UNIT 5. Chapter 26: Business Finance (Part 1)

Question 1

When would a business require finance? (5)

Answer 1

• 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

Question 2

Def. Start up capital

Answer 2

Capital needed by an entrepreneur to set up a business.

Question 3

Def. Working capital

Answer 3

Finance needed to pay for raw materials, day-to-day running costs and credit offered to costumers. Working capital = Current assets - current liabilities.

Question 4

Def. Capital expenditure

Answer 4

Involves the purchase of assets that are expected to last for more than one year, such as buildings or machinery.

Question 5

Def. Revenue expenditure

Answer 5

Involves the spendings on all costs and assets other than fixed assets and includes wages and salaries and materials bought for inventory.

Question 6

A business without sufficient working capital?

Answer 6

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.

Question 7

Def. liquidity

Answer 7

The ability of a firm to be able to pay its short term debts

Question 8

Def. Liquidation

Answer 8

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

Question 9

Disadvantages of too little or too much working capital?

Answer 9

• 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.

Question 10

What is the working capital cycle?

Answer 10

Cash => Inventory => Production => Sell on credit =>

Question 11

How much working capital?

Answer 11

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.

Question 12

What are the two types sources of finance?

Answer 12

• 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

Question 13

Types of internal sources of finance (3)

Answer 13

• Retained profits
• Sale of assets
• Reductions in working capital

Question 14

What are retained profits?

Answer 14

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.

Question 15

Sale of assets?

Answer 15

Assets that are no longer fully employed could be sold to raise cash.

Question 16

Reductions in working capital?

Answer 16

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.

Question 17

Benefits of internal sources of finance? (2)

Answer 17

• 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

Question 18

Limitations of internal sources of finance? (2)

Answer 18

• Newly formed companies with few ‘spare’ assets cannot benefit from these sources
• It can slow down business growth, as the pace of development is limited by the annual profits or assets to be sold.

Question 19

Types of external sources of finance? (3)

Answer 19

• Short term sources
• Sources of medium term finance
• Long-term finance

Question 20

Types of external short term sources of finance? (5)

Answer 20

• Bank overdrafts
• Trade credit
• Debt factoring
• Grants
• Venture capital

Question 21

Bank overdrafts

Answer 21

• 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.

Question 22

Trade credit

Answer 22

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’.

Question 23

Debt factoring

Answer 23

• 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.

Question 24

Types of external medium term sources of finance? (2)

Answer 24

• Hire purchase and leasing

* Medium term bank loan (1-5 years)

Question 25

Hire purchase

Answer 25

• 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.

Question 26

Leasing

Answer 26

• 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.

Question 27

Types of external long term finance? (3)

Answer 27

• Long term loans from banks
• Long term bonds or debentures
• Equity finance

Question 28

Long term loan from banks

Answer 28

• 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.

Question 29

Long term bonds or debentures

Answer 29

• 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.