Chapter 19.1 - Business Finance: Needs and Sources
Learning Objective: Sources of Finance (19.1)
Businesses need financing... It's obvious. Every business needs financing.
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.
Case Study - Startup Capital (p. 245) - 10 Minutes, Handwritten
When it comes to business finance, they can be of two types:
1. Short-term finance: usually small amounts that can be invested within a short-period of time (e.g. purchasing a new computer);
2. Long-term finance: used for activities that require large sums of money and therefore is spread out over a longer period of time.
The different sources of finance businesses have at their availability might be appropriate for some types of businesses but not for others, the reason being:
Sole traders and partnerships cannot rise finance through selling shares;
Smaller companies focus on financing small projects;
Small companies are considered by lenders as high-risk.
Businesses financing can come from two different sources:
1. Internal Sources of Finance:
2. External Sources of Finance:
Let's start by discussing Internal sources of financing, more specifically Retained Profits:
This is the part of the profit of the company that is kept to reinvesting (after paying shareholders' dividends and taxes).
Retained profits is a source of finance that can be used by any businesses of all sizes;
Retained profits have no costs to the business whatsoever;
It can only be used, however, by profitable businesses.
Sale of non-current (fixed) assets is another commonly used source of internal finance:
A business can sell or rent its assets to raise finance;
Businesses sometimes do 'sale and lease back' fixed assets;
Such method has no costs to the business and allows it to raise large amounts of finance;
It can, however, be disadvantageous: costs of moving, costs of leasing back, and it can be hard to find buyers at the time needed.
Some fixed assets are easy to sell (vehicles, buildings) whereas others are hard to sell (specific machines).
The use of working capital is also considered a source of internal finance:
As you know, working capital is used to cover short-term expenses of the firm.
Some businesses use this cash balance as a source of finance for different activities.
It needs to be done carefully since it may lead the business to not being able to pay its day-to-day expenses and even possible emergency expenditures (it can lead a business to bankruptcy).
Businesses can choose to reduce their inventory levels as a way to raise finance internally:
It's the concept of opportunity cost:
Reducing inventory leads to more capital / money / finance / cash to be invested in any other business activity;
Problems of reducing inventory: not being able to meet demand, loss of sales, reputation, market share, idling resources.
Finally, by reducing the amount of trade receivables companies can raise a high degree of finance internally:
By shortening credit/payment terms to consumers companies will be bringing in more cash (finance) to the business - it can lead to reduced sales due to competition;
Companies can also employ a more efficient system for chasing debtors in order to raise finance from trade receivables.
To summarize, internal sources of finance are those that the business can take on themselves without needing to go to external parties;
Internal sources of finance do not have direct costs to the business.
To-Do-List:
Activity 19.3 (p. 250)
Chapter 19.1 - Business Finance: Needs and Sources
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