Chapter 26 Business Finance

Question 1

Why business activity requires finance?

Answer 1

1 Setting up a business will require cash injections from the owner(s) to purchase essential capital equipment and, possibly, premises.
2 All businesses will have a need to finance their working capital – the day-to-day finance needed to pay bills and expenses and to build up stocks
3 When businesses expand, further finance will be needed to increase the capital assets held by the firm

Question 2

What is start up capital?

Answer 2

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

Question 3

What is working capital?

Answer 3

Working capital is the capital needed to pay for raw materials, day-to-day running costs and credit offered to customers.

Question 4

How to calculate working capital?

Answer 4

working capital = current assets – current liabilities

Question 5

What is capital expenditure?

Answer 5

Capital expenditure involves the purchase of assets that are expected to last for more than one year, such as building and machinery

Question 6

What is revenue expenditure?

Answer 6

Revenue expenditure is spending on all costs and assets other than fixed assets and includes wages and salaries and materials bought for stock

Question 7

Why is working capital so significant to a business?

Answer 7

Working capital is often described as the ‘lifeblood’ of a business. Finance is needed by every business to pay for everyday expenses, such as the payment of wages and buying of stock. Without sufficient working capital a business will be illiquid – unable to pay its immediate or short-term debts.

Question 8

What is Liquidity?

Answer 8

Liquidity is the ability of a firm to be able to pay its short-term debts

Question 9

What is liquidation?

Answer 9

Liquidation is when a firm ceases trading and its assets are sold for cash to pay suppliers and other creditors

Question 10

Where does finance come from?

Answer 10

1 Internal money raised from the business’s own assets or from profits left in the business (ploughed-back or retained profits)
2 External money raised from sources outside the business

Question 11

What are the different internal sources of finance?

Answer 11

1 Profits retained in the business
2 Sale of assets
3 Reductions in working capital

Question 12

Internal sources of finance: Explain Profits retained in the business.

Answer 12

If a company is trading profitably, some of these profits will be taken in tax by the government (corporation tax) and some is nearly always paid out to the owners or shareholders (dividends). If any profit remains, this is kept (retained) in the business and becomes a source of finance for future activities

Question 13

Internal sources of finance: Explain Sale of assets.

Answer 13

Established companies often find that they have assets that are no longer fully employed. These could be sold to raise cash. In addition, some businesses will sell assets that they still intend to use, but which they do not need to own. In these cases, the assets might be sold to a leasing specialist and leased back by the company. This will raise capital – but there will be an additional fixed cost in the leasing and rental payment.

Question 14

Internal sources of finance: Explain Reductions in working capital

Answer 14

When businesses increase stock levels or sell goods on credit to customers (debtors), they use a source of finance. When companies reduce these assets – by reducing their working capital – capital is released, which acts as a source of finance for other uses.

Question 15

What are the different short term External sources of finance?

Answer 15

1 Bank overdrafts
2 Trade credit
3 Debt factoring

Question 16

External sources of finance Short-term sources: Explain Bank overdrafts

Answer 16

A bank overdraft is where a bank agrees to a business borrowing up to an agreed limit as and when required

Question 17

External sources of finance Short-term sources: Explain Trade credit

Answer 17

By delaying the payment of bills for goods and services received, a business is, in effect, obtaining finance. Its suppliers, or creditors, are providing goods and services without receiving immediate payment and this is as good as ‘lending money’.

Question 18

External sources of finance Short-term sources: Explain Debt factoring

Answer 18

Debt factoring is the selling of claims over debtors to a debt factor in exchange for immediate liquidity – only a proportion of the value of the debts will be received as cash

Question 19

What are the different medium-term External sources of finance?

Answer 19

1 Hire purchase

2 Leasing

Question 20

External sources of finance Medium-term sources: Explain Hire purchase

Answer 20

Hire purchase means an asset is sold to a company that agrees to pay fixed repayments over an agreed time period – the asset belongs to the company

Question 21

External sources of finance Medium-term sources: Explain Leasing

Answer 21

Leasing means obtaining the use of equipment or vehicles and paying a rental or leasing charge over a fixed period. This avoids the need for the business to raise long-term capital to buy the asset. Ownership remains with the leasing company

Question 22

What are the different Long-term External sources of finance?

Answer 22

1 Long-term loans from banks
2 Long-term bonds or debentures
3 Sale of shares – equity finance

Question 23

External sources of finance Long-term sources: Explain Long-term loans

Answer 23

Long-term loans are loans that do not have to be repaid for at least one year

Question 24

External sources of finance Long-term sources: Explain Long-term bonds or debentures

Answer 24

Long-term bonds or debentures are bonds issued by companies to raise debt finance, often with a fixed rate of interest

Question 25

External sources of finance Long-term sources: Explain Sale of shares – equity finance

Answer 25

Equity finance is permanent finance raised by companies through the sale of shares

Question 26

What are the different other Long-term External sources of finance?

Answer 26

1 Grants

2 Venture capital

Question 27

External sources of finance Other long-term sources: Explain Grants

Answer 27

Government grants are usually 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 28

External sources of finance Other long-term sources: Explain Venture capital

Answer 28

Venture capital is risk capital invested in business start-ups or expanding small businesses that have good profit potential but do not find it easy to gain finance from other sources

Question 29

What are the rights of the Shareholders?

Answer 29

1 part ownership of the company in proportion to the numbers of shares owned
2 to attend the AGM and vote, e.g. on election of directors
3 to receive dividend by the board
4 to receive a share of the capital if the business is wound up after all debts have been paid

Question 30

What are the responsibilities of the Shareholders?

Answer 30

1 capital invested cannot be claimed back from the company except when it ceases trading

Question 31

What are the objectives of the Shareholders?

Answer 31

1 to receive an annual return on investment in shares – the dividend
2 to receive capital growth through an increase in share price
3 possibly, to influence company policy through pressure at the AGM

Question 32

What are the rights of the Banks?

Answer 32

1 to receive interest payments as laid down in the loan or overdraft agreement
2 to be repaid before shareholders if the company is wound up

Question 33

What are the responsibilities of the Banks?

Answer 33

1 to check on business viability before loan or overdraft is agreed; this is both a responsibility to the bank’s shareholders and to the business – advice to customers is an important responsibility

Question 34

What are the objectives of the Banks?

Answer 34

1 to make a profit from the loan
2 to receive repayment of capital at the end of the loan term
3 to establish a long-term relationship, of mutual benefit, with the business

Question 35

What are the rights of the Creditors?

Answer 35

1 to receive payment as agreed
2 to be repaid before shareholders in the event of the business being wound up
3 to attend creditors’ meetings if the business is put into liquidation

Question 36

What are the responsibilities of the Creditors?

Answer 36

1 to provide regular statements of amount owing and terms of repayment

Question 37

What are the objectives of the Creditors?

Answer 37

1 to provide credit to encourage the business to purchase stock
2 to establish a relationship built on trust so that credit can be offered in confidence

Question 38

What are the factors to consider before making a financing choice?

Answer 38

1 Cost
2 Amount required
3 Legal structure and desire to retain control
4 Size of existing borrowing
5 Flexibility