit may be too low to provide the finance needed for a major expansion programme. External finance may be required too.
4. Form of business ownership and desire to retain
control
* Share issues can only be used by limited companies, and only public limited companies can sell shares directly to the public.
* Issuing additional shares risks the current owners losing some control, unless they all buy shares with a rights issue.
* If the owners want to retain control of the business at all costs, then a sale of shares might be unwise.
5. Level of existing borrowing
* The higher the existing debts of a business (compared with its equity capital), the greater the risk of borrowing more. Banks and other lenders will become anxious about lending more finance.
* This concept is referred to as gearing .
* A high level of existing debt might mean that internal sources should be considered, such as the sale of assets.
6. Flexibility
* When a firm has a variable need for finance (for example, it has a seasonal pattern of sales and cash receipts), a flexible form of finance is better than a long-term and inflexible source.
