Business finance: needs and sources | IGCSE Class 10 Business Studies Notes

This note covers why businesses need finance, the difference between short-term and long-term finance needs, internal and external sources of finance with examples, the main short-term and long-term sources (including overdraft, trade credit, debt and equity), alternative sources such as micro-finance and crowd-funding, the factors that affect the choice of finance, and how to recommend and justify an appropriate source of finance in given circumstances.

Why does a business need finance?

Business finance is the money a business needs to carry out its activities, from starting up to running day-to-day operations and growing.

A business cannot function unless adequate funds are made available to it, and the owner's own capital is not always sufficient to meet every financial requirement, so other sources must be found.

Definition: Business finance. The funds required by a business to establish itself, to run its daily operations and to expand or modernise.

There are three main reasons a business needs finance.

1. Start-up capital: money needed before trading begins, to buy premises, equipment, fixtures and an opening stock of materials or goods.
2. Capital for expansion: money needed to open new branches, buy new machinery, enter new markets or take over another business.
3. Additional working capital: money needed for day-to-day running costs such as buying raw materials, paying wages, rent and other current expenses.

Fixed capital is the money invested in fixed assets such as land, buildings, plant and machinery, which stays tied up in the business for a long period.

Working capital is the money used to pay for day-to-day running costs and to hold current assets such as stock and amounts owed by customers.

A business that sells on credit, or whose sales turn over slowly, usually needs more working capital than one that sells for cash with a quick turnover.

The need for both fixed and working capital grows as a business expands, so planning finance carefully becomes more important at that stage.

What is the difference between short-term and long-term finance needs?

Finance needs can be split by how long the funds are required for.

• Short-term finance is needed for a period of up to one year, mainly to cover working capital gaps such as a temporary shortage of cash before customers pay their bills, or to build up stock ahead of a busy season.
• Long-term finance is needed for periods of several years, usually to buy fixed assets or to fund expansion, since these assets are expected to generate returns over a long period.

Matching the length of the finance to the length of the need matters a great deal.

A long-term expansion plan should not be financed by a short-term source that must be repaid quickly, because the business may not have generated enough income from the expansion by the time repayment is due.

Equally, it would be wasteful to tie up a short-term cash shortage with an expensive long-term loan.

What are internal sources of finance?

Internal sources of finance are funds generated from within the business itself, without approaching anyone outside it.

Definition: Internal source of finance. Funds raised from within the business, such as by reinvesting profit or collecting money owed more quickly, rather than from outsiders.

The main internal sources are:

• Retained profit (also called retained earnings or ploughing back profit): the portion of profit after tax that the owners choose not to withdraw or pay out as dividends, and instead keep in the business for future use.
• Collecting money owed by customers more quickly, which speeds up the cash coming into the business.
• Selling off surplus stock or unused assets to free up cash.

Retained profit does not involve any explicit cost such as interest, and because the funds are generated internally there is greater operational freedom, since no outside lender or investor can impose conditions.

However, it is an uncertain source, because profit fluctuates from year to year, and using too much of it may leave owners dissatisfied if it reduces the amount paid out to them.

Internal sources can only meet limited needs; a business wanting to raise a large amount quickly usually has to look outside.

What are external sources of finance?

External sources of finance are funds that come from outside the business, such as suppliers, lenders and investors.

Definition: External source of finance. Funds raised from outside the business, for example from banks, other lenders, suppliers or new shareholders.

When a large amount of money is required, it is generally raised through external sources, because internal funds alone are rarely enough.

External finance can be more costly than internal finance, and in some cases the business has to offer security (an asset pledged as a guarantee of repayment) before a lender will provide funds.

External sources include bank overdrafts and loans, trade credit from suppliers, leasing, and raising capital by issuing shares or debt.

Advantages of external sources

• They allow a business to raise much larger amounts than internal profit could provide.
• They let a business act quickly, such as taking up a growth opportunity without waiting years to build up retained profit.
• Specific sources, such as bank loans, can be matched closely to the exact period for which funds are needed.

Limitations of external sources

• They are often more expensive, because interest or dividends must be paid.
• Lenders may require security over the business's assets, and may investigate the business closely before agreeing to lend.
• Some external sources, such as issuing new shares, dilute the control that existing owners have over the business.

What are the main short-term sources of finance?

Bank overdraft

An overdraft allows a business to withdraw more money from its bank account than it has in credit, up to an agreed limit, and is one of the most common short-term sources of finance.

Definition: Overdraft. An agreement with a bank that lets a business withdraw more than its account balance, up to an agreed limit, usually at a flexible but relatively high rate of interest.

An overdraft is flexible: the business only pays interest on the amount actually overdrawn, and the amount borrowed can rise or fall with day-to-day cash needs, so it suits temporary gaps such as waiting for customers to pay.

Its main drawback is that the bank can usually demand repayment at short notice, and the interest rate charged is normally higher than on a longer-term loan.

Trade credit

Trade credit is credit extended by one trader to another for the purchase of goods or services, allowing the buyer to take delivery of goods now and pay for them later.

It is a convenient and continuous source of short-term funds, is readily available where the buyer has a good payment record, and does not create any charge over the business's assets.

However, only a limited amount of funds can be raised this way, and taking on too much trade credit can tempt a business into overtrading, which adds to its risk.

Suppliers may also charge more for goods bought on credit than for goods paid for immediately, making it a relatively costly source compared with others.

What are the main long-term sources of finance?

Equity (issuing shares)

Equity share capital is capital raised by selling shares in the business to investors, who in return become part-owners with voting rights and a share of future profits.

Equity shareholders do not receive a fixed return; they are paid a dividend only out of profits actually earned, so there is no fixed burden on the business when profits are low.

Equity capital is a long-term, permanent source that does not have to be repaid while the business continues, and it does not create any charge over the business's assets.

Its main limitations are that issuing new shares dilutes the control and earnings of existing owners, and investors who want a steady, predictable income may not find equity attractive because returns fluctuate with profit.

Debt (loans and debentures)

Debt finance is money borrowed that must be repaid, usually with interest, within an agreed period. Long-term debt can take the form of a bank loan or, for a company, a debenture.

Definition: Debenture. A document acknowledging that a company has borrowed money from the holder and promises to repay it at a future date, with a fixed rate of interest paid in the meantime.

Debenture and loan holders are creditors of the business, not owners, so they do not normally have voting rights and financing through debt does not dilute the control of existing owners.

Interest on debt must be paid whether or not the business makes a profit, which is why debt is described as a fixed charge on earnings.

Debt is suitable where sales and earnings are fairly stable, so that the fixed interest payments can reliably be met.

Leasing

A lease is a contractual agreement in which the owner of an asset (the lessor) grants another party (the lessee) the right to use the asset for a specified period in return for a periodic lease rental.

At the end of the lease period the asset usually goes back to the lessor.

Leasing lets a business acquire the use of an asset such as equipment with a much lower initial outlay than buying it outright, and it provides finance without diluting ownership or control.

Its main limitation is that the lessee never becomes the owner of the asset and so never benefits from any residual value it may have.

What are the advantages and limitations of debt and equity finance?

Advantages of debt finance

• It does not dilute the control of existing owners, since lenders do not normally have voting rights.
• Interest on debt is often tax-deductible, which can make it cheaper than other sources once tax is taken into account.
• It is suitable when a business has stable, predictable earnings that can cover fixed interest payments.

Limitations of debt finance

• Interest and repayments are fixed obligations that must be met whether or not the business earns a profit.
• Lenders often require security over the business's assets, which puts those assets at risk if repayments are missed.
• A business that already carries a lot of debt may find it harder to borrow more, since lenders see it as a greater risk.

Advantages of equity finance

• There is no obligation to pay a dividend in a year when profits are low or absent.
• It does not have to be repaid while the business continues, so it is effectively permanent capital.
• Raising equity improves the financial strength of the business, which can make it easier to borrow on good terms later.

Limitations of equity finance

• Issuing new shares dilutes the ownership, voting power and share of profit of existing owners.
• Investors seeking a steady income may be reluctant to buy shares, since dividends are not guaranteed.
• Issuing shares is usually a more formal, costly and time-consuming process than taking out a loan.

What are micro-finance and crowd-funding?

Alongside the traditional sources above, smaller or newer businesses increasingly use alternative sources of capital.

Definition: Micro-finance. Small loans and other financial services provided to individuals or very small businesses that would not normally qualify for finance from a mainstream bank, often because they lack security to offer.

Definition: Crowd-funding. Raising finance by asking a large number of people, usually through an online platform, to each contribute a small amount of money towards a business idea or project.

These alternative sources matter because they open finance up to entrepreneurs who may not have the trading history, security or scale that banks and investors usually require.

Micro-finance institutions lend small amounts, often with simpler application processes, to help very small businesses start up or grow.

Crowd-funding platforms let a business present its idea directly to the public; backers may give money in return for a reward, an early product, a share of future profit, or simply out of interest in the idea.

Both sources can make start-up and expansion capital available to businesses that would otherwise struggle to raise it, though the amounts raised through each are often smaller than what an established bank loan, debenture or share issue could provide.

What factors affect the choice of a source of finance?

No single source of finance is free of limitations, so a business usually uses a combination of sources, and a number of factors affect which combination is chosen.

1. Size and legal form of business: a sole trader or partnership cannot raise money by issuing shares, since only a company can do that; a small business may also be too young or too small to be considered for a bank loan or a public issue of debt.
2. Amount required: a small amount can often be met from retained profit, trade credit or an overdraft, while a large amount usually needs an external, longer-term source such as a loan, debenture issue or share issue.
3. Length of time funds are needed for: a short-term need, such as covering a temporary cash gap, should be met from a short-term source such as trade credit or an overdraft; a long-term need, such as buying fixed assets or expanding, is better matched by debt or equity.
4. Existing loans: a business that has already borrowed heavily may find it harder, or more expensive, to borrow further, since lenders will see additional fixed interest payments as adding to the risk of the business being unable to pay.
5. Cost: the cost of raising the funds and the cost of using them (such as interest or dividends) should both be considered; a business will generally prefer the cheapest source available to it.
6. Control: issuing more shares dilutes the control of existing owners, so a business, or its owners, wanting to retain full control may prefer debt.
7. Risk: debt carries the risk of having to make fixed interest and repayment obligations regardless of profit, while equity carries less risk for the business itself since dividends need not be paid if profits are low.

How do you recommend and justify a source of finance?

In an exam, or in real decision-making, choosing a source of finance means weighing the factors above against the specific situation given. A useful approach is to work through the question in four steps.

1. Identify the amount of finance needed and whether it is a one-off, large sum or a smaller, repeated need.
2. Decide whether the need is short-term (up to a year, for example covering a cash-flow gap) or long-term (several years, for example buying equipment or opening a new branch).
3. Check what the business's legal form allows, and consider its existing debt, assets and cash flow, since these limit which sources are realistically available.
4. Match the need to the most suitable source or sources, and justify the choice by weighing cost, risk, control and the length of time the funds are needed for against the alternatives.

For example, a sole trader needing a small, short-term amount to cover a seasonal stock build-up would reasonably be advised to use trade credit or an overdraft, both of which are quick to arrange and do not threaten the owner's control, rather than a long-term source that would tie up funds for far longer than needed.

A company planning a large, multi-year expansion of its factory, by contrast, would normally be advised towards a mixture of debt (such as a loan or debenture issue) and equity (a share issue), since the scale and length of the need call for long-term capital.

Going beyond the syllabus

Businesses rarely rely on just one source of finance. A growing firm might, for example, use retained profit and trade credit for its day-to-day working capital, a bank overdraft to smooth short-term cash gaps, and a mixture of a long-term loan and a new share issue to fund a major expansion, choosing the mix that best balances cost, risk and control at each stage of its growth.

Glossary

• Business finance: the funds a business needs to start, run and grow its operations.
• Start-up capital: money needed before a business begins trading, to buy premises, equipment and opening stock.
• Working capital: money used for day-to-day running costs and to hold current assets such as stock.
• Fixed capital: money invested in long-lasting assets such as land, buildings and machinery.
• Internal source: finance generated from within the business, such as retained profit.
• External source: finance raised from outside the business, such as a bank or new shareholders.
• Retained profit: profit kept in the business rather than paid out to owners as dividends.
• Overdraft: a bank facility allowing a business to withdraw more than its account balance, up to an agreed limit.
• Trade credit: an arrangement allowing a business to buy goods or services now and pay the supplier later.
• Debenture: a document acknowledging a company's borrowing, carrying a fixed rate of interest.
• Equity: capital raised by selling shares, giving investors part-ownership and voting rights.
• Lease, lessor, lessee: a rental agreement for an asset; the owner is the lessor and the user is the lessee.
• Micro-finance: small loans and financial services for individuals or very small businesses lacking access to mainstream banking.
• Crowd-funding: raising finance in small amounts from a large number of people, typically through an online platform.
• Security (collateral): an asset pledged to a lender as a guarantee that a loan will be repaid.

Common errors and misconceptions

• Misconception: an overdraft and a bank loan are the same thing. Correct: an overdraft is a flexible, short-term facility attached to a current account, while a loan provides a fixed sum repaid over an agreed term.
• Misconception: retained profit is free finance. Correct: it has no interest cost, but using it reduces the amount available to pay out to owners, so it is not without cost to them.
• Misconception: debt finance is always riskier than equity for a business. Correct: debt carries fixed interest obligations regardless of profit, but equity dilutes ownership and control, so each carries a different type of risk, not simply a greater or lesser one.
• Misconception: only large companies can use crowd-funding or micro-finance. Correct: these are aimed particularly at small, new or very small businesses that cannot easily access mainstream bank finance.
• Misconception: trade credit is a cost-free source of finance. Correct: suppliers may charge more for goods bought on credit than for immediate cash payment, making it a relatively costly source.
• Misconception: a sole trader can raise finance by issuing shares. Correct: only a company can issue shares; sole traders and partnerships must rely on other sources such as personal capital, loans or retained profit.
• Misconception: short-term finance can always be used to fund long-term needs if the amount is right. Correct: mismatching the length of the source to the length of the need, for example financing long-term expansion with an overdraft, creates repayment risk because the asset may not generate returns before repayment is due.

Exam-style questions with model answers

Q1. State two reasons why a business might need additional working capital. [2 marks]

1. To pay for day-to-day running costs such as wages or rent when cash is temporarily tight.
2. To build up stock ahead of a busy trading season before the extra sales revenue comes in.

Q2. Distinguish between a short-term source of finance and a long-term source of finance, using one example of each. [4 marks]

1. A short-term source provides funds for a period of up to around one year, typically to cover a temporary gap in working capital, for example a bank overdraft.
2. A long-term source provides funds for several years, typically to buy fixed assets or fund expansion, for example a long-term bank loan or an issue of shares.
3. The key distinction is the length of time the funds are tied up for and what they are used for: working-capital gaps versus fixed-asset or growth investment.

Q3. Explain two advantages of financing a small bakery's new oven through leasing rather than a bank loan. [4 marks]

1. Leasing lets the bakery acquire the use of the oven with a much lower initial outlay than buying it outright, which helps cash flow in the early years.
2. At the end of the lease, the owner (lessor) takes the equipment back, so the bakery is not left holding an asset it must sell if it later needs to upgrade; this gives flexibility to move to newer equipment.

Q4. A small start-up needs $2,000 to cover stock purchases while it waits six weeks for customers to pay invoices. Explain how this differs from a need for $200,000 to open a second shop, and recommend a suitable source of finance for each. [6 marks]

1. The $2,000 need is small in amount and short in time (six weeks), so it is a working-capital gap rather than an investment need.
2. The $200,000 need is large in amount and long-term, since a new shop is a fixed asset that will take years to generate returns.
3. For the $2,000 need, a bank overdraft or trade credit from suppliers is suitable, because both are flexible, quick to arrange and matched to a short period.
4. For the $200,000 need, a mixture of long-term debt (a bank loan or, if the business is a company, a debenture) and possibly equity (an issue of shares) is suitable, because the scale and length of the investment call for long-term capital that need not be repaid within a year.
5. Using an overdraft for the $200,000 shop would be unsuitable because the bank could demand repayment at short notice, long before the shop has generated enough income.
6. Using a long-term loan for the $2,000 stock need would be unsuitable because it would tie up finance, and incur interest, for far longer than the six-week gap requires.

Q5. Evaluate whether a growing partnership should raise $500,000 for expansion mainly through a bank loan or by converting to a company and issuing shares. [8 marks]

1. A bank loan does not dilute the partners' control of the business, since lenders do not normally gain voting rights, and interest paid is often tax-deductible, which can reduce its effective cost.
2. However, a loan creates a fixed obligation to pay interest and repay the principal regardless of whether the expansion succeeds, which is risky if earnings are not yet stable, and the bank may require security over the partnership's assets.
3. Converting to a company and issuing shares raises permanent capital that need not be repaid while the business continues, and dividends need only be paid when profits allow, which reduces the risk of a fixed burden during the early years of expansion.
4. The drawback is that issuing shares brings in new owners who dilute the control and share of profit of the original partners, and converting to a company involves more formal procedures.
5. As a sole trader or partnership cannot issue shares, converting to a company form is a prerequisite for this route, which adds cost and time compared with simply approaching a bank.
6. On balance, if the partners value keeping full control and the expansion's returns are fairly predictable, a bank loan is more suitable; if the amount is very large relative to the business's size and the partners are willing to share ownership to reduce fixed repayment risk, converting to a company and issuing shares is more suitable.

Q6. State one example of an alternative source of capital other than a bank loan or share issue, and explain why it might suit a very small new business. [3 marks]

1. Crowd-funding, where a large number of people each contribute a small amount, usually through an online platform, towards the business idea.
2. It might suit a very small new business because such a business often lacks the trading history, security or scale that a bank or institutional investor would require.
3. Crowd-funding also lets the business test public interest in its idea at the same time as raising the money it needs.

Key takeaways

• Businesses need finance for start-up capital, capital for expansion and additional working capital.
• Short-term finance needs are met within about a year; long-term finance needs run for several years and usually fund fixed assets or growth.
• Internal sources, mainly retained profit, come from within the business; external sources come from outsiders such as banks, suppliers and investors.
• An overdraft and trade credit are the main short-term sources; debt (loans, debentures) and equity (shares) are the main long-term sources.
• Leasing lets a business use an asset without buying it, paying a periodic rental to the lessor.
• Micro-finance and crowd-funding are alternative sources that widen access to capital for small or new businesses.
• Choosing a source depends on the size and legal form of the business, the amount required, the length of time needed and any existing loans.
• A good recommendation matches the source to the need and weighs cost, risk and control against the alternatives.

Test yourself

What is the difference between fixed capital and working capital?

Fixed capital is money invested in long-lasting assets such as buildings and machinery; working capital is money used for day-to-day running costs and current assets.

Give one example of an internal source of finance.

Retained profit, which is profit kept in the business rather than paid out to the owners.

Why might a business prefer an overdraft to a long-term loan for a short-term cash gap?

An overdraft is flexible, quick to arrange and interest is only paid on the amount actually used, matching a short, temporary need better than a long-term loan would.

Why can a sole trader not raise finance by issuing shares?

Only a company can issue shares; a sole trader is not a separate company and so has no shares to sell.

Name one advantage of equity finance for a business owner.

There is no obligation to pay a dividend in a year when profits are low or absent, unlike fixed interest on debt.

What is crowd-funding?

Raising finance by asking a large number of people, usually through an online platform, to each contribute a small amount towards a business idea.

Why does existing debt affect a business's choice of further finance?

A business that has already borrowed heavily may find it harder or more expensive to borrow more, since lenders see additional fixed interest payments as adding risk.