The role of finance for businesses

Finance plays a vital part in setting up and running businesses, covering both initial setup and ongoing needs.

Categories of business expenditure

• Capital expenditure - Spending on long-term assets like buildings, machinery, or technology.
• Revenue expenditure - Funding for everyday running costs, such as buying materials, paying staff wages, or settling utility bills.

Businesses often require finance to handle these expenses.

Key definitions in business finance

Important financial terms

• Capital expenditure - Spending on fixed assets and equipment that provide long-term benefits.
• Revenue expenditure - Funding needed for routine operations, including purchases of raw materials, employee salaries, and energy costs.
• Stock market (or stock exchange) - A marketplace where shares in public limited companies are bought and sold.
• Overtrading - When a business expands rapidly without enough finance to maintain its activities.

Internal sources of finance

Internal finance involves using a business's own resources to fund its needs, avoiding the need to borrow from outside parties.

Types of internal finance sources

• Personal funds - Often used by sole traders or partners, drawing from their savings to start or support the business.
• Retained profit - Profits kept in the business after dividends are paid, which can be reinvested for growth.
• Sale of assets - Selling unused or outdated fixed assets to generate cash.

External sources of finance

When internal options are insufficient, businesses turn to external sources, which involve borrowing or sharing ownership with outsiders.

Main categories of external finance

External finance falls into two broad types: share capital, which involves selling ownership stakes, and loan capital, which means borrowing with repayment obligations.

Share capital

• A long-term option for limited companies, raised by selling shares to investors.
• An IPO happens when a company first issues shares publicly.
• Only public limited companies can list on stock exchanges, and selling shares dilutes existing owners' control.

Loan capital

• Borrowing from lenders like banks, with repayment over time plus interest (fixed or variable).
• Includes various forms tailored to different needs.

Specific forms of external finance

• Mortgage - A long-term loan secured against property or other fixed assets.
• Debenture - Long-term borrowing tied to a specific asset; holders receive interest before shareholders get dividends, but they have no ownership rights.
• Overdrafts - Short-term borrowing allowing a business to spend beyond its account balance.
• Trade credit - Suppliers provide goods or services with payment delayed (typically 30 to 60 days).
• Grants - Non-repayable government funding for startups, research, or job creation.
• Subsidies - Government support to lower costs and boost output.
• Debt factoring - A service where a factor (like a bank) collects owed money from debtors for a fee.
• Leasing - Renting assets like equipment for a monthly fee, with the lessor handling maintenance.
• Venture capital - Investment from specialist firms in promising startups or growing small businesses, often involving partial ownership and expert advice.
• Business angels - Wealthy individuals who invest their own money in risky ventures with high potential returns.

Short-, medium- and long-term finance

Finance sources are classified by duration to match business needs, ensuring short-term options cover immediate costs and long-term ones support major investments.

Classifications of finance by time period

• Short-term finance - Lasts up to one year, suitable for daily operations; examples include overdrafts and trade credit.
• Medium-term finance - Covers up to five years, often for equipment or temporary projects; includes bank loans, subsidies, and leasing.
• Long-term finance - Extends beyond five years, ideal for expansion; sources like mortgages, debentures, and share capital fit here.

Matching the finance type to its purpose is key.

Appropriateness of finance sources

Choosing the right finance depends on the business's size, stage, and circumstances, balancing benefits against risks like debt levels or loss of control.

Factors influencing suitability of finance sources

• Sale of assets - Suitable for replacing old equipment or easing cash flow issues.
• Share capital - Appropriate for limited companies needing large funds without debt.
• Venture capital and business angels - Ideal for innovative startups lacking bank access.
• Loan capital - Fits most businesses for asset purchases.
• Debt factoring - Helpful for quick cash when debtors delay payments.

Advantages and disadvantages of internal sources

Internal sources offer independence but may not provide enough funds for ambitious plans.

Advantages and disadvantages of external sources

External sources can unlock more capital but introduce costs and risks like interest or shared ownership.