Why businesses need finance and where it comes from

Last time

Before we start: last time, in Profitability and liquidity ratios, and users of accounts, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Money to start and grow

Every business needs money: to start, to keep running from day to day, and to grow. Where it comes from matters, because some money must be repaid with interest, and some gives away a share of the business. This lesson covers why finance is needed, and the sources.

Why finance is needed

Start-up capital: to buy premises, equipment and first stock before any sales. To expand: new branches, machines or takeovers. And to keep running: paying wages and suppliers while waiting for customers to pay. This is working capital.

Working capital

Working capital is current assets minus current liabilities: the money available for day-to-day running. It pays wages, suppliers and bills on time, so production does not stop. Too little working capital means the business cannot pay its debts, even if it is profitable.

Capital and revenue spending

Capital expenditure is spending on non-current assets that last more than a year: buildings, machines, vehicles. Revenue expenditure is spending on day-to-day costs: wages, rent, raw materials, electricity. Long-term needs should use long-term finance; short-term needs, short-term finance.

Internal sources

Retained profit: profit kept in the business. No interest and no loss of control, but new businesses have none. Selling assets that are no longer needed, such as old machines or spare land. Owner's savings, for sole traders and partnerships. Internal sources are cheap, but limited.

External short-term sources

A bank overdraft lets the business spend more than is in its account, up to a limit. Flexible, but the interest is high. Trade credit: suppliers let the business pay later, often 30 or 60 days. No interest, but discounts may be lost. These suit working capital needs, not big purchases.

External long-term sources

A bank loan: a fixed amount repaid with interest over a set time. Needs security, and interest must be paid. Selling shares: for limited companies. No repayment and no interest, but owners give up some control and share dividends. Leasing: renting equipment instead of buying it. Government grants. And microfinance for small, poor entrepreneurs.

Crowdfunding

Crowdfunding raises money from many people, usually through a website, each giving a small amount. It can test interest in an idea and reach investors banks would not. But the target may not be reached, the idea is made public for rivals to copy, and platforms charge fees.

Choosing a source

Which source fits? Use these factors from the case.

A choice in the case

A sole trader buying a delivery van might use a bank loan, because it is long-term and the business cannot sell shares. A company needing a large amount for a new factory might sell shares, to avoid heavy interest. A shop short of cash for a month might use an overdraft.

Mistakes that lose marks

Mistake one: suggesting a sole trader sells shares. Only companies can. Mistake two: using an overdraft to buy a building. Mistake three: choosing a source without considering cost, control and the legal form. The fix: match the source to the purpose, the amount and the business type.

The full-marks tip

The full-marks tip: match the source to the need: long-term for assets, short-term for working capital. Check the legal form: only companies can sell shares.

On one card

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