Theme 2: Managing business activities
2.1 Raising finance
2.1.1 Internal finance
A) Owner's capital: personal savings
Owner's capital - Shows the stake the owner has in the business - also known as owner's equity. The
owner may have used a redundancy pay out of their own personal savings to start the business. For
limited companies, owner's capital is share capital.
Advantages:
Doesn't have to be paid back - reduces pressure on a business.
Lowers cost of a business.
No interest charged.
Disadvantages:
May not be sufficient.
Personal savings - Appropriate source of finance for a sole trader/partnership. The amount of finance
raised using this method depends on the personal savings of the owner.
B) Retained profit
Retained profit - Profits that can be reinvested in order to help the business grow. Appropriate source of
finance for all types of business so long as the business is profitable and hasn’t recently started up.
Advantages:
No interest to pay.
Nothing to pay back.
Not giving up ownership and therefore control is retained.
Disadvantages:
Often insufficient on its own in terms of expansion prospects.
Once used = gone.
May not be profitable so don’t have any.
C) Sale of assets
Asset sales - Selling items that the business already owns (e.g. machinery, land, premises, vehicles etc.).
Appropriate source of finance for all types of business so long as they are not a start-up (since the
business would have no assets).
Advantages:
Used as collateral to help gain loans.
No interest to pay.
Nothing to pay back.
Disadvantages:
An efficiently run business may not have any assets to sell.
May not generate sufficient finance for a business to pursue their objectives.
,No longer have the benefit of that asset - business looks less attractive to investors (will not appear on
balance sheet).
2.1.2 External finance
A) Sources of finance: family and friends, banks, peer-to-peer funding,
business angels, crowdfunding, other businesses
Family and friends - Capital gained from the owners family/friends, most likely used by a sole trader or
partnership.
Advantages:
Family and friends may be more lenient with repayments - may not even expect interest.
Disadvantages:
May cause tension and problems if the finance is not repaid, or if it isn't used in a sensible way.
Banks - May lend a loan to a business to start-up or grow and may provide a business with an overdraft
to help with cash-flow problems.
Will ask to see business plan, so they can have assurance their loan will be paid back.
Will ask for security or collateral on a loan against an asset that can be seized if it is not paid
back.
Peer-to-peer funding - Unsecured loans without going through a bank
Student loans.
Payday loans.
Debt factoring - firm sells its debts to a debt factoring company.
Lease agreements.
Business angels - Will take shares in a business in return for providing equity finance. Provide venture
capital to help the business grow, whilst also bringing their experience and advice. Will then follow up
their deal by taking a role on the board or actively supporting the business.
May provide loans but not expect immediate payment.
Look for a high rate of return in a specific period.
Harder to use for start-ups, as business angels often look for a strong business plan and a proven
track record.
Crowdfunding - Large number of people fund a project, each making small investments:
1. Donate - no money paid back, but other rewards like tickets, newsletters or the product itself,
which can often be worth more than the donation itself.
2. Lend - money back with interest and satisfaction of supporting the success of the start-up.
3. Invest - in the business in exchange for equity shares, which prospectively will increase in value.
Other businesses - Finance can be borrowed by other existing businesses as part of a deal with the
owners (e.g. suppliers).
,B) Methods of finance: loans, share capital, venture capital, overdrafts,
leasing, trade credit, grants
(ST or LT) Loans - When a firm borrows a sum of money that must be repaid in fixed, regular instalments
with interest charged on top.
Banks will loan money to small businesses but may not to those that have only just set up, as
they have no proven track record of business/financial activity.
Quick to set up.
Variable interest loan rate - means that if interest goes up, the cost of borrowing will too, and
the business will have to pay back more interest to the bank.
Fixed rate loans - can be arranged by banks to avoid uncertainty.
(LT) Mortgage - Secured, long term loan usually used to buy property, which in turn can be used as
collateral.
Gearing - Measures the proportion of capital invested in a business that is borrowed.
High gearing = considered bad: the business is more at risk of insolvency as it may not be able to
pay back any borrowed funds.
High gearing can discourage banks and new shareholders from investing more into the firm.
Formula:
Gearing = noncurrent liabilities (long-term loans) / capital invested by business* x 100
*Formula:
Capital invested = share capital + noncurrent liabilities
(LT) Share capital - Finance is provided by an individual or organisation in return for part ownership of
the business.
Not used to fund the short-term purchase of raw materials.
Only used by limited companies.
Some form of ownership is given up - no capital needs paying back.
(LT) Venture capital - Large sums of capital and advice will be invested in return for shares - also known
as equity finance.
(ST) Overdrafts - When a bank allows an individual or organisation to draw out more money than they
have in their bank account.
Used to deal with cash-flow problems.
High charges/interest rates. This interest is charged on a daily basis, so if overdraft is used
effectively in the short-term, it can be more cost-efficient.
(ST or LT) Leasing - Renting the use of an item (e.g. vans, photocopiers, premises, equipment etc.).
Used as a business grows (needs more equipment).
Leasing allows equipment to be updated regularly.
Do not own equipment, however, the firm leasing usually never pays for repairs.
(ST) Trade credit - When a supplier allows a firm to have supplies (stock) but invoices (bills) them and
allows payment at a later date.
Supplier gives the buyer a certain deadline to pay i.e. 30, 60, 90 days.
Buyer can then sell goods in their shop before they have to pay for them.
Wholesaler may give the buyer a discount when they use cash.
,Grants - Firms can sometimes qualify for a sum of cash that does not have to be repaid.
Government/EU may provide financial help to a business to overcome employment problems.
Does not need repaying.
Owners keep full control of the business - no change to business structure.
Reasons for raising finance:
To buy stock (trade credit).
To pay bills and wages.
To pay debts (consolidation loan, which may pay off suppliers).
To overcome a slow trading period (overdraft).
To expand (long-term finance i.e. bank loan).
Choosing a source/method of finance:
The reason for raising finance (payment for fixed assets i.e. equipment and buildings must come
from long-term sources of finance; day-to-day expenses require working capital - overdraft or
personal finance is more appropriate; stock = overdraft or trade credit).
The legal structure of the business (limited companies can sell shares, whereas sole traders or
partnerships may have to rely on internal finance).
The amount of finance required (larger sums = less chance of personal sources i.e. savings, so
loans or share capital may be applicable; banks may want to see the receiver of a loan take risk,
so a loan can often be combined with personal sources to show this).
The profit levels of the business (profitable firms have more retained profit, so may not need
help from external sources; less profitable firms must look for alternative sources).
The level of risk (risky businesses will find difficulty in borrowing, but a venture capitalist may
take that risk).
The views of the owner (owners who want control are less likely to seek venture capital or share
capital; owners have personal preferences based on their past experiences with obtaining
finance).
2.1.3 Liability
A) Implications of limited and unlimited liability
Limited liability - The most a shareholder/investor can lose is the original amount they invested in the
business. Therefore, the owner only loses the value of their investment.
Protects the owner.
Encourages people to invest.
Does not protect against wrongful/fraudulent trading or when personal assets have been
guaranteed.
Also known an incorporated business.
Implications of limited liability - :
Significantly reduces the risk faced by shareholders (owners) - allows a business to raise more
finance.
Separate legal identities - sued separately.
Separate assets owned by owner and business.
, Can sell parts of a business (shares) to shareholders.
Protection of owner's personal assets - cannot be made to sell personal possessions, so only
losing their original investment.
Registered with companies house as ltd or plc.
Unlimited liability - Owners of a business are personally responsible for the debts of the business should
it fail. Therefore, the owner may be forced to sell their personal possessions to pay off any business
debts.
Also known as an unincorporated business.
Implications of unlimited liability - :
Sole traders/partnerships may have to sell their own assets to pay debts.
Unable to sell shares.
Can secure other sources of finance - demonstrating to a bank they are prepared to risk their
own finances.
No distinction between owner and the business.
B) Finance appropriate for limited and unlimited liability businesses
Finance appropriate for limited liability businesses - :
Share capital
Venture capital
Retained profit
Sale of assets
Debentures
Leasing
Trade credit
Grants
Loan (secure/unsecured)
Overdrafts
Finance appropriate for unlimited liability businesses - :
Owner's savings
Retained profit
Loan (secured/unsecured)
Peer to peer lending
Grants
Crowdfunding
Trade credit
Overdraft
Sale of assets
Any business operating in a high-risk activity is best to gain limited company status and enjoy limited
liability. Owners/shareholders will be protected should the business become insolvent.
2.1.4 Planning
