business finance chapter 29

Question 1

start up capital

Answer 1

the capital needed by an entrepreneur to set up a business

Question 2

working capital

Answer 2

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

Question 3

business activities that require financing

Answer 3

start up capital is needed to purchase essential capital equipment

working capital is needed to pay bills and expenses to build up inventories

When businesses grow, further finance will be needed to buy more assets and to pay for higher working capital needs. Growth through developing new products will require finance for research and development.

Growth can be achieved by taking over other businesses. Finance is then needed to buy out the owners of the other firm.

Special situations may lead to a need for finance.

Question 4

short term finance

Answer 4

money required for short periods of time of up to one year

Question 5

long term finance

Answer 5

money required for more than one year

Question 6

the distinction between long term and short term finance

Answer 6

Many businesses, especially small ones, often need short-term finance instead of long-term finance. Short-term loans are helpful to businesses that experience seasonal demand, it would not be possible to pay off short term loans of large amounts with the income earned in just one year, in this case a long term loan is used.

Question 7

profit

Answer 7

the value of goods sold (revenue) less costs

Question 8

liquidity

Answer 8

the ability of a business to pay its short term debts

Question 9

the difference between cash and profit

Answer 9

these two financial concepts do not have the same meaning or significance. It is very common for profitable businesses to run short of cash. On the other hand, loss-making businesses can have high business inflows of cash in the short term. cash can be equal to profit if the inflows and outflows of cash are same as the profit because all purchases and transactions were in cash. if there is inflow of cash is more than the profit then there the business has bought goods on credit that are yet to be paid. if cash is less than the profit then the the business has sold goods on credit for which the payment has yet to be received, it then has low level of liquidity because it can run out of cash to pay for everyday costs.

Question 10

administration

Answer 10

when administrators manage a business that is unable to pay its debts with the intention of selling it as a going concern. If a business fails due to lack of finance, it is often placed in administration. Specialist administration accountants are appointed to try to keep the business operational and to find a buyer for it.

Question 11

bankcruptcy

Answer 11

the legal procedure for liquidating a business (or property owned by a sole trader) which cannot fully pay its debts out of its current assets. it is caused by poor administration

Question 12

liquidation

Answer 12

when a business ceases trading and its assets are sold for cash to pay suppliers and other creditors. The aim of liquidation is to raise as much finance as possible to pay back those people. It is cause by bankruptcy

Question 13

importance of working capital

Answer 13

Without sufficient working capital, a business will be illiquid and unable to pay its immediate or short-term debts. the business has to either raise finance quickly or it may be forced into liquidation or administration by its creditors. 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.

Question 14

current assets

Answer 14

assets that either are cash or likely to be turned into cash within 12 months (inventory and trade receivables or debtors).

Question 15

current liabilities

Answer 15

debts that usually have to be paid within one year.

Question 16

where does the capital to finance these important assets for business come from

Answer 16

Most businesses obtain some of this finance in the form of current liabilities. Overdrafts and trade payables (creditors who need to be paid by the business) are the main forms. However, it would be unwise to obtain all of the funds needed from these sources. These debts may have to be repaid at very short notice, resulting in a liquidity problem.

Question 17

permanent increase in working capital

Answer 17

When businesses expand, they generally need higher inventory levels and the total value of products sold on credit will increase. This increase in working capital is likely to be permanent, so long-term or permanent sources of finance will be needed, such as bank (long-term) loans or share capital.

Question 18

managing working capital

Answer 18

managing the level of working capital can be achieved by managing inventor, managing trade payables and/or managing trade receivables

Question 19

ways that inventory can be managed

Answer 19

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

minimize 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.

Question 20

ways that trade payable can be managed

Answer 20

delaying payments to suppliers to increase the credit period

only buying goods from suppliers who will offer credit.

Question 21

Trade receivables can be managed by

Answer 21

only selling products for cash and not on credit

reducing the credit period offered to customers

Question 22

capital expenditure

Answer 22

the purchase of non-current assets that are expected to last for more than one year, such as buildings and machinery.

Question 23

revenue expenditure

Answer 23

spending on all costs and assets other than non-current assets, which includes wages, salaries and inventory of materials.

Question 24

business ownership and sources of finance

Answer 24

Business ownership has a big impact on the sources of finance available to any particular firm. a PVT.LTD cannot raise capital by selling shares to the public like a PLC

Question 25

finance for limited companies

Answer 25

companies are able to raise finance from a wide range of sources. these are classified as internal sources and external sources. another classification is short and long term finance

Question 26

internal sources

Answer 26

raising finance from the business’s own assets or from profits left in the business (retained earnings). sources are
retained earnings
sale of unwanted assets
sale and leaseback of non current assets
working capital
evaluation of internal sources of finance

Question 27

external sources

Answer 27

raising finance from sources outside the business, for example banks.

Question 28

internal sources: retained earnings

Answer 28

profit after tax retained in a company rather than paid out to shareholders as dividends. Dividends will nearly always be paid out to the shareholders. If any profit remains, this is kept or retained in the business and, if held in cash form, becomes a source of finance for future activities. Clearly, a newly formed company or one trading at a loss will not have access to this source of finance. For other companies, retained earnings is a very significant source of funds for expansion. Once invested back into the business, these retained earnings will not be paid out to shareholders, so they represent a permanent sources of finance

Question 29

internal sources: sale of unwanted assets

Answer 29

established companies often find they have assets that are no longer fully employed. these could be sold to raise cash

Question 30

internal sources: sale and leaseback of non current assets

Answer 30

some businesses will sell non-current assets that they still intend to use, but which they do not need to own. The assets could be sold to a specialist financial institution and leased back by the company. This will raise capital, but the lease payment becomes an additional fixed cost.

Question 31

internal sources: working capital

Answer 31

When companies reduce the finance held as working capital, finance is released for other uses. So, reducing the level of inventory releases cash into the business. There are risks in cutting down on working capital, however. Cutting back on current assets by selling inventories or reducing trade receivables may reduce the liquidity of the business - its ability to pay short-term debts-to risky levels.

Question 32

internal sources: evaluation of internal sources of finance

Answer 32

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.

Question 33

non current assets

Answer 33

assets kept and used by the business for more than one year.

Question 34

overdraft

Answer 34

credit that a bank agrees can be borrowed by a business up to an agreed limit as and when required.

Question 35

factoring

Answer 35

selling of claims over trade receivables (debtors) to a specialist organisation (debt factor) in exchange for immediate liquidity.

Question 36

short term external sources of finance

Answer 36

bank overdrafts
trade credit
debt factoring

Question 37

short term external sources of finance: bank overdrafts

Answer 37

it is the most flexible of all sources of finances. the amount can vary from day to day, depending on the needs the needs of the business. the bank allows the business to overdraw on its account at the bank making payments greater than the balance. the overdrawn amount should always be agreed in advance and always have a limit beyond which the business should not go. businesses may need to increase the overdraft for short periods of time if customers do not pay as quickly as expected or if a large delivery of supplies has to be paid for. it has high interest charges. bank can call in the overdraft and force the firm to pay it back. in extreme cases it can lead to business failure. it is also an important source of finance for unincorporated businesses.

Question 38

short term external sources of finance: trade credit

Answer 38

By delaying payment to suppliers for goods or services received, a business is, in effect, obtaining finance. Its suppliers become trade payables or trade creditors. They supply goods and services without receiving immediate payment. The drawback to these periods of credit is that they are not free. Discounts for quick payment are often lost if the business takes too long to pay its suppliers.

Question 39

short term external sources of finance: debt factoring

Answer 39

When a business sells goods on credit, it creates trade receivables. The longer the time allowed to pay up, the more finance the business has to find to carry on trading. One option, if it is commercially unwise to insist on cash payments, is to sell these claims on trade receivables to a debt factor. In this way immediate cash is obtained, but not for the full amount of the debt. This is because the debt factoring company’s profits are made by discounting the debts and not paying their full value. When full payment is received from the original customer, the debt factor makes a profit. Smaller firms who sell goods on hire purchase often sell the debt to credit loan firms, so that the credit agreement is never with the firm but with the specialist provider

Question 40

Long term external sources of finance

Answer 40

hire purchase and leasing (usually for up to five years)
bank (long-term) loans
debentures (also known as loan stock or corporate bonds)
share capital (or equity capital)
business mortgages
government grants
venture capital.

Question 41

Long term external sources of finance: hire purchase

Answer 41

a company purchases an asset and agrees to pay fixed repayments over an agreed time period. the asset belongs to the purchasing company once the final payment has been made. avoids making large initial cash payment to buy the asset. the hire purchase agreement allows the purchasing business to own the asset. the interest rate can be higher than a bank loan. regular payments of interest and partial payments of the capital sum have to be made

Question 42

Long term external sources of finance: leasing

Answer 42

obtaining the use of an asset and paying a leasing charge over a fixed period, avoiding the need to raise long-term capital to buy the asset. The asset is owned by the leasing company. it involves a contract with the leasing company. allows business to avoid the cash purchase of the asset. the risk of unreliable or outdated equipment is reduced as the leasing company will repair and update the asset as part of the agreement. 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.

Question 43

Long term external sources of finance: bank (long) term loans

Answer 43

loans that do not have to be repaid for at least one year. 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. Companies borrowing from banks will often have to provide security or collateral for the loan. This means the right to sell an asset is given to the bank if the company cannot repay the debt. Businesses with few assets to act as security may find it difficult to obtain loans or may be asked to pay higher rates of interest.

Question 44

Long term external sources of finance: debentures

Answer 44

A company wanting to raise funds can issue or sell debentures (also known as bonds) to interested investors. The company agrees to pay a fixed rate of interest each year for the life of the debenture. The buyers may resell to other investors if they want to raise cash before the debenture matures. Debentures can be a very important source of long term finance. No collateral security will be required over any non-current assets. Convertible debentures can (if the borrower requests it) be converted into shares after a certain period of time. This means that the company issuing them will never have to pay the debenture back.

Question 45

Long term external sources of finance: share capital

Answer 45

permanent finance raised by companies through the sale of shares. able to sell additional shares - up to the limit of their authorized share capital. Private limited companies can sell further shares to existing shareholders. This has the advantage of not changing the control or ownership of the company, as long as all shareholders buy shares in proportion to those already owned. Owners of a private limited company can also decide to go public and obtain the necessary authority to sell shares to the wider public. This has the potential to raise much more capital than from just the existing shareholders. There is the risk of some loss of control to the new shareholders.

Question 46

Long term external sources of finance: business mortgages

Answer 46

long-term loans to companies purchasing a property for business premises, with the property acting as collateral security on the loan. The interest rate can be fixed or variable.

Question 47

Long term external sources of finance: government grants

Answer 47

There are agencies that are prepared, under certain circumstances, to grant funds to businesses. The two major sources in most European countries are the central government and the European Union. Usually, grants from these two bodies are given to small businesses or those expanding in developing regions of the country. Grants often come with conditions attached, such as location and the number of jobs to be created, but if these conditions are met, grants do not have to be repaid.

Question 48

Long term external sources of finance: venture capital

Answer 48

risk capital invested by venture capitalists in business start ups or expanding small businesses (unquoted companies) that have good profit potential but do not find it easy to gain finance from other sources. These risks could come from the new technology that the company is dealing in or the complex research it is planning. Other providers of finance may not be prepared to get involved.

Question 49

unquoted companies

Answer 49

company not listed on the stock exchange.

Question 50

venture capitalists

Answer 50

specialist organisations or wealthy individuals. They are prepared to lend risk capital to, or purchase shares in, business start-ups or small to medium-sized businesses. they generally expect a share of the future profits or a sizeable stake in the business in return for their investment

Question 51

selling shares to public on the alternative investment market

Answer 51

the alternative investment market. is part of the Stock Exchange concerned with smaller companies that want to raise only limited amounts of additional capital. The strict requirements for a full Stock Exchange listing are relaxed.

Question 52

selling shares on stock exchange

Answer 52

Apply for a full listing on the Stock Exchange by satisfying the criteria of (a) selling at least £50000 worth of shares and (b) having a satisfactory trading record to give investors some confidence in the security of their investment. This sale of shares can be undertaken in two main ways: Public issue by prospectus or rights issue of shares to existing shareholders

Question 53

share issue: public issue by prospectus

Answer 53

This advertises the company and its share sale to the public and invites them to apply for the new shares. This is expensive, as the prospectus has to be prepared and issued. The share issue is often underwritten or guaranteed by a merchant bank, which charges for its services.

Question 54

share issue: Rights issue of shares to existing shareholders:

Answer 54

Once a company has gained public limited company status, it is still possible for it to raise further capital by selling additional shares. This is often done by means of a rights issue of shares. The company raises capital relatively cheaply as no public promotion or advertising of the share offer is necessary. However, the rights issue increases the supply of shares to the stock exchange. The short-term effect is often to reduce the existing share price. This might not give existing shareholders a lot of confidence in the business if the share price falls too sharply.

Question 55

rights issue

Answer 55

existing shareholders are given the right to buy additional shares at a discounted price. rights issues of shares do not change the ownership of the company

Question 56

collateral security

Answer 56

an asset which a business pledges to a lender and which must be sold off to pay a debt if the loan is not repaid.

Question 57

advantages of loans

Answer 57

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

Question 58

advantages of share capital

Answer 58

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.

Question 59

unincorporated businesses

Answer 59

sole traders and partnerships. cannot raise finance from the sale of shares. they are unlikely to be successful in selling debentures as they are unlikely to be successful in selling debentures as they are likely to be relatively unknown firms. owners and partners in an unincorporated business have unlimited liability. lenders are often reluctant to offer loans or overdrafts unless the owners give personal guarantees, supported by their own assets, should the business fail. Family and friends might lend finance, but they may find it difficult to charge interest and can insist upon repayment at any time. Any non-repayment could damage relationships too. Owners may have insufficient savings to invest in the business. Sole traders can ask potential partners to inject finance.

Question 60

ways unincorporated businesses

Answer 60

bank overdrafts and bank loans including microfinance
crowd funding
credit from suppliers (trade payables)
loans from family and friends
owners investment
taking on partners with capital to invest

Question 61

microfinance

Answer 61

providing financial services for poor and low-income customers who do not have access to the banking services, such as loans and overdrafts, offered by traditional commercial banks. provides small capital sums to entrepreneurs. It is now a very important source of finance in developing, relatively low-income countries. There is evidence that entrepreneurship is greater in regions with microfinance schemes in operation - and that average incomes are rising because of more successful businesses. One possible drawback to microfinance is that interest rates can be quite high as the administration costs of many very small loans are considerable. Some economists also suggest that if a small business start-up financed by microfinance fails, then the scheme has encouraged very poor people to take on debts that they cannot repay.

Question 62

crowdfunding

Answer 62

the use of small amounts of capital from a large number of individuals to finance a new business venture. an increasingly significant source of finance for new business start-ups. The idea behind it is that entrepreneurs rarely have sufficient finance to set up their own businesses. Banks may be unwilling to lend or may charge very high interest rates, especially if the entrepreneur has no proven business record. 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 a small sum, such as $10. Through these websites, the entrepreneur will explain, perhaps with the aid of a video and graphics, what the business is about, what its objectives are and why finance is needed. The publicity generated can also be an effective form of promotion for the new business and its product.

Question 63

how do investors profit from crowdfunding

Answer 63

investors will hope to make a return on their investment. The failure rate of newly created businesses is high and investors may not receive any returns at all.

Question 64

what will crowdfunding investors that have invested in successful business receive

Answer 64

their initial capital back plus interest-this is sometimes known as peer to peer landing- or an equity in the business and a share in profits when these are eventually made.

Question 65

advantages of crowdfunding

Answer 65

they receive capital that would otherwise have been difficult to obtain.

Question 66

disadvantages of crowdfunding

Answer 66

they must keep record of of thousands of investors to pay back either interest and capital, or a share of the profits.

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.

Question 67

why factors influencing finance choice is important: why the finance is needed and the time period it is needed for

Answer 67

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.

Question 68

why factors influencing finance choice is important: cost

Answer 68

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.

Question 69

why factors influencing finance choice is important: amount required

Answer 69

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.

Question 70

why factors influencing finance choice is important: form of business ownership and desire to retain control

Question 71

why factors influencing finance choice is important: level of existing borrowing

Answer 71

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.

gearing

A high level of existing debt might mean that internal sources should be considered, such as the sale of assets.

Question 72

why factors influencing finance choice is important: flexibility

Answer 72

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

Question 73

selecting the appropriate source of finance

Answer 73

Selecting the most appropriate source of finance is essential for long-term business success. A source which is too costly, inflexible or can be withdrawn quickly might end up destroying the business. Finance managers and directors have very important finance decisions to make and must consider a number of factors before selecting the best source.