Business finance: needs and sources
- Start-up capital: Money needed before the business opens its doors. This covers initial costs like buying equipment, renovating premises, and marketing.
- Capital for expansion: Funds required to grow the business, such as opening new branches, launching new products, or acquiring competitors.
- Additional working capital: Extra cash needed to manage day-to-day operations, especially when there is a mismatch between money coming in (sales) and money going out (expenses).
Building on previous concepts: Finance is distinct from profit. Profit is the surplus after costs are paid; finance is the funding used to generate that profit.
Short-term vs. Long-term needs
It is critical to distinguish between why money is needed and how long it is needed for.
- Short-term finance is needed for immediate, recurring operational costs. The goal is usually to maintain liquidity (cash flow) rather than to grow the asset base.
- Long-term finance is needed for significant investments that will benefit the business over several years. This is often called capital expenditure.
Long-term finance needs refer to requirements for capital expenditure. This is money needed to purchase non-current assets (fixed assets) like machinery, vehicles, or property, or to fund major expansion projects. These funds are usually required for more than one year.
| Source Type | Typical Use Case | Definition & Purpose |
|---|---|---|
| Short-term Source | A retailer uses a bank overdraft to pay suppliers while waiting for customers to pay their credit accounts. | Flexible funding for immediate cash flow gaps or working capital needs. |
| Short-term Source | A cafe receives milk from a supplier and pays the invoice 30 days later (trade credit). | Credit extended by suppliers allowing payment after goods are received. |
| Long-term Source | A manufacturing company takes a bank loan to buy a new factory building. | Borrowed money repaid over a long period with interest. |
| Long-term Source | A private limited company issues shares to raise funds for expansion. | Raising capital by selling ownership shares in the business. |
| Long-term Source | A large corporation issues debentures to fund a new research and development project. | Bonds or debentures issued to investors, promising repayment with interest. |
Sources of finance are categorized by where the money comes from:
Internal Sources: Funds generated from within the business.
- Retained profit: Profits kept in the business rather than paid out as dividends to owners.
- Sale of assets: Selling non-current assets (e.g., old machinery) or current assets (e.g., inventory).
- Owner’s savings: Personal funds invested by the owner(s).
External Sources: Funds obtained from outside parties.
- Debt finance: Borrowing money that must be repaid with interest (e.g., bank loans, overdrafts, debentures).
- Equity finance: Selling ownership stakes in the business (e.g., shares for limited companies).
- Alternative sources: Newer or niche methods like crowdfunding, micro-finance, or government grants.
Traditional sources like bank loans are not always accessible, especially for start-ups or small businesses with poor credit history. Alternative sources have become important because they offer:
Accessibility: Easier to obtain than traditional bank finance.
- Micro-finance: Small loans provided to individuals who lack access to conventional banking services. It often requires less paperwork and no collateral.
- Crowdfunding: Raising small amounts of money from a large number of people, typically via the internet. It allows businesses to test public interest in a product before launch.
No Interest/Low Cost: Some forms, like crowdfunding (reward-based) or grants, do not require repayment of interest.
Market Testing: Crowdfunding allows businesses to gauge customer reaction to their ideas.
When deciding on a source of finance, a business must consider several key factors. These determine what is possible and what is practical.
- Size and legal form of the business: Sole traders have limited options (e.g., cannot sell shares) compared to public limited companies. Large businesses can issue debentures; small ones cannot.
- Amount required: Small amounts might be covered by savings or overdrafts; large sums usually require loans or equity finance.
- Length of time needed: Short-term needs suit overdrafts; long-term needs suit loans or shares to match the asset's life.
- Existing loans/debts: If a business already has high debt, lenders may refuse more finance due to risk.
- Cost/Interest rate: The expense of borrowing must be weighed against the benefit.
- Control: Equity finance dilutes ownership; debt finance does not but requires regular repayments.
Correct Understanding:
- If the question asks 'Why does the business need finance?', you must state the purpose (e.g., 'to purchase new machinery' or 'to pay wages').
- Do NOT answer with 'because they need a bank loan'. A bank loan is the source, not the need.
Error: Assuming profit is used only for day-to-day costs.
Correct Understanding: Profit can be used for both working capital (short-term) and expansion (long-term). Retained profit is an internal source that can fund either need.
Why examiners accept this: Examiners look for application to the specific business context. A generic list of advantages is insufficient. You must link the feature of the finance source to the specific situation described in the case study.
Example: Instead of saying 'Crowdfunding has no interest,' say: 'Crowdfunding is suitable because it requires no interest payments, which helps the start-up maintain positive cash flow during its initial launch phase.'
Strategy: Use the structure: Source + Feature + Application to Case Study + Benefit.
Disadvantage: The business may not raise the full amount required if the campaign fails. This wastes time and resources spent on promoting the campaign without securing funds.
- The amount of money required.
2. The length of time the finance is needed for.
Explanation: For a sole trader, taking a bank loan would increase cash outflows due to interest and principal repayments, which could strain cash flow in the early stages. Using personal savings avoids this debt burden and keeps control of the business entirely with the owner, as no external lender needs to be satisfied.
Justification: The need is for short-term working capital (only for the Christmas season). An overdraft is flexible, allowing the business to borrow only what it needs and repay it as soon as sales revenue comes in. A long-term loan would be inappropriate because the money is not needed for years, and interest costs would be unnecessary. Micro-finance might have high interest rates, making an overdraft cheaper for this short period.