Unit 5 Flashcards
When would a business require finance? (5)
- Setting up a business (start up capital)
- For working capital
- For expansion of the business
- For overtaking other business as a way of expansion
- For research and development
Def. Start up capital
Capital needed by an entrepreneur to set up a business.
Def. Working capital
Finance needed to pay for raw materials, day-to-day running costs and credit offered to costumers. Working capital = Current assets - current liabilities.
Def. Capital expenditure
Involves the purchase of assets that are expected to last for more than one year, such as buildings or machinery.
Def. Revenue expenditure
Involves the spendings on all costs and assets other than fixed assets and includes wages and salaries and materials bought for inventory.
A business without sufficient working capital?
Is an illiquid business - unable to pay its immediate or short term debts. The business would have to raise finance quickly (such a bank loans), or it would be forced into liquidation.
Def. liquidity
The ability of a firm to be able to pay its short term debts
Def. Liquidation
When a firm ceases trading and its assets are sold for cash to pay suppliers and other creditors
Disadvantages of too little or too much working capital?
- Too little working capital => unable to pay debts
* Too much working capital => too much opportunity cost, it could have been invested elsewhere such as fixed assets.
What is the working capital cycle?
Cash => Inventory => Production => Sell on credit =>
How much working capital?
It depends on the length of the working capital cycle. The longer the time period from buying material to receiving payment from customers, the greater the working capital needed.
What are the two types sources of finance?
- Internal sources of finance: possibly from business’s own assets or from profits left in the business
- External sources of finance: raised from sources outside the business
Types of internal sources of finance (3)
- Retained profits
- Sale of assets
- Reductions in working capital
What are retained profits?
Any remained net profit after the dividends have been paid is invested back into the business. Once invested into the business, they will not be paid out to shareholders, so they represent a permanent source of finance.
Sale of assets?
Assets that are no longer fully employed could be sold to raise cash.
Reductions in working capital?
When companies reduce assets, such as inventory levels, by reducing their working capital, capital is released, which can act as a source of finance for other uses.
Benefits of internal sources of finance? (2)
- It doesn’t increase the liabilities or debts of the business
- No risk of loss of control by the original owners as no shares are sold
Limitations of internal sources of finance? (2)
- New companies = few ‘spare’ assets
- Slow down business growth
Types of external sources of finance? (3)
- Short term sources
- Sources of medium term finance
- Long-term finance
Types of external short term sources of finance? (5)
- Bank overdrafts
- Trade credit
- Debt factoring
- Grants
- Venture capital
Bank overdrafts
• A bank agrees to a business borrowing up to an agreed limit as and when required.
The most ‘flexible’, because the amount raised can vary day to day. For example the business may need to increase the overdraft for short periods of time if customers do not pay as quickly or large delivery of raw materials has to be paid for.
Trade credit
Obtaining finance by delaying bills of goods and services received. If suppliers or creditors are providing goods and services without immediate payment, it could be thought of as ‘lending money’.
Debt factoring
• selling of claims over debtors to a debt factor in exchange for immediate liquidity (cash) - only a proportion of the value of the debts will be received.
Types of external medium term sources of finance? (2)
- Hire purchase and leasing
* Medium term bank loan (1-5 years)
Hire purchase
• An assets is sold to a company that agrees to pay fixed repayments over an agreed period of time (a form of credit). The asset belongs to the company.
Leasing
• Obtaining the use of a fixed assets and paying charges over a fixed period of time. This avoids the need for the business to raise large finance to purchase the asset. The risk of using outdated equipment is reduced to the leasing company as they remain the ownership over it.
Types of external long term finance? (3)
- Long term loans from banks
- Long term bonds or debentures
- Equity finance
Long term loan from banks
- Loans that do not have to be repaid for at least one year.
- Can have variable or fixed interest rates
- Companies borrowing from banks will provide security for the loan - the right to sell an asset is given to the bank if the loan is not repaid => businesses with few assets may find it difficult to obtain loans.
Long term bonds or debentures
- bonds issued by companies to raise debt finance, often with a fixed rate interest
- a company will sell such bond to an investor
- the company will agree to pay fixed interest to keep the life of the bond (may be up to 25 years)
- investors can sell the bond if they can’t wait for their investment to be paid back
- They are usually not secured
- When secured on an asset they will be called mortgage debentures
- Convertible debentures can be converted into shares, so the company will never have to pay it back.
Def. equity finance
• Permanent finance raised by companies through the sale of shares.
How can a business go publcic? (2)
- By obtaining a listing on the alternative investment market (AIM), which is a part of the Stock Exchange concerned with smaller companies that want to raise only limited amount of capital. The strict requirements for a full Stock Exchange listing are relaxed.
- Apply for a full listing on the stock exchange by satisfying the criteria of (a) selling at least £50,000 worth of shares and (b) having a satisfactory trading record.
What are the two main ways of sales of shares?
- Publics issue by prospectus - 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.
- Right issue of shares.
Benefits and limitations to rights issue of shares? (2 1)
Benefits:
• The ownership of the business does not change
• Raise in capital rather cheaply as no advertising required.
Limitations:
• The increase in the supply of shares would reduce its share price, which would worry current shareholders.
Def. Rights issue
Existing shareholders are given the right to buy additional shares at a discounted price.
Grants (3)
- For most european countries, grants come from the government or the European Union.
- Usually given to small businesses or expanding businesses in developing regions of the country.
- Grants usually come with conditions attached, such as locations or the number of jobs created. If the conditions are met, grants don’t have to be paid back.
Def. Venture capital
Risk capital invested by venture capitalists (who could be specialist organisations or wealthy individuals) 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. e.g in ‘high tech’ businesses.
Def. Micro-finance
The providence of small capital sums to entrepreneurs by any investors to unincorporated businesses.
Def. Business plan
A detailed document giving evidence about a new or existing business, and that aims to convince external lenders and investors to extend finance to the business.
What are the factors influencing finance choices? Name no explanation (6)
- Use to which finance is to be put
- Cost
- Amount required
- Legal structure and desire to retain control
- Size of existing borrowing
- Flexibility
Explain how the “use to which finance is to be put” affects the finance choice? (3)
- It is very risky to borrow long term finance for short term needs
- Permanent capital may be needed for long-term business expansion.
- Short term finance would be advisable to finance short term needs.
Explain how the “cost” affects the finance choice? (2)
- Even internal finance may have opportunity cost
* Loans may become more expensive during a period of rising interest rates
Explain how the “amount required” affects the finance choice? (2)
- Share issues or debentures could be used to raise large capital sums
- Bank overdrafts could be used to raise small capital sums
Explain how “legal structure and desire to retain control” affects the finance choice?
• If the owners want to retain control of the business, than further sales of shares are unwise. (Rights issue could be used).
Explain how the “size of existing borrowing” affects the finance choice?
• The higher the existing debts, the greater the risks of borrowing more. Banks would be more anxious to lend more.
Explain how the “flexibility” affects the finance choice?
• When a firm has a variable need for finance, for example it has a seasonal pattern of sales, a short term form of finance would be better.
Uses of cost data? (5)
- Aid ‘profit equations’, to calculate profits and losses
- Aid profitable decision making
- Aid other departments e.g marketing departments to make pricing decisions
- To make comparisons from previous years
- To forecast