The need for short-term and long-term finance

Businesses require finance to cover various costs, from daily operations to major investments.

Key definitions

Short-term finance refers to funds borrowed for one year or less, while long-term finance involves funds borrowed for more than one year. Capital is money provided by the business owners.

Reasons for short-term finance

Businesses may need short-term finance when sales revenue does not fully cover ongoing expenses, such as wages, utilities, or raw materials. This helps maintain smooth operations.

Reasons for long-term finance

Long-term finance supports major investments that benefit the business over extended periods. It can come from owners (as capital) or external lenders like banks, and is often used to acquire assets like machinery, property, or equipment.

Finance for business start-ups

New businesses often need substantial funds before generating revenue. This start-up capital covers one-off costs, including:

• Equipment purchases.
• Other expenses like research, premises conversion, legal fees, website creation, and initial marketing.

Finance for business expansion

Established businesses may seek finance to grow, which requires significant spending. Common expansion goals include:

• Increasing production capacity.
• Creating new products or entering overseas markets.
• Diversifying.

Internal sources of finance

Internal finance is generated from within the business itself, without relying on outside lenders.

Key internal sources of finance

• Personal savings - Owners contribute their own funds, such as from redundancy payments, family gifts, or asset sales. This is common for small start-ups.
• Retained profit - Profits kept in the business instead of distributed to owners. It is inexpensive and flexible, allowing funds to accumulate in a bank account for future use, though owners may prefer to receive these profits directly.
• Selling assets - Disposing of unused resources like machinery, land, or buildings to generate cash. Larger firms might sell off divisions, or lease back needed assets after selling them.

External sources of finance

External finance involves borrowing from outside the business, offering more options but often with costs like interest. It includes both short-term and long-term methods, used for reasons such as seasonal cash shortages, large orders, delayed customer payments, or unexpected repairs.

Short-term external sources

• Bank overdraft - Allows a business to spend beyond its account balance up to an agreed limit. Interest applies only when overdrawn, making it flexible, but the bank can demand repayment anytime.
• Trade payables - Purchasing supplies on credit and paying later (often 30-90 days). This preserves cash flow but may miss discounts for early payment, increase costs, or strain supplier relationships.
• Credit cards - Convenient for small purchases or travel expenses, with no interest if paid within the credit period (typically 56 days). However, overdue balances incur high interest rates.

Long-term external sources

• Loan capital - Fixed agreements with banks for repayment in instalments, including interest. Can be unsecured (higher risk and rates, no asset backing) or secured.
• Mortgages - Long-term loans (up to 25 years) backed by property or land. Lower interest than unsecured loans, but failure to repay allows the lender to repossess the asset.
• Debentures - Fixed-interest loans issued by public limited companies (PLCs), secured against assets. Holders receive interest but no ownership rights, with repayment at maturity.
• Hire purchase - Loans for buying equipment or vehicles, with a down payment followed by instalments. Ownership transfers only after full payment; default allows repossession. More expensive than bank loans due to lenient checks.
• Share capital - Limited companies sell shares to raise funds, often through rights issues offering discounts to existing shareholders. No interest required, but dividends may be expected; administration costs apply, and it is permanent finance.
• Venture capital - Specialist investors provide funds to small or medium businesses, often in tech sectors, in exchange for equity and some control. Business angels (individual investors) offer $10,000-$100,000 for start-ups, but require aligned goals and profit-sharing.
• Crowd funding - Online platforms where many individuals invest small amounts in a business idea. Avoids banks, with investors often receiving shares; suitable for ventures like community projects, but platforms may not always verify fundraisers.

Differences in finance options for large and small businesses

Small businesses, like sole traders, have fewer finance choices, often limited to personal capital, mortgages, or basic loans. They face higher interest rates due to perceived risk. Larger businesses, such as private or public limited companies, access a broader range, including shares, debentures, and venture capital, often at lower costs due to their scale and security.