Business finance, working capital and sources of finance

Last time

Before we start: last time, in Operations, production methods, capacity utilisation and outsourcing, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Funding the business

Every business needs finance: to start, to run day to day, and to grow. A lack of finance is one of the commonest reasons businesses fail. This lesson covers why finance is needed, working capital, and the sources of finance, and how to choose between them.

Why finance is needed

Start-up capital: premises, equipment and initial inventory. Working capital: to pay day-to-day costs while waiting for customers to pay. Capital expenditure for growth: new machinery, premises or acquisitions.

Working capital

Working capital is current assets minus current liabilities. Too little working capital means the business cannot pay its bills, even if it is profitable. Too much means cash is tied up in inventory and receivables that could be used better.

Why lack of finance causes failure

Without enough cash, a firm cannot pay suppliers or staff, so production stops and creditors may force closure. It cannot invest to keep up with competitors, so it loses market share. And it may have to borrow at high interest, worsening its position.

Internal sources

Retained profit: no interest or loss of control, but limited and may disappoint shareholders. Sale of assets, or sale and leaseback: raises cash but loses the asset or commits to rent. Reducing working capital: cutting inventory or collecting debts faster.

External sources: short term

Bank overdrafts: flexible, but expensive and can be withdrawn. Trade credit: paying suppliers later; no interest, but discounts may be lost. Debt factoring: selling receivables to a factor for immediate cash, at a discount.

External sources: long term

Bank loans and debentures: fixed repayments with interest; no loss of control, but raise gearing and risk. Share capital: no repayment or interest, but dilutes ownership and control. Venture capital adds expertise, but wants a share and influence. Leasing, hire purchase, government grants, crowdfunding and microfinance are also options.

Choosing a source

The factors that decide the most appropriate source.

Funding a pharmaceutical business

Drug development is long, costly and risky, so long-term finance is needed. Share capital or venture capital suits high-risk projects, as there is no fixed repayment; loans may be too risky. Retained profit suits established firms. The best source depends on the firm's size, structure and existing debt.

Mistakes that lose marks

Mistake one: suggesting a sole trader issues shares. Mistake two: using an overdraft for long-term investment. Mistake three: ignoring gearing and control when choosing finance. The fix: match source to need, structure and risk.

The full-marks tip

The full-marks tip: match the source to the purpose: short-term for working capital, long-term for investment. Evaluate by cost, control, risk and the business's structure.

On one card

So, on one card: business finance. Keep it for revision.