Unit 5 Example 1

Chapter 29 Jay buys fish from the market everyday and she pays cash. She sells all her stock
who also pays cash.
Business Finance
- In a typical week she buys fish for $1,000 and sells it for $2,000
Introduction
- What is her profit? (ignore other cost) $1,000
No business can exist without finance. Financial decisions are the most crucial - Difference between inflows and outflows? $2,000 - $1,000= $1,000 (all
decisions managers have to make as inadequate finance will lead to failure of the sales were in cash)
business. - In this example Profit = Cash (we ignored other costs)

Why do businesses need finance? Example 2

• To set up a business Shey owns fine foods, last month she bought $500 worth of fresh goods on one
• For working capital
month credit from a supplier. Good sold very slowly and she had to reduce prices
• Expansion - to buy assets or take over
and eventually she old them for $300 paid in cash.
• For R & D
• For Special situations
- Profit or loss ? Loss of $200 = $500-$300 Even though she has not paid
Situations are different one to one, some situations require permanent finance, yet $500 is a cost to the company.
some medium term, some short term. All these requirements cannot be fulfilled - It's a positive cash flow since she has not yet paid any cash out to her
using the same resources. Managers will have to decide what type of finance will suppliers.
suit each situation. - Cash was not same as profit.

• Start up capital- Capital needed by an entrepreneur to set up a business. Example 3

• Working capital- The capital needed to pay for raw materials, day to day
running costs and credit offered to customers. Sanjit is concerned for his jewellery business about his competition. He buys most
• In accounting terms, Working capital = Current Assets - Current
of his stock over the internet for cash. He has decided to increase the credit terms
Liabilities
up to two months. Last month he brought some rings for $3,000 paid in cash and
Difference between profit and cash sold them all for $7,000 in the same month. But he will not yet receive payment
until two months.
Many businesses fail because the owners do not realise the difference between
the financial concepts, cash and profit. Depending on a firm's ability to manage - Profit ? $7,000 - $3,000 = $4,000. Even though he has not received cash
cash, some profitable businesses may run out of cash and loss making companies a revenue of $7,000 has been made.
might have a healthy short-term cash flow. - Cash flow position ? It's a negative outflow $3,000. He may not have a lot
of cash in hand to manage his day to day expensive.
(Textbook page - 494 , Example 1, 2 & 3) - Cash was not the same as profit - there is a real danger of running out of
cash.

Profit is a surplus after total cost has been deducted from the total revenue
whereas cash is money at bank or in hand, readily available for use.
Profits are calculated in the trading, profit and loss account whereas cash is shown
in the cash flow forecast or cash flow statement.
Cash is only recorded when the money changes hands, that is it will only be
recorded in the statement once the business has actually received money rather
than what it is promised to receive.
Example - If a business makes sales which are 20% on cash and 80% on credit,
then the cash flow statement will only record the money received for the 20% of
sales and it will record the rest of the 80% when it has actually received this
money.
On the other hand, because of our 'accrual concept' in the same example above,
when you calculate profit, you will include the cash as well as credit sales which
means all of the sales made. Now this shows that though the business will show
'profitable in books', it will actually be short on cash.
Some other cases where profitable businesses can run out of cash.
I. purchase of fixed assets
II. overtrading
Without sufficient cash, creditors can take you to the court and declare you
bankrupt or insolvent in case of companies.
Profits are essential for the long term survival of the business. Otherwise, no
institution will be interested to invest in a business which yields them low returns on
their capital investment.
Working Capitla - Meaning and significance
Working capital is crucial to everyday operations, without it the business will be
illiquid and unable to settle short term debts, in case there is no sufficient working
capital the business should raise finance quickly or it may be forced into
‘Liquidation’ by its creditors.
Liquidity -The ability of a firm to be able to pay its short term debts.
Liquidation- When a firm ceases trading and its assets for cash to pay
suppliers and other creditors.
Many companies use Current Liabilities to manage their day to day operations
• Overdrafts
• Creditors
It is unwise to obtain funds from the above sources as the firm will have to pay
back in a short period of time and the firm will again face a liquidity problem. Also it
will leave no working capital to extend further credit or buying stock.
Capital expenditure and revenue expenditure
Capital expenditure- involves the purchase of assets that are expected to last
for more than one year such as buildings and machinery.
Revenue expenditure- spending on all costs and assets other than fixed
assets. Includes wages, salaries and stock
Capital expenditure is any item brought by a business and retained for more than
one year, that is the purchase of fixed or non-current assets.
Revenue expenditure is any expenditure on costs other than non-current asset
expenditure.
All revenue expenditure is on assets and expenses that give short-term benefits to
the business - within one year. They will all be recorded in full on each year’s profit
and loss account.
Capital expenditure is more complicated. Example when you purchase a vehicle
that is expected to last for ten years and if the entire cost is immediately recorded,
-This would not appear in the fixed assets as it is recorded as an expense – this
would lower the value of the business than its true worth
-This would lower the profits of that particular year and profits of later years will be
higher
Capital expenditure is recorded on the accounts by a process called depreciation.
How much working capital is needed? Medium term loans

Sufficient working capital is when a firm has enough capital to pay short term Short term - Bank OD
debts. Too less working capital will make the company illiquid and too much
working capital will make resources idle which could be invested in the business. Creditors

The working capital requirements of a business will depend on the working capital
cycle. The longer time it will take to complete, the more working capital you need.
The shorter the time to complete the less working capital you will need.
Cash
Sell on credit Raw Materials
Factoring
• Internal money is raised from the businesses own assets or from
retained profits.
• External money is raised from sources outside the business.
• Selling shares is not an internal method of finance, even though
shareholders own the business. The firm is a separate legal unit so
shareholders are considered as outsiders.
Internal sources of finance

1. Profits retained in the business

als After tax and dividends if any profits remain in the business they are
Production
called retained profits and used for investment purposes. This is a
significant source of finance as once they are invested they will not be
paid out to the shareholders. Therefore it is a permanent source of
Where does finance come from? finance but unfortunately newly started businesses will not have access to
this.
Sources of limited companies:
2. Sale of assets
Internal Companies can sell assets that they no longer use to raise funds. Some
companies sells assets who intend to use a leasing specialist and lease it
- Retained profits back. And they will have to pay a fixed rent or a leasing cost.
- Sale of assets
- Reductions in working capital 3. Reduction in working capital
When a business sell on credit or increase its inventory the money get
tied up in these assets. When a firm reduces these assets the money will
External - Long term - Share issues become free and the working capital will reduce, this money can be used
for other purposes but however reducing working capital can be risky.
Debentures Cutting down the CA will reduce the firm’s liquidity.
Long term loans
An evaluation on internal sources of finance.
Grants
• Has no direct costs other than lease or rent
Medium term - Leasing • Doesn’t increase liabilities or debts
• No risk of losing control
Hire purchase
 • Not freely available for start ups
Solely depending on internal finance is not advisable.
External sources of finance.
Short term sources
1. Bank overdraft
Bank agrees to a business borrowing up to an agreed limit as and when
required.
In this case, bank allows the business to issue cheques to a greater value than the
account balance. The overdraft amount is priory agreed and there is a limit. Also
the bank can call in overdraft anytime. This form of finance carries interest and will
increase the short term liabilities but it is a flexible method.
2. Trade Credit
Firms can obtain finance by delaying payments. The downside is that it is not for
free. The firm will lose discounts and supplier confidence.
3. Debt Factoring
Factoring is selling 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.
The longer debtors take to pay up, the more finance a business needs. Most of the
time it is unwise to sell only in cash so the firm has to sell these claims on these
debtors to factoring companies. In this way immediate cash can be obtained but
not the full payment.
Medium term sources
1. Hire purchase and leasing
Leasing is obtaining the use of equipments or a vehicle and paying a
rent/lease charge over a fixed period of time. This avoids the need for a
business to raise long term capital. Ownership remains with the leasing
company.
Hire purchase - An asset is sold to a company that agrees to pay fixed
repayments over an agreed period of time, the asset belongs to the
company.
These methods are used to raise medium term finance, when you lease a fixed
asset for a period of 1-5 years you will not have to pay a large sum of money at
once. This will improve the short term cash flow. Also using outdated unreliable
equipment is reduced as the leasing company will be responsible for repairs and
updates. However neither of these options is cheap.
2. Medium term bank loans
Long term sources
There are two main sources of long term finance
• Debt finance – Loans that do not have to be repaid for at least one year.
• Equity finance – Permanent finance raised by the company through sale
of shares.
Debt Finance
1. Long term loans from bank/ Mortgages
Long term loans are given to companies on a fixed interest rate. The business will
have to provide collateral to get the loan and they will have to pay high interest.
Businesses with few assets will find it difficult to gain finance but in UK there is a
loan guarantee scheme to support such firms.
2. Long term bonds and debentures
Bonds issued by companies to raise debt finance often with a fixed rate of
interest.
Debentures are sold to interested parties and will agree to a fixed rate of interest. It
will have the life span of 25 yrs and the ability to resell.
Convertible Debentures
If the borrower requests, the debenture can be converted into a share after a
period of time. Then the company will not have to pay back as this becomes a part
of the permanent finance
Equity Finance
1. Sale of shares
There are two methods in which Private Ltd companies can raise funds:
- Selling shares to the existing shareholders
If the shareholders buy shares according to the same proportion, the ownership
and control will not change.
- Going public
The company will lose control if they decide to follow this method.
I. List in alternative investment markets – low restrictions
II. Apply full listing on the stock exchange satisfying the criteria
- Selling $50000 worth of shares.
- Having a satisfactory trading record to give confidence to the
investors.
There are two methods a public limited company could raise fund:
- Public issue of prospectus - Relatively very expensive due to legal
fees and advertising.
- Rights issue of shares – Arranging a place and inviting shareholders
and interested parties without the expense of full public issue.
Rights issue: Existing shareholders are given the right to buy additional
shares at a discounted price.
Once the company has received the PLC status they can resell additional shares
to source finance. This will increase the supply of shares therefore share prices will
reduce. If share prices reduce drastically it would raise the concern of
shareholders.
Evaluation on Debt or Equity Capital
This is a tough question to answer and most organizations use both these methods
in major projects.
Advantages of Debt Finance
• Ownership of the company will not be affected.
• Loans will be paid eventually and no permanent increase in liabilities
other than convertible debentures.
• No voting rights for lenders at the annual general meeting.
• The gearing increases.
• Interest is paid before tax and dividends from the profit.
Advantages of Equity Finance
• This is permanent capital therefore the companies do not have to pay
back.
• Dividends do not have to be paid every year but interest has to be
paid annually.
Other sources of long term finance
1. Grants
There are agencies willing to grant funds for businesses, usually they are given to
small businesses in need of expansion. Grants come with certain restrictions:
• The business will have to contribute to the funding as well.
• A well drafted proposal and a business plan is needed.
• Specific projects should be visible within the time frame.
If the given conditions are met, then repaying is not needed.
2. Venture Capital (Risk Capital)
Long term committed share capital to help companies grow and succeed; venture
capital is different from a loan. It is invested in exchange for an equity stake in a
business. In return he will get treated like a shareholder.
Venture capital- Risk capital invested in business start ups or expanding
small businesses that have good profit potential but do not find finance
easily from other sources.
Finance for Unincorporated Businesses

Unincorporated businesses find it hard to fund the business so they tend to depend on:

• Bank Overdrafts
• Borrowings
• Personal Savings
• Profits
• Bank loans – Loans will only be given if they are able to provide collateral
• Government grants- Available for some small and newly formed businesses

1. Micro Finance

Micro finance : Providing financial services for poor and low income customers who do not have access to banking services, such as loans overdrafts offered by
traditional commercial banks.

Means of extending credit usually in the form of small loans with no collateral to poor unemployed people. The goal of micro finance is to give low income earners an
opportunity to become self sufficient.

The Grameen bank was found by Mohammad Yunus with the following objectives

• Extending banking facilities to low income earners.

• Eliminate the exploitation of the poor by money lenders.
• Create opportunities for self employment for the vast multitude of unemployed people.

To reverse the age old vicious circle of poverty into a virtuous circle of ,

Low income Injection of credit Investments More income More Savings

2. Crowd Funding

Crowd funding is the use of small amounts of capital from a large number of individuals to finance a new business venture.

The banks still refuse to lend. Crowd funding is a fast-growing approach to raising finance for business start ups. Crowd funding” as a concept arrived in the UK a couple of
years ago. The concept is pretty simple. Instead of one large investor putting money into a business, larger numbers of smaller investors contribute as little as £10 each to
raise the required capital.
The first UK-based crowd funding website was 'Crowd Cube' and there are other websites like 'Kickstarter' that allows entrepreneurs to publicise their ideas through videos and
graphics. Also the publicity generated can also be effective form of promotion.

The returns to investors are,

• Their initial capital plus interest

• Equity stake and profit share

However this method is most suitable for 'sophisticated investors' as it is highly risky

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Finance and Stakeholders

When shareholders provide finance to the company they form a relationship with the firm. That gives them rights, responsibilities and objectives.

Rights Responsibilities Objectives

- Banks - Receive interest - Check on the - Receive payment
- Get paid before the company viability of the - Make a profit
fails firm to repay. - Establish a long term relationship with the firm

- Creditors - Receive payments - Provide a - Provide credit for firms

- Get paid before the company fails statement of - Establish a long term relationship with the firm
- Attend creditors meeting before a amount the
liquidation firm owes

- Shareholders - Part ownership - Invested - Receive dividends

- Attend and vote at the AGM capital cannot - Influence decisions at the AGM
- Influence the decisions be taken back - Receive capital growth
- Receive a share of capital when the unless the firm
firm quits is dissolved.

Business Plans – Raising External Finance

A detailed document giving evidence about a new or existing business and the aims to convince lenders and investors to extend finance to the business.

A firm will not receive finance without providing a properly constructed business plan. They will want details, background and experience of the business. A
plan must be thorough if not they can delay the loan until you provide necessary information.

Purpose of a business plan:

- Enables managers to think long and hard about the business in a logical manner.
- Gives managers/owners a guide and a clear plan of action.
- To show the employees what lies ahead

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Making Financial Decisions

There are many options for limited companies to find finance. Different situations require different types of funds. These decisions should be taken by the
top management as incorrect decisions will lead to the failure of the business.

Factors Influencing Why Significant

- Too risky to borrow long term finance for short term need
According to the time period - Long term expansion requires permanent finance

Costs - Interest rates are very high

- Always there is an opportunity cost
- Going public is very costly

Amount Required - Share issues and debentures are for large projects
- Small bank loans or overdrafts for small sums

- New share issues will have the risk of losing control

Legal structure and desire to retain control - Rights issue will not affect control and ownership

- If the firm had already borrowed a large sum the financial institutes will feel anxious and
Size of the existing borrowings give more
- Gearing concept

Flexlibility - When firms needs finance only during certain time periods if there is a pattern its better to
slip to flexible, slow short term finance than long term finance.

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