Business finance: needs and sources Revision Notes

Finance is the money that businesses require to operate, grow, and survive. Without adequate finance, a business cannot purchase resources, pay employees, or invest in opportunities. Finance is essential at every stage of a business’s life cycle, from startup to expansion and ongoing operations.

Businesses require finance for various purposes, which can be broadly categorised into initial funding, expansion capital, and working capital. Each purpose has distinct characteristics and timeframes, influencing the type and source of finance needed.

• Finance is essential for starting, running, and growing a business.
• Different financial needs arise at different stages of a business’s life.
• Understanding these needs helps in planning and choosing appropriate finance sources.

Initial funding refers to the money needed to start a business. This includes costs such as purchasing equipment, renting premises, buying stock, and covering initial marketing and administrative expenses.

Without sufficient initial funding, a business cannot begin operations effectively. This finance is often required before the business generates any revenue, making it a critical phase.

Initial funding is typically a long-term financial need because it involves investment in assets and resources that will be used over several years.

• Covers startup costs like equipment, premises, and stock.
• Needed before the business earns revenue.
• Usually considered a long-term financial need.

Expansion capital is finance required to grow the business after it has started. This could involve opening new branches, increasing production capacity, investing in new technology, or entering new markets.

Expansion often requires significant investment and is planned based on business opportunities and market demand. It is a long-term financial need because the benefits and returns from expansion usually occur over several years.

Effective use of expansion capital can increase a business’s market share and profitability.

• Used for growth activities like new branches or technology.
• Planned based on opportunities and demand.
• Classified as a long-term financial need.

Working capital is the finance needed to manage the daily operations of a business. It covers expenses such as paying suppliers, wages, utility bills, and other short-term costs.

Working capital ensures the business can continue operating smoothly without interruptions. It fluctuates regularly depending on sales, purchases, and payment cycles.

This is a short-term financial need because it relates to ongoing operational costs that must be met within a short period, usually less than a year.

• Covers daily operational expenses.
• Ensures smooth business functioning.
• A short-term financial need due to its ongoing nature.

Short-term financial needs are those that arise for a period of less than one year. They mainly relate to working capital requirements such as paying bills, wages, and managing inventory.

Long-term financial needs extend beyond one year and are associated with investments in assets, business expansion, or initial startup costs.

Understanding this distinction helps businesses select appropriate finance sources. For example, overdrafts or trade credit suit short-term needs, while loans or equity finance are better for long-term needs.

• Short-term needs last less than one year, mainly working capital.
• Long-term needs last more than one year, related to assets and growth.
• Choosing finance depends on matching the finance duration to the need.

Businesses require finance to start, operate, and grow. Finance can be sourced internally or externally.

Internal sources of finance come from within the business itself. The most common internal source is retained earnings, which are profits kept in the business rather than distributed to owners or shareholders. Using retained earnings avoids interest payments and loss of control but depends on the business generating sufficient profit.

External sources of finance come from outside the business and can be short-term or long-term. Short-term external finance is typically used to manage working capital needs, while long-term finance is used for investment in assets or expansion. Examples include bank overdrafts (short-term), loans, and equity finance (long-term).

• Internal finance: retained earnings (profits reinvested).
• External finance: short-term (e.g., overdrafts), long-term (e.g., loans, equity).

Short-term finance is needed for periods usually less than one year, often to cover temporary cash flow shortages or working capital needs. Examples include:

Overdrafts: Allow businesses to withdraw more money than is in their bank account up to an agreed limit. Interest is charged only on the amount overdrawn. Flexible but can be expensive if used long-term.

Trade credit: Suppliers allow businesses to pay for goods after delivery, improving cash flow temporarily. No interest if paid within agreed terms, but late payment can damage credit rating and supplier relationships.

• Short-term finance examples: overdrafts, trade credit.
• Long-term finance is used for investments lasting more than one year, such as buying machinery or expanding premises. Examples include:
• Bank loans: Fixed amount borrowed and repaid with interest over a set period. Interest rates and repayment terms vary depending on creditworthiness and loan size.
• Equity finance: Selling shares to investors to raise capital. Does not require repayment but dilutes ownership and may involve sharing profits as dividends.

Micro-finance provides small loans to entrepreneurs or small businesses that lack access to traditional banking services, often in developing countries. It supports business start-ups and growth where conventional finance is unavailable.

Crowd-funding involves raising small amounts of money from a large number of people, typically via online platforms. It can be donation-based, reward-based, or investment-based (equity crowd-funding). This method allows businesses to access capital while also marketing their products or ideas.

Both methods are significant because they increase access to finance for businesses that might otherwise struggle to secure funds, especially start-ups and small enterprises. They often come with fewer formal requirements but may have higher costs or require sharing future profits.

• Micro-finance: small loans for those without traditional credit access.
• Crowd-funding: raising capital from many small investors or donors online.
• Benefits include increased access to finance and marketing opportunities.
• Limitations include potential high costs and sharing of profits or control.

When choosing a source of finance, businesses must consider several key factors:

Size of the business: Larger businesses often have easier access to bank loans and equity finance due to established credit histories and assets. Small businesses may rely more on internal finance or alternative methods.

Legal structure: Limited companies can raise equity by selling shares, whereas sole traders and partnerships cannot. This limits their external finance options to loans or internal funds. Limited liability status also affects risk and willingness of lenders to provide finance.

• Business size affects access to finance and borrowing capacity.
• Legal structure determines ability to issue shares and liability exposure.

Amount required: Small amounts may be covered by internal finance or short-term borrowing, while large investments usually require long-term loans or equity.

Duration: Short-term needs suit overdrafts or trade credit; long-term needs require loans or equity.

Existing debts: Businesses with high existing debts may find it harder or more expensive to borrow more due to increased risk perceived by lenders. This influences the choice and terms of finance.

• Amount and duration of finance needed guide source selection.
• Existing debts affect borrowing capacity and cost of finance.

Consider a small sole trader needing £5,000 to buy new equipment and cover short-term cash flow gaps. Since the business cannot issue shares, internal finance (retained earnings) or a bank overdraft might be suitable for short-term needs. For the equipment purchase, a bank loan or micro-finance could be appropriate if internal funds are insufficient.

For a large limited company planning a £1 million factory expansion, issuing shares (equity finance) or taking a long-term bank loan would be suitable. The choice depends on the cost of finance, control considerations, and existing debt levels.

In each case, the business must weigh the cost, risk, control implications, and repayment terms to justify the chosen source of finance.

• Small sole trader: internal finance, overdraft, micro-finance.
• Large limited company: equity finance, long-term loans.
• Decision depends on cost, control, risk, and repayment ability.