Why business needs finance?

• All businesses need finance sooner or later. Usually businesses need finance for three main reasons.

Startup Capital

• Business might need finance to at the start in the form of Capital. This is known as startup capital. Startup capital is used up for initial investment such as land, building, machinery, employee people etc.

Expansion• A business might need additional source of finance when it

needs to expand. This expansion may include• extension of present facilities such as purchasing additional

machinery and extending capacities.• a business might also need to go in for inorganic expansion

such as purchase of another business through a takeover. Usually a business will have to arrange huge amount of additional finances for these purposes.

• entering new markets. It involves huge investments in research and development and aggressive marketing campaigns.

Research and Development

• Businesses need finance to develop new products. Multinational businesses usually spend millions of dollars every year in Research and Development purposes. R & D is carried out regularly in big businesses as a mean to get a competitive edge over its competitors.

Running of the business

• Apart from investment at the initial stages a business needs a constant flow of capital in the form of working capital. A shortage of working capital might lead to serious consequences for the business or cash flow problems.

During trouble times

• A business might need additional dose of capital or financial help during troubled times such as a recession, or when the sales of the business are fall temporarily due to market conditions.

Sources of finance

Internal: • this is money raised from inside the business. It includes• Sales of assets: Business might sell off old, obsolete

assets which are no longer used by the business to raise additional cash for the business.

• Advantage• Better use of capital• Disadvantage• A new business might not have any old or obsolete

assets

Retained profits:

• Businesses (especially limited companies) usually keep some part of the profit every year for future use. This is also known as ploughed back profit. Over a period of time it can total up to a huge amount which can be used for financing the business

• Advantage• Does not increase liabilities• No need to pay interest• Disadvantage• Not available to new businesses

Reduction in working capital:

• Cutting the stock levels can also help the business to raise additional cash.

• Advantage• Costs related to storage of stock is reduced• Disadvantage• May lead to shortage of stock and loss of sales

External:

• This is the money raised from outside the business. It includes

Short Term Bank overdraft:

• Bank overdraft is a facility given by banks to its business customers, people having current accounts. Through this facility the customers can overdraw their accounts to a greater value than the balance in the account. To overdrawn amount is agreed in advance with the bank manager. The bank assigns a limit to overdraw from the account and the business can meet its short term liabilities by writing cheques to the extent of limit allowed.

• Advantage• No need for collaterals or security.• More flexible and the overdraft amount can be adjusted every month

according to needs.• Disadvantage• Interest rates are usually variable and higher than bank loans.• Cash flow problems can arise if the bank asks for the overdraft to be repaid at

a short notice.

Trade Credit:• Usually in business dealing supplier give a grace period to

their customers to pay for the purchases. This can range from 1 week to 90 days depending upon the type of business and industry.

• Advantage• No interest has to be paid.• Disadvantage• The business may not get cash discounts.• By delaying the payment of bills for goods or services

received, a business is, in effect, obtaining finance which can be used for more important expenditures.

Medium TermHire purchase or Leasing:

• It involves purchasing an asset paying for it over a period of time. Usually a percentage of the price is paid as down payment and the rest is paid in installments for the period of time agreed upon. The business has to pay an interest on these installments.

• Leasing involves using an asset, but the ownership does not pass to the user. Business can lease a building or machinery and a periodic payment is made as rent, till the time the business uses the assets. The business does not need to purchase the asset.

• Advantage• The business can benefit from the asset without

purchasing it.• Usually the maintenance of the asset is done by the

leasing firm.• Disadvantage• The total cost of leasing may end up higher than the

purchasing of asset

Medium term bank loan: A bank loan for 1 year to 5 years

Long term Bank loan or Issue of share:

• borrowing from bank for a limited period of time. The business has to pay an interest on the borrowing. This interest may be fixed or variable. Businesses taking loan will often have to provide security or collateral for the loan.

• It is a permanent source of finance but only available to limited companies. Public limited companies can sell further shares up to the limit of their authorized share capital. Private limited companies can sell further shares to existing shareholders.

• Advantage• Permanent source of capital.

In case of ordinary shares business will only pay dividends if there is a profit.

• Disadvantage• Dividends have to be paid to the shareholders.

Debentures:

• A debenture is defined as a certificate of acceptance of loans which is given under the company's stamp and carries an undertaking that the debenture holder will get a fixed return (fixed on the basis of interest rates) and the principal amount whenever the debenture matures. It is issued for a long periods of time. Debentures are generally freely transferrable by the debenture holder. Debenture holders have no voting rights and the interest given to them is a charge against profit.

Sales and lease back:

• This involves a firm selling its assets or property to an investment company and then leasing it back over a long period of time. The business thus can use the asset without purchasing it and can use the revenue earned from its sale for other purposes.

What is Working Capital?

• Working Capital is the cash available to the business for carrying out its day to day activities. It might include paying for labour wages, purchasing stock, paying short term creditors etc.

• A healthy working capital position is a measure of both a company's efficiency and its short-term financial health.

• The working capital ratio is calculated as:

Working Capital = Current Assets – Current Liabilities

• Positive working capital means that the company is able to pay off its short-term liabilities.

• Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory).

Importance of Working Capital• If a company's current assets do not exceed its current liabilities, then it

may run into trouble paying back creditorsin the short term. The worst-case scenario is bankruptcy.

• A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company's sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller.

• Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations.

Working Capital Management

Maintaining a stable working capital position in the business depends on the following factors• Cash management• Inventory management• Debtors management• Short term finances