Cambridge IGCSE0450

Business finance: needs and sources

Business Studies 0450 Chapter Notes

What this chapter covers

Business finance: needs and sources - The need for business financeBusiness finance: needs and sources - The main sources of finance
ShareWhatsAppPost
Business finance: needs and sources notes

Unable to load PDF

The notes viewer could not load. Please refresh the page.

Read online free. Download a watermarked copy with a free account.

Read the notes

The full Business finance: needs and sources notes as text: skim, search, and jump between subtopics.

~14 min read

In this chapter

  1. 1Why Businesses Need Finance
  2. 2Matching Finance to Business Needs
  3. 3Internal Sources of Finance
  4. 4External Sources of Finance
  5. 5Selecting the Best Finance Source

1. Why Businesses Need Finance

All businesses, from a small local shop to a huge multinational corporation, need money to operate and grow. This money is called 'finance' or 'capital'. The reasons for needing finance can be split into two main categories: capital expenditure and revenue expenditure. Capital expenditure is money spent on long-term assets that will be used repeatedly over a long period, like buildings, machinery, or vehicles. These are major purchases that help the business produce goods or services. Revenue expenditure (also called operating expenditure) is the money spent on the day-to-day running of the business, such as paying wages, utility bills, and buying raw materials. Without finance for both, a business cannot start, survive, or expand.

Key term

Capital Expenditure: Money spent on acquiring or maintaining non-current (fixed) assets, such as land, buildings, and equipment.

Common pitfall

Students often confuse capital and revenue expenditure. Remember: if it's a major item that lasts a long time, it's capital; if it's a regular, day-to-day cost, it's revenue.

Worked example 14 marks

A new bakery, 'The Rolling Pin', is setting up. It needs to buy a large industrial oven for £8,000 and also needs to pay for its first batch of flour and sugar, costing £500. Identify which spending is capital expenditure and which is revenue expenditure. Explain your answer.

  1. 1

    Step 1: Identify the purpose of each item. The oven is a long-term asset that will be used for many years to bake bread and cakes. The flour and sugar are raw materials that will be used up quickly to make products for immediate sale.

  2. 2

    Step 2: Classify the oven. The purchase of the industrial oven (£8,000) is capital expenditure because it is a non-current (fixed) asset that the business will use for a long time to generate income.

  3. 3

    Step 3: Classify the flour and sugar. The purchase of flour and sugar (£500) is revenue expenditure because these are day-to-day running costs (raw materials) that will be used up in the production process.

  4. 4

    Step 4: Conclude by summarising the classifications based on the definitions.

Recap

  • Businesses need finance to start up, operate daily, and expand.
  • Capital expenditure is for purchasing long-lasting assets like machinery and buildings.
  • Revenue (operating) expenditure covers day-to-day running costs like wages and raw materials.
  • Both types of expenditure are essential for a business's survival and success.

Quick check

  1. Is paying the monthly electricity bill an example of capital or revenue expenditure?1 mark
  2. State one reason why a new business would need start-up capital.1 mark

2. Matching Finance to Business Needs

Just as there are different reasons for needing finance, there are different timeframes for it. Finance can be short-term or long-term. Short-term finance is money that needs to be repaid within one to two years. It's used to cover temporary cash shortages or to pay for revenue expenditure, like buying inventory. Long-term finance is money borrowed for a longer period, typically more than two years. It is used for major investments, i.e., capital expenditure like buying property or funding a large expansion project. A crucial principle in business finance is 'matching the term of the finance to the need'. This means using long-term finance for long-term assets and short-term finance for short-term needs. Using a long-term loan to pay a weekly wage bill would be inefficient and costly, while using a short-term overdraft to buy a factory would be incredibly risky.

Key term

Working Capital: The finance available for the day-to-day running of a business, calculated as current assets minus current liabilities.

Examiner insight

Examiners reward students who clearly apply the 'matching principle', explaining why the lifespan of an asset or project dictates the choice between short-term and long-term finance.

Fun fact

The term 'working capital' comes from the idea that this is the money that is constantly 'working' or circulating through the business, from cash to inventory to receivables and back to cash.

Worked example 14 marks

A construction company needs finance for two purposes:(a) to purchase a new crane that will last for 15 years, and(b) to pay for a large delivery of cement that it will use on a project over the next two months. For each purpose, state whether short-term or long-term finance would be more appropriate and justify your choice.

  1. 1

    Step 1 (Crane): The crane is a non-current (fixed) asset with a very long useful life (15 years). Therefore, it should be financed using a long-term source of finance.

  2. 2

    Step 2 (Justification for Crane): Using long-term finance, like a bank loan spread over several years, matches the lifespan of the asset. This spreads the cost and makes payments more manageable, avoiding a large, immediate drain on cash. Using short-term finance would be inappropriate as the business would have to repay a huge sum very quickly.

  3. 3

    Step 3 (Cement): The cement is a raw material that will be used up in the short term (two months). This is a working capital need. Therefore, it should be financed using a short-term source of finance.

  4. 4

    Step 4 (Justification for Cement): Using short-term finance, like trade credit from the supplier or a bank overdraft, matches the short-term nature of the need. The finance can be repaid once the construction client pays for the project. Using long-term finance for this would be unnecessarily expensive due to interest costs over a long period.

Recap

  • Short-term finance is for needs up to two years and covers revenue expenditure.
  • Long-term finance is for needs over two years and covers capital expenditure.
  • The 'matching principle' states that the finance term should match the asset's life or the need's duration.
  • Mismatching finance terms creates either unnecessary cost or high risk.

Quick check

  1. Would a 10-year bank loan be considered short-term or long-term finance?1 mark

3. Internal Sources of Finance

Internal finance is money generated from within the business itself. It is often the first place a business looks for funding because it is readily available and doesn't involve dealing with external parties. There are three main sources. First is owner's capital, which is the personal savings invested by the owner(s), especially common for sole traders and partnerships. Second is retained profit, which is the profit made by the business in previous years that was not paid out to owners/shareholders as dividends. It is a vital source for established, profitable businesses. Third is the sale of non-current (fixed) assets, where a business sells assets it no longer needs, like an old vehicle or unused machinery, to raise cash. The main advantages of internal finance are that there are no interest payments and the business maintains full control.

Key term

Retained Profit: Profit kept in the business after tax has been paid and dividends have been distributed to shareholders, which can be reinvested.

Common pitfall

Forgetting that drawings (for sole traders/partnerships) or dividends (for companies) must be subtracted from profit to find the actual retained profit available for reinvestment.

Worked example 13 marks

'Clean Cut' is a gardening partnership run by two friends. Last year, they made a total profit of £30,000. They each took £10,000 as drawings. They also have an old lawnmower they no longer use, which they can sell for £200. Calculate the total amount of internal finance they can raise for the upcoming year.

  1. 1

    Step 1: Calculate the retained profit. Total Profit = £30,000. Total Drawings (money taken by owners) = 2 x £10,000 = £20,000.

  2. 2

    Step 2: Retained Profit = Total Profit - Total Drawings = £30,000 - £20,000 = £10,000.

  3. 3

    Step 3: Identify the value from the sale of assets. The old lawnmower can be sold for £200.

  4. 4

    Step 4: Calculate the total internal finance available. Total Internal Finance = Retained Profit + Sale of Assets = £10,000 + £200 = £10,200.

  5. 5

    Step 5: State the final answer clearly: 'Clean Cut' can raise a total of £10,200 from internal sources.

Recap

  • Internal finance comes from within the business.
  • The main internal sources are owner's capital, retained profit, and the sale of assets.
  • Internal finance does not require interest payments.
  • The amount of internal finance available may be limited, especially for new or unprofitable businesses.

Quick check

  1. State two sources of internal finance.2 marks

4. External Sources of Finance

When a business cannot raise enough money internally, it must look to external sources of finance. This is money provided by individuals or institutions outside of the business. External finance can be short-term or long-term. Common short-term sources include bank overdrafts (allowing the business to have a negative bank balance up to an agreed limit), and trade credit (where suppliers allow the business to 'buy now, pay later', usually within 30-90 days). Common long-term sources include bank loans (a fixed sum paid back with interest over a set period), mortgages (a specific type of long-term loan for property), leasing (renting an asset instead of buying it), and hire purchase (paying for an asset in instalments). For limited companies, two very important long-term sources are selling shares (equity finance) and debentures (long-term loans to the company). External finance provides access to larger sums of money but usually comes with costs (interest) and risks (loss of control or assets).

Key term

External Finance: Money raised from individuals or institutions outside of the business, such as banks, suppliers, or investors.

Examiner insight

Examiners look for a clear distinction between debt finance (which must be repaid with interest) and equity finance (which is permanent capital in exchange for ownership).

Worked example 15 marks

A private limited company needs £20,000 to buy a new delivery van. It has been offered a bank loan at 5% interest per year, repayable over 4 years. Alternatively, it could use hire purchase, which involves a 10% deposit and 48 monthly payments of £420. Which option is cheaper overall?

  1. 1

    Step 1: Calculate the total cost of the bank loan. Annual interest = 5% of £20,000 = £1,000. Total interest over 4 years = £1,000 x 4 = £4,000. Total repayment for the loan = Principal + Total Interest = £20,000 + £4,000 = £24,000.

  2. 2

    Step 2: Calculate the total cost of the hire purchase. Deposit = 10% of £20,000 = £2,000.

  3. 3

    Step 3: Calculate the total of the monthly payments. Total payments = 48 months x £420/month = £20,160.

  4. 4

    Step 4: Calculate the total hire purchase cost. Total HP cost = Deposit + Total payments = £2,000 + £20,160 = £22,160.

  5. 5

    Step 5: Compare the two options. The total cost of the hire purchase (£22,160) is cheaper than the total cost of the bank loan (£24,000).

  6. 6

    Step 6: Conclude that the hire purchase option is the cheaper choice for the company.

Worked example 24 marks

Explain the difference between share capital and a bank loan as sources of finance for a limited company.

  1. 1

    Step 1: Define share capital. Share capital (equity finance) is money raised by selling ownership stakes (shares) in the company. It is permanent capital and does not need to be repaid.

  2. 2

    Step 2: Define a bank loan. A bank loan (debt finance) is money borrowed from a bank that must be repaid, with interest, over an agreed period.

  3. 3

    Step 3: State the key difference regarding ownership. Issuing shares dilutes ownership, as new shareholders become part-owners and have a say in the business. A bank loan does not affect ownership; the bank is a lender, not an owner.

  4. 4

    Step 4: State the key difference regarding payments. A bank loan requires regular, fixed interest payments, which are a legal obligation. Share capital does not have interest payments; instead, the company may choose to pay dividends to shareholders if it is profitable.

Recap

  • External finance comes from sources outside the business.
  • Short-term external sources include overdrafts and trade credit.
  • Long-term external sources include bank loans, mortgages, leasing, and hire purchase.
  • Limited companies can also raise long-term finance by issuing shares (equity) or debentures (debt).
  • External finance often involves paying interest and can increase the business's risk.

Quick check

  1. What is the key difference between leasing and hire purchase?2 marks
  2. Is trade credit a short-term or long-term source of finance?1 mark

5. Selecting the Best Finance Source

Choosing the right source of finance is a critical decision that can determine the success or failure of a business. Managers must consider several factors to make the best choice. This is often a balancing act between cost, risk, and control. The key factors are: 1. Purpose and Time Period: Is the money for a long-term asset or a short-term cost? This determines whether long-term or short-term finance is needed (the matching principle). 2. Amount Needed: Small amounts might be raised from an overdraft or owner's savings, while large investments like a new factory will require major sources like a large bank loan or a share issue. 3. Cost: Debt finance involves interest payments, which increase costs and reduce profit. Equity finance involves paying dividends and potential loss of ownership. 4. Legal Structure and Size: A sole trader cannot issue shares. A new, small business may be seen as high-risk and find it hard to get a bank loan. A public limited company (PLC) has many more options, including selling shares to the public. 5. Risk and Gearing: Relying too heavily on long-term loans (high gearing) is risky. If profits fall or interest rates rise, the business may be unable to make its repayments and could lose assets put up as security (collateral).

Gearing Ratio (%) = (Non-current liabilities / Capital Employed) × 100

Key term

Gearing: A measure of the proportion of a business's capital that is financed through long-term debt.

Examiner insight

Top marks in 'recommend and justify' questions are awarded for weighing up the pros and cons of different, suitable options in the specific context of the business in the case study, before making a final, well-supported judgement.

Worked example 18 marks

A successful public limited company (PLC) wants to raise £10 million to fund the development of a new product line. It is considering two options: (A) issuing new shares, or (B) taking out a 10-year bank loan. Recommend and justify which source of finance it should choose.

  1. 1

    Step 1: Analyse the need. The finance is for a large amount (£10m) and a long-term purpose (new product development), so a long-term source is appropriate. Both options are suitable in this regard.

  2. 2

    Step 2: Evaluate Option A (Issuing Shares). Advantage: This is permanent capital and does not need to be repaid. It does not increase the company's gearing (risk). Disadvantage: It will dilute the ownership of existing shareholders, and they may receive lower dividends per share in the future.

  3. 3

    Step 3: Evaluate Option B (Bank Loan). Advantage: The ownership of the company is not diluted. Interest payments are a tax-deductible expense. Disadvantage: The company is legally obligated to make regular interest payments, regardless of profitability. This increases gearing and financial risk. The bank may also require collateral.

  4. 4

    Step 4: Make a recommendation with justification. 'The PLC should choose to issue new shares. Although this dilutes ownership, the company is described as 'successful', suggesting it is profitable and can attract investors. A new product launch is inherently risky, and burdening the company with £10 million of debt and compulsory interest payments (from the loan) could be dangerous if the product is not as successful as hoped. Equity finance (shares) is more flexible as dividends can be reduced or skipped in a difficult year, making it the less risky option for a major new venture.'

  5. 5

    Note: An alternative answer recommending the loan could also gain marks if well-justified, e.g., by arguing that the owners want to retain control and are confident in the project's profitability to cover interest payments.

Recap

  • The choice of finance depends on its purpose, amount, cost, and the time period involved.
  • The legal structure of the business (e.g., sole trader vs. PLC) limits the available options.
  • Relying too much on debt finance increases financial risk, a concept measured by gearing.
  • The best choice involves balancing the need for funds with the costs and risks of each source.
  • Always apply the matching principle: long-term needs require long-term finance.

Quick check

  1. State one reason why a sole trader cannot issue shares to raise finance.1 mark
  2. What does a high gearing ratio indicate about a business?1 mark

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Identify two reasons why a business needs finance.2 marks
  2. Explain the difference between capital expenditure and revenue expenditure, giving one example of each.4 marks
  3. A sole trader is buying a new laptop for £1,200. Explain why a bank loan would be a more appropriate source of finance than a mortgage.4 marks
  4. Analyse one advantage and one disadvantage for a business of using retained profit as a source of finance.6 marks
  5. Explain two factors that a business should consider when choosing a source of finance.4 marks
  6. A private limited company needs to raise £50,000 to purchase new machinery. Explain the difference between using a bank loan and issuing more shares to raise this finance.6 marks
  7. A retailer has a short-term cash flow problem and cannot pay its suppliers. Explain how a bank overdraft could help solve this problem.4 marks
  8. Why might a new start-up business find it more difficult to secure external finance than an established, profitable business?5 marks
  9. A partnership wants to buy new premises for £250,000. It has £50,000 in retained profit. Recommend and justify a suitable source of finance for the remaining amount.8 marks
  10. Evaluate the use of debt finance versus equity finance for a public limited company planning a major, high-risk international expansion project costing £50 million.10 marks

Go deeper

Practise and revise with member-only material for this chapter.

Workbook

Exam-style practice questions with full worked solutions.

Unlock with a plan

Chapter at a Glance

A single-page summary of every key idea for fast revision.

Unlock with a plan

Free notes are just the start.

Unlock every Workbook and Chapter at a Glance, and generate your own worksheets and predicted papers.

Explore plans

Related chapters

Business activityClassification of businessesEnterprise, business growth and sizeTypes of business organisationBusiness objectives and stakeholder objectivesMotivating employees