Chapter 26 Business Finance Flashcards
Why business activity requires finance?
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
What is start up capital?
Start-up capital is the capital needed by an entrepreneur to set up a business
What is working capital?
Working capital is the capital needed to pay for raw materials, day-to-day running costs and credit offered to customers.
How to calculate working capital?
working capital = current assets – current liabilities
What is capital expenditure?
Capital expenditure involves the purchase of assets that are expected to last for more than one year, such as building and machinery
What is revenue expenditure?
Revenue expenditure is spending on all costs and assets other than fixed assets and includes wages and salaries and materials bought for stock
Why is working capital so significant to a business?
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.
What is Liquidity?
Liquidity is the ability of a firm to be able to pay its short-term debts
What is liquidation?
Liquidation is when a firm ceases trading and its assets are sold for cash to pay suppliers and other creditors
Where does finance come from?
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
What are the different internal sources of finance?
1 Profits retained in the business
2 Sale of assets
3 Reductions in working capital
Internal sources of finance: Explain Profits retained in the business.
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
Internal sources of finance: Explain Sale of assets.
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.
Internal sources of finance: Explain Reductions in working capital
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.
What are the different short term External sources of finance?
1 Bank overdrafts
2 Trade credit
3 Debt factoring
External sources of finance Short-term sources: Explain Bank overdrafts
A bank overdraft is where a bank agrees to a business borrowing up to an agreed limit as and when required
External sources of finance Short-term sources: Explain Trade credit
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’.
External sources of finance Short-term sources: Explain Debt factoring
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
What are the different medium-term External sources of finance?
1 Hire purchase
2 Leasing
External sources of finance Medium-term sources: Explain Hire purchase
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
External sources of finance Medium-term sources: Explain Leasing
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
What are the different Long-term External sources of finance?
1 Long-term loans from banks
2 Long-term bonds or debentures
3 Sale of shares – equity finance
External sources of finance Long-term sources: Explain Long-term loans
Long-term loans are loans that do not have to be repaid for at least one year
External sources of finance Long-term sources: Explain Long-term bonds or debentures
Long-term bonds or debentures are bonds issued by companies to raise debt finance, often with a fixed rate of interest
External sources of finance Long-term sources: Explain Sale of shares – equity finance
Equity finance is permanent finance raised by companies through the sale of shares
What are the different other Long-term External sources of finance?
1 Grants
2 Venture capital
External sources of finance Other long-term sources: Explain Grants
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
External sources of finance Other long-term sources: Explain Venture capital
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
What are the rights of the Shareholders?
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
What are the responsibilities of the Shareholders?
1 capital invested cannot be claimed back from the company except when it ceases trading
What are the objectives of the Shareholders?
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
What are the rights of the Banks?
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
What are the responsibilities of the Banks?
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
What are the objectives of the Banks?
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
What are the rights of the Creditors?
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
What are the responsibilities of the Creditors?
1 to provide regular statements of amount owing and terms of repayment
What are the objectives of the Creditors?
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
What are the factors to consider before making a financing choice?
1 Cost 2 Amount required 3 Legal structure and desire to retain control 4 Size of existing borrowing 5 Flexibility
