Key definitions in business finance

Understanding the core terms in business finance is essential for grasping how companies manage their funds. These concepts distinguish between different types of financial needs and sources.

Capital and expenditure types

• Start-up capital - Funds required by a new enterprise to acquire essential non-current assets (such as machinery) and current assets (like initial stock) before operations can commence.
• Working capital - Resources needed to cover everyday operational expenses, ensuring smooth day-to-day functioning.
• Capital expenditure - Spending on non-current assets that provide benefits for more than one year, for example, purchasing vehicles or buildings.
• Revenue expenditure - Costs associated with routine operations that do not result in acquiring long-term assets, such as salaries or utility bills.

Finance sources

• Internal finance - Funds generated from within the organisation itself, without relying on outside parties.
• External finance - Resources obtained from entities outside the business, such as banks or investors.
• Micro-finance - Small-scale loans and financial services provided to individuals or groups typically excluded from conventional banking, often in less developed areas.
• Crowdfunding - A method of raising capital online by collecting small contributions from a wide pool of individuals to support a project or business idea.

Reasons businesses need finance

Businesses require finance at various stages to support their operations and growth. The specific needs can vary depending on whether the business is new or established, and they often relate to the timing and purpose of the funds.

Main purposes for seeking finance

• Start-up capital - Essential for new ventures to purchase initial assets and cover setup costs before generating revenue.
• Capital for expansion - Required by growing businesses to invest in new equipment, premises, or markets to increase capacity.
• Additional working capital - Needed to manage ongoing expenses, such as paying suppliers or employees, especially during periods of cash flow shortages.

Short-term versus long-term finance needs

Short-term finance addresses immediate, temporary requirements, often repaid within a year, such as covering seasonal stock purchases. Long-term finance supports sustained investments, like buying property, with repayment over several years.

The choice depends on the business's development stage, with startups often needing more long-term funds for establishment, while mature firms might seek short-term options for operational flexibility.

Factors to consider when choosing sources of finance

Selecting the right source of finance involves evaluating several aspects to ensure it aligns with the business's situation and goals. Poor choices can lead to high costs or loss of control.

Key considerations in finance selection

• Amount required - Smaller sums might suit internal sources or short-term loans, while larger investments often need external long-term options like share issues.
• Size and type of business organisation - Sole traders may rely on personal savings, whereas limited companies can access share capital.
• Control over the business - Sources like loans preserve ownership, but issuing shares might dilute control among new investors.
• Risk and gearing - Businesses with existing debts (high gearing) should avoid further loans to prevent financial strain; lower-risk options like grants are preferable.
• Purpose and period of time required - Short-term needs favour flexible sources like overdrafts, while long-term projects suit leases or bank loans.

Internal sources of finance

Internal finance comes from the business's own resources, offering advantages like no external repayment obligations. However, it may not always provide sufficient funds, especially for new or expanding operations.

Common internal finance options

• Owner savings - Personal funds from the business owner, available immediately without interest charges, though the amount may be limited.
• Sale of inventories:
  • Converting excess stock into cash to free up tied-up capital and reduce storage expenses.
  • Maintaining too low a level risks losing sales due to unfulfilled customer demand.
• Sale of existing assets:
  • Selling underused non-current assets to generate funds without increasing debt, improving efficiency.
  • Can be time-consuming and depends on having saleable items.
• Retained profit:
  • Profits kept within the business after distribution, requiring no repayment or interest.
  • Ideal for established firms but unavailable to startups and potentially unpopular with shareholders expecting dividends.

External sources of finance

External finance involves obtaining funds from outside the business, which can be categorised into short-term and long-term options. These sources often require repayment or conditions but can provide larger sums than internal methods.

Long-term external finance options

These are suitable for major investments with repayment over several years:

• Grants and subsidies - Non-repayable funds from governments or organisations, often with conditions like job creation, reducing financial burden but not always available.
• Bank loans - Borrowed sums arranged quickly with flexible repayment terms, including interest; security (like assets) is usually needed, making them suitable for established businesses.
• Issue of shares - Selling ownership stakes to investors, avoiding repayment but involving dividend expectations; this can alter control and is limited to limited companies.
• Selling debentures - Issuing long-term bonds (e.g., for 30 years) to raise capital, repaid with interest, providing an alternative to shares without diluting ownership.
• Hire purchase - Spreading asset costs over time without a large upfront payment, though interest applies and ownership transfers only after the final instalment.
• Leasing - Renting assets long-term, avoiding big initial outlays and including maintenance, but total costs exceed outright purchase.
• Crowdfunding - Online platforms where many small investors contribute, helping test market interest in the idea, though it may reveal business details to rivals.

Short-term external finance options

These address immediate needs, typically repaid within a year:

• Trade credit - Suppliers allowing delayed payment without interest, improving cash flow, but late payments can damage relationships.
• Micro-finance - Small loans for underserved groups, requiring no collateral but charging interest; amounts are limited, aiding startups in low-income areas.
• Factoring debt - Selling unpaid invoices to a factor for immediate cash, removing collection risks, though the business receives less than the full invoice value.
• Overdraft - Bank facility allowing borrowing up to a limit, with interest only on the used amount; flexible for short-term gaps but costly if prolonged and repayable on demand.