5: FINANCIAL INFORMATION AND DECISIONS

• WORKING CAPITAL - the money that is used to pay day-to-day expenses such as wages, rent etc.
• CAPITAL EXPENDITURE - large sums spent on buying new assets (e.g. machinery)
• 1. FOR START-UP CAPITAL- *capital needed by an entrepreneur when first starting a business* to buy land or premises, equipment and advertising
  2. TO EXPAND THE BUSINESS- like buying more land to expand factory, buying new shops or upgrading capital expenditure like machinery.
  3. ADDITIONAL WORKING CAPITAL to pay for day-to-day expenses such as wages, buying new materials, fuel expenses etc.
• LONG-TERM FINANCE NEEDS is Debt or equity used to finance the purchase of non-current assets (fixed assets)or finance expansion plans. When a business borrows from a bank using long term finance, it expects to pay back the loan over more than a one year period e.g 20 year mortgage or building a new factory
• SHORT TERM FINANCE NEEDS are loans or debt that the business expects to pay back within one year e.g purchase of new computers due to possible

  • uneven flow of cash into the business
  • working capital for day-to-day operations
• What are long-term finance needs?

  Debt/equity used to finance the purchase of non-current assets or finance expansion plans.
• Internal finance is capital which can be raised from the business itself.
• RETAINED PROFITS is an internal source of finance when the profit remaining after all expenses, tax and dividends have been paid is then reinvested back into the business or kept as a reserve for specific objectives (such as to pay off a debt or purchase a capital asset)
• • an advantage of retained profits is that there is no cost to the business so it does not need to be repaid.
  • a disadvantage of retained profits is that it is only available when the business is profitable. If profits are low, there will not be enough retained profits to fund large investment projects.
  • Another disadvantage is if the business makes a loss, there will not be enough retained profit for reinvestment.
• SALE OF FIXED(non-current)ASSETS is the sale of a fixed asset that is not expected to be used up in the current accounting period

  • the leaseback of non-current assets, for example, selling land and buildings owned by the business and then renting this back from the new owner
• An advantage of SALE OF FIXED ASSETS is that :

  1. it has no direct cost to the business, so debt cannot increase from this * Depends on if the business has unwanted assets to sell and if someone is willing to buy them*
  2. It can raise very large amounts of money.
• A disadvantage of the SALE OF FIXED ASSETS is :

  1. Takes time until assets get sold
  2. Leasing charges are likely to increase each time the lease is renewed
  3. Future fixed costs of the business will increase as they now have to pay annual leasing charges to the new owner
  4. When the leasing agreement comes to an end the business may have to find new premises if the new owner decides they want to use the land or buildings for other purposes.
• CASH BALANCES ( internal source of finance) - Any cash a business has can be used to finance capital expenditures. Businesses must make sure they have enough cash to finance their day-to-day expenditures. If too much cash is used to finance capital spending, they risk not being able to pay day-to-day expenses. This could threaten the survival of the business.
• REDUCING INVENTORY LEVELS (internal source of finance) is when the business may decide to reduce the quantity of raw materials and components or finished goods it holds.

  For example, if a business has inventories valued at $60,000 and is able to reduce this to $50,000, then this means that $10,000 less cash is tied up in inventories. This cash Is now available for other, more profitable uses.
• REDUCING TRADE FOR ( or accounts receivables) *internal source of finance* is when a business can reduce the length of time it has to wait for payment by making sure customers pay on time or offering discounts on early payment. By reducing the total of accounts receivable in this way the business's cash balances increase and this provides a possible source of internal funds for capital expenditure.
• OVERDRAFT (external sources of finance) is an agreement with the bank which allows a business to spend more money than they have in its account up to an agreed limit. The loan has to be repaid within 12 months.

  • It is a flexible source of finance because businesses are able to change the amount of borrowing at short notice depending on their needs
  • It is used only to meet short-term cash shortages as the cost of this type of borrowing is often higher than other sources of borrowing.
• TRADE CREDIT ( external source of finance) - A business can borrow money from a supplier to pay for goods and services for the length of an agreed credit period.

  • If a business can negotiate longer credit terms with suppliers it will increase short-term finance.
• Limitations of delaying payment to the supplier in TRADE CREDIT is :

  1. Any discount offered by the supplier for prompt or early payment will be lost
  2. The supplier may refuse further deliveries to the business until the outstanding payment has been made
  3. If delayed payment occurs too often, the supplier may demand payment before delivery.
• DEBT FACTORING (external sources of finance)- A business sells its trade receivables to a third party to improve business liquidity.

  • The longer period of time a business gives its customers to pay, the greater amount of finance they will need to find from other sources to be able to meet day-to-day expenses and other short-term debts
  • Because of this, the debt would have to be sold to a debt-factoring company which buys the debt for a discounted amount, gaining them profit as they are provided with immediate cash.
• BANK LOAN (external sources of finance) is the provision of finance by a bank which the business will repay with interest over an agreed period of time.

  • Small businesses often find it hard to obtain bank loans as they are seen as a greater risk by the banks.
  • If they are able to obtain a loan this is often at a higher rate of interest than charged to larger businesses which are seen to be at a much lower risk of not being able to repay the loan when due.
  • Larger businesses often have collateral which they can use as security against any money borrowed.
• LEASING (external sources of finance) is obtaining the use of a non-current asset by paying a fixed amount per time period over a fixed period of time(usually monthly or quarterly). Ownership remains with the leasing company, which is responsible for the maintenance and repair of the asset.
• HIRE PURCHASE (external sources of finance) - The purchase of an asset by paying a fixed repayment amount per time period, such as 1-5 years, over an agreed period of time. The asset is owned by the purchasing company on completion of the final repayment.
• An Advantage of both LEASING and HIRE PURCHASE is that they enable a business to have the use of an asset without the need for a one-off cash investment.

  They both include an interest charge as part of the payment
• The limitation of LEASING and HIRE PURCHASE is that they are expensive as interest charges are much higher than other finance options.
• MORTGAGE( external source of finance) - A long-term loan secured for the purchase of land or buildings.

  • Interest is charged on the amount borrowed and this must be paid each year. By the end of the mortgage term, the amount borrowed must be completely repaid.
• DEBENTURE (external source of finance)- Bonds issued by companies to raise long-term finance usually at a fixed rate of interest. At the end of the debenture term, the full purchase price of the debenture must be repaid to the debenture holder.

  • It is usual for a business to provide security against the value of the debenture so that the debenture holder is guaranteed to get its money back even if the business is unable to repay it themselves.
• SHARE ISSUE (external source of finance) is a source of permanent capital available to limited liability companies.

  • The company can offer to sell shares up to a maximum number ( Authorised share capital)
  • The amount of capital raised through a share issue becomes permanent capital and never has to be repaid unless the business ceases to trade.
• EQUITY FINANCE is permanent finance provided by the owners of a limited company
• an advantage of EQUITY FINANCE(long-term) is that it never has to be repaid. There is no ongoing cost. If the business makes a loss it does not have to pay dividends to shareholders.

  A disadvantage of EQUITY FINANCE is the increase in shareholders 'dilutes' the ownership of the company. Producing a prospectus to offer the shares for sale is expensive.
• a benefit of DEBT FINANCING is that it does not change the ownership of the company as lenders have no say in the running of the company.

  A limitation of DEBT FINANCING is that interest is charged on the amount borrowed and this increases business costs. Interest must be paid even if the business makes a loss. The amount borrowed must be repaid.
• OWNERS SAVINGS (internal source of finance) -For a sole trader and partnership, since they’re unincorporated (owners and business are not separate), any finance the owner directly invests from his own saving will be internal finance.
• An advantage of OWNERS SAVINGS as an internal source of finance is that it is easily able to obtain and no interest has to be paid.

  A disadvantage is that it increases the risk taken by the owners.
• • CROWDFUNDING raises capital by asking for small funds from a large pool of people, e.g. via Kickstarter. These funds are voluntary ‘donations’ and don’t have to be returned or paid a dividend.
• MICRO-FINANCE - special institutes are set up in poorly-developed countries where financially lacking people looking to start or expand small businesses can get small sums of money. They provide all sorts of financial services
• a factor influencing the choice of finance is SIZE AND LEGAL FORM of the business:

  
  

  Unincorporated smaller businesses such as sole traders and partnerships are unable to raise finance by issuing shares and will find it more difficult to borrow from banks and other lenders. This is because they are considered at a greater risk of not being able to pay back the amount borrowed. They will be charged at higher interest if they borrow.

  
  

  
  

  
  

  
  

  
  

  
  

  
  

  
  

  
  

  
  

  
  
• the larger the business, the more likely it is to use equity finance because there is less need for external sources of finance due to its size. It may also be easier to raise finance through debt financing as banks are more willing to lend to established companies with good credit ratings.
• a factor influencing the choice of finance is the AMOUNT OF FINANCE required:

  If a large capital amount is required then share issues and debentures are more appropriate. A smaller amount may be financed through bank loans or leasing and hire purchases.
• a factor influencing the choice of finance is LENGTH OF TIME:

  If it needs finance for long-term finance it may want to consider debentures or share issues. In the short term, an overdraft may be the most flexible solution. The longer the period of time finance is borrowed the more costly it will be because of interest payments
• a factor influencing the choice of finance is whether or not the business has existing borrowing:

  If a business already has existing borrowing it might find it more difficult to borrow further amounts from banks and other lenders because it will be seen as a greater risk.
• CASH IS IMPORTANT to a business because without it, a business will not be able to pay :

  • its employees' wages
  • its suppliers for goods and services
  • rent, heating, lighting and other costs for its premises.