Chapter 29 - Business Finance
Lesson Objective: To understand needs of finance and working capital
Businesses need financing... It's obvious. Every business needs financing.
Lack of finance is one of the main causes of business failure (bankruptcy) which is the responsibility and lack of administration. Businesses bankruptcy oftentimes lead to liquidation, a process that aims to raise as much finance as possible to pay back those people and companies the bankrupt business owes money to.
Why do businesses need finance?
Businesses need startup capital:
This is the capital needed by an entrepreneur when starting a business.
Businesses need finance to purchase so called non-current (a.k.a. fixed) assets:
These are long-term assets (>12 months) such as buildings, machines, technology, and vehicles.
Such investments are called capital expenditure - which is the simple act of spending on such capital items.
Businesses also need capital for the purpose of working capital:
Working capital:
The capital needed to finance the day-to-day running expenses and pay short-term debts of a business:
Wages;
Suppliers;
Fuel.
Businesses need finance for expansion:
Growth is one of businesses most common objectives - it leads to market share, economies of scale, revenue, brand image, reputation, profitability, etc.
R&D is another business activity that requires large amounts of financing:
These are the activities that companies undertake to innovate and introduce new products and services.
Other reasons why businesses need finance include:
Adjust and cope with special situations/scenarios (e.g. economic recessions);
Business takeover, which is closely related to expansion and growth.
Different needs for finance also require different sources of finance: some of which are short-term and others long-term.
Short-term finance would be used for, for example, finance larger inventories awaiting a holiday season which can then be paid back within a few weeks or months;
Long-term finance, on the other hand, could be used to finance large expansions and the purchase of fixed assets.
In Business Finance it also key that we all have it clear that there is a big difference between profit and cash:
Profit = Revenue - Costs
- Important in the long-term of the business as most businesses'
Cash is important for liquidity and therefore relates to business survival in the short-term.
Going back to Working Capital: why do you think this such an important measure for businesses?
Working Capital is the cash a business needs to remain liquid:
Liquidity is the ability of a business to pay its short-term debts (day-to-day expenses);
A business that runs out of cash is considered insolvent;
Insolvent businesses that are unable to further finance their debts go into liquidation.
The formula to calculate Working Capital:
* Where Current Assets are the ones that can be turned into cash within 12 months and Current Liabilities are amounts due to be paid to creditors within the next 12 months.
But how much working capital/cash a business really needs to have in hands? Too much working capital is also not desirable.
It all depends on the Working Capital Cycle:
How much inventory the business keeps;
How quickly suppliers are paid (trade credit);
How long is the production process;
How easy/quickly it is to sell goods;
How long customers take to pay for the products they bought (trade credit).
Note: Usually, the longer the working capital cycle, the more working capital the business will need in hands.
When a business expands it is also likely that the required working capital raises: inventory levels and the value of products sold on credit will increase.
To mitigate a steep increase in working capital, therefore, businesses have two options:
Better manage inventories:
Keep smaller inventory levels;
Implement JIT;
Efficient inventory control to reduce losses, damages, shrinkage, and wastage;
Better manage trade payables:
Better manage trade receivables:
Finally, let's understand the difference between Capital and Revenue expenditure:
Most business expenditures, therefore, fall under two major categories:
Capital Expenditures
Revenue Expenditures
Capital expenditure is the purchase of a fixed (non-current) asset (e.g. truck);
Revenue expenditure, on the other hand, are the day-to-day expenses other than non-current assets expenditure (e.g. fuel).
To-Do-List:
Activity 29.1
Activity 29.2
Chapter 29 - Business Finance
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