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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
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In this chapter

  1. 1Start-up capital
  2. 2Additional working capital
  3. 3Capital for expansion
  4. 4Short-term and long-term finance
  5. 5Internal and external sources
  6. 6Bank loans, shares and leasing
  7. 7Short-term and long-term finance
  8. 8Microfinance
  9. 9Crowdfunding
  10. 10Factors in choosing a source
  11. 11Recommending and justifying a source

1. Start-up capital

Start-up capital is the finance a new business needs before it can trade. It buys what the business must have from day one, such as equipment and machinery.

A new business has no regular cash inflows yet, so it also needs working capital to pay its expenses.

Examiner insight

“Stronger candidates went on to apply the reason to the business in the case, for example, by recognising that this is a new business which needed working capital to pay expenses before they had regular cash inflows or that the business produced mobile phone covers.” “Weaker candidates needed to go beyond giving a reason with a generic example or gave the same reason twice, such as expenses to pay for wages and raw materials.”

Worked example 14 marks

Kofi is opening Lens & Light, a wedding photography studio. He has no lighting equipment, and he must pay rent on the studio before his first customer pays him. Outline two reasons why Kofi needs finance to start his business.

  1. 1

    Knowledge: to buy the equipment the business needs before it can trade. [1]

  2. 2

    Application: Kofi has no lighting equipment for his wedding photographs. [1]

  3. 3

    Knowledge: to provide working capital to pay expenses before cash inflows are regular. [1]

  4. 4

    Application: the rent on the studio is due before Kofi's first customer pays him. [1]

2. Additional working capital

Working capital is the funds used to pay day-to-day expenses, such as wages and raw materials. It is also there for use in emergencies.

A business needs additional working capital when expenses must be paid before cash comes in. Enough of it means there is no cash flow problem. A lack of working capital is one reason why a business might fail.

Examiner insight

“A common mistake was to assume working capital is the day-to-day costs rather than the funds used to pay them.” “Many candidates provided two examples of expenses which could be paid by a hairdresser. Such answers gained a maximum of 2 marks as they illustrated one reason.”

Worked example 14 marks

Asha runs Curl Up, a hairdressing salon with three stylists. Outline two reasons why Curl Up needs working capital.

  1. 1

    Knowledge: to pay day-to-day expenses. [1]

  2. 2

    Application: for example, the wages of the three stylists. [1]

  3. 3

    Knowledge: for use in emergencies. [1]

  4. 4

    Application: for example, replacing a hairdryer that breaks during the day. [1]

3. Capital for expansion

Capital for expansion pays for a business to grow, for example by opening another factory. It buys non-current assets, such as new equipment, new machinery or new premises.

These purchases are very expensive, so a business may spread the repayments over a few years.

A growing business often needs both kinds of finance. Capital for expansion pays for the new asset. Additional working capital gets the new site up and running.

Examiner insight

“Long-term finance might be needed for the restaurants that needed to update ovens and cooking equipment. This would be very expensive.”

Worked example 16 marks

Maya owns Spice Route, a café that is always full. She plans to open a second café across town. Its kitchen equipment will cost $60 000, and she must employ four new staff. Explain two reasons why Maya needs finance to open the second café.

  1. 1

    Knowledge: capital for expansion buys non-current assets. [1]

  2. 2

    Application: the $60 000 of kitchen equipment for the second café. [1]

  3. 3

    Analysis: this is very expensive, so Maya needs finance with repayments spread over a few years. [1]

  4. 4

    Knowledge: additional working capital pays day-to-day expenses. [1]

  5. 5

    Application: the wages of the four new staff. [1]

  6. 6

    Analysis: the second café has no regular cash inflows at first, so without working capital Maya cannot pay the staff and the café cannot open. [1]

4. Short-term and long-term finance

Short-term finance is needed to pay day-to-day expenses and to solve cash flow problems. Long-term finance is needed for expansion and for buying non-current assets.

The difference is what the finance is for. Paying wages every week is a short-term need. Updating ovens and cooking equipment is a long-term need.

Match the finance to the need. A short-term source, such as an overdraft, is not appropriate to pay for a non-current asset.

Examiner insight

“Quite a few candidates were not able to distinguish between short-term and long-term finance.” “Others identified short-term sources, such as overdraft, which are not appropriate to fund capital expenditure.”

Worked example 16 marks

Dara runs Green Gate Bakery, which sells bread to local shops. Her flour supplier wants payment next week, but the shops pay her at the end of the month. Dara is also buying a second oven. Explain one short-term and one long-term finance need of Green Gate Bakery.

  1. 1

    Knowledge: short-term finance pays day-to-day expenses and solves cash flow problems. [1]

  2. 2

    Application: the flour must be paid for next week, before the shops pay Dara. [1]

  3. 3

    Analysis: without it she cannot buy flour, so she cannot bake bread and she loses sales. [1]

  4. 4

    Knowledge: long-term finance is needed to buy non-current assets. [1]

  5. 5

    Application: the second oven that Dara is buying. [1]

  6. 6

    Analysis: an oven is very expensive, so Dara needs to spread the repayments over a few years. [1]

Recap

  • Start-up capital: finance a new business needs to buy what it must have before it can trade.
  • Working capital: the funds used to pay day-to-day expenses and for use in emergencies.
  • Capital for expansion: finance to grow, used to buy non-current assets.
  • Short-term finance: day-to-day expenses and cash flow problems.
  • Long-term finance: expansion and non-current assets.
  • Two examples of one reason earn one knowledge mark.
  • Every answer names the business and what the finance pays for.

5. Internal and external sources

An internal source of finance comes from inside the business. Examples are retained profit and the sale of non-current assets.

An external source comes from outside the business. Examples are a bank loan, a share issue, crowdfunding, leasing and government grants.

A new business has not yet made a profit. It has no retained profit and no non-current assets to sell, so these sources are not open to it. The most common answers for a new business are a bank loan and the owner’s own savings.

Examiner insight

“A common error was to identify external sources of finance which the question excluded.” “Some ignored the fact that this was a new business and therefore did not have access to some sources such as retained profits.”

Worked example 12 marks

Greenway Garden Supplies has traded for 20 years and wants to expand its shop. Identify two internal sources of finance Greenway could use.

  1. 1

    Knowledge: retained profit, built up over twenty years of trading. [1]

  2. 2

    Knowledge: the sale of non-current assets, such as an old delivery van. [1]

6. Bank loans, shares and leasing

A bank loan can raise a large amount and is repaid over time. Interest is charged, so repayments raise the business’s expenses.

A share issue is open only to a limited company. The money does not have to be repaid, so it is permanent capital. The original owners share ownership with the new shareholders.

With leasing, the business pays to use an asset without finding a large cash sum. The leasing company can look after the asset. At the end the business owns nothing to sell.

Examiner insight

“Others identified short-term sources, such as overdraft, which are not appropriate to fund capital expenditure.” “Less successful responses showed some confusion about leasing, for example stating that PPE was leasing out its own equipment.”

Worked example 16 marks

KYX is a public limited company. It manufactures beds in country Y. Country Y has experienced economic growth and demand for KYX’s beds increased by 30% last year. KYX’s managing director plans to open another factory in country Y. She will also need to decide on an external source of finance to fund the new factory. Explain two external sources of finance KYX could use to fund the new factory.

  1. 1

    Knowledge: a bank loan is an external source of finance. [1]

  2. 2

    Analysis: it can raise a large amount, enough to pay for a factory. [1]

  3. 3

    Application: country Y has economic growth and demand for KYX’s beds increased by 30%, so borrowing the full amount now is beneficial. [1]

  4. 4

    Knowledge: a share issue is an external source of finance. [1]

  5. 5

    Application: KYX is a public limited company, so it is able to sell shares. [1]

  6. 6

    Analysis: shares do not have to be paid back, so there is no interest to pay. [1]

7. Short-term and long-term finance

Short-term finance pays day-to-day expenses and solves cash flow problems. An overdraft and trade credit are examples.

Long-term finance pays for expansion and for buying non-current assets. It is debt, such as a bank loan, or equity, such as a share issue. Loan repayments can be spread over several years.

Match the source to the need. A short-term source such as an overdraft is not appropriate to fund capital expenditure. A long-term source such as selling shares does not solve a short-term cash flow problem.

Examiner insight

“Some candidates switched the reasons for short-term finance with those of long-term finance.” “A typical error was to confuse the term overdraft with a bank loan.”

Worked example 14 marks

Tilda’s Tea Rooms has low takings in winter, but wages are paid every week. The owner also plans to buy new ovens. Explain why Tilda’s Tea Rooms might use an overdraft and a bank loan.

  1. 1

    Knowledge: an overdraft is short-term finance for day-to-day expenses. [1]

  2. 2

    Application: it lets Tilda pay wages on time in winter when takings are low. [1]

  3. 3

    Knowledge: a bank loan is long-term finance for buying non-current assets. [1]

  4. 4

    Application: repayments for the new ovens can be spread over several years. [1]

8. Microfinance

Microfinance offers small loans to people on a low income. The money is not provided by traditional banks.

It is an external source. It matters because new businesses may have access to fewer sources of finance. Give the whole phrase: ‘small loans’ alone is too vague.

Examiner insight

“A common error was to state that governments would give bank loans or provide microfinance.” “Better answers understood that microfinance involved offering small loans to people on a low income.”

Worked example 12 marks

Nadia sells hand-woven baskets from a market stall. She lives on a low income and needs a small sum to buy cane. Explain one reason why microfinance might suit Nadia.

  1. 1

    Knowledge: microfinance offers small loans to people on a low income. [1]

  2. 2

    Application: Nadia lives on a low income and needs only a small sum to buy cane for her baskets. [1]

9. Crowdfunding

Crowdfunding raises money from the public through a crowdfunding site. Its advantages are no or low interest, no need for collateral or a credit history, and the chance to test public reaction to the idea. It can also build customer relationships.

Its main disadvantage is that there is no guarantee of raising the full amount. If the target is missed, everyone must be repaid and another source is needed. The site may reject the proposal or take a percentage of the funds, and competitors can learn about the idea.

Crowdfunding matters because it may be available when other sources of finance are not.

Examiner insight

“Some answers lacked precision. For example, answers about easy to arrange, large amount or low cost were too vague.” “Another common mistake was to compare crowdfunding to other sources of finance which was unnecessary.”

Worked example 16 marks

Peter wants to start up a small business as a photographer who takes photographs at weddings. Peter will operate his business as a sole trader. He is considering using crowdfunding as a source of finance. Explain one advantage and one disadvantage to Peter of using crowdfunding as a source of finance.

  1. 1

    Knowledge (advantage): no or low interest is charged. [1]

  2. 2

    Analysis: so it does not increase cash outflows. [1]

  3. 3

    Application: this helps Peter, who is a sole trader. [1]

  4. 4

    Knowledge (disadvantage): no guarantee that the full amount is raised. [1]

  5. 5

    Analysis: everyone must be repaid if the full amount is not raised, so Peter may need to find another source. [1]

  6. 6

    Application: his wedding photography business is new, so a shortfall could stop it starting up. [1]

10. Factors in choosing a source

The syllabus lists the main factors: the size and legal form of the business, the amount required, the length of time the finance is needed and existing loans. Examiners also name the interest rate.

Legal form matters because a limited company can sell shares and a partnership cannot. Existing loans matter because a high level of debt can make it difficult to gain more loans, or can lead to cash flow problems.

The question asks for factors, not sources. Each factor needs an explanation of how it changes the choice between sources.

Examiner insight

“A common mistake was to identify sources of finance as the analysis point rather than explain why factors such as interest rate and amount would influence the choice of finance being considered.” “However, only stronger candidates could explain how these factors affected the choice of which source of finance to use.”

Worked example 16 marks

Kestrel Joinery is a partnership of two carpenters and has traded for three years. The partners need textdollar8 000 for a new saw. Explain two factors the partners should consider when choosing a source of finance.

  1. 1

    Knowledge: the amount required is a factor. [1]

  2. 2

    Application: textdollar8 000 for one saw is a small sum, so Kestrel does not need a source that raises a large amount. [1]

  3. 3

    Analysis: borrowing more than is needed would mean paying interest on money the partners do not use. [1]

  4. 4

    Knowledge: the legal form of the business is a factor. [1]

  5. 5

    Application: Kestrel is a partnership, so it cannot sell shares. [1]

  6. 6

    Analysis: that rules out a share issue, so the choice is between sources such as retained profit and a bank loan. [1]

11. Recommending and justifying a source

A recommendation chooses one source and gives a reason for the choice. It then explains why the alternatives are rejected, without repeating earlier points.

Weigh each option against the business: the amount needed, how long it is needed, the interest to pay and who owns the business afterwards.

A description of a source is not a recommendation. The source must be judged for the named business.

Examiner insight

“Evaluation for the majority of candidates was generally unsuccessful and was a repeat of the points stated earlier in the answer.” “Better responses included a recommendation that justified one method, such as a bank loan, giving a reason for this choice without simply repeating earlier points and then justified why the alternative methods were rejected.”

Worked example 112 marks

Manuel owns Delta Coaches, a private limited company that runs school trips. Retained profit stands at textdollar20 000. He wants to buy two coaches costing textdollar180 000 in total. He can take a bank loan for the full amount at 6% interest a year, or sell shares to a family friend. Justify which source of finance Manuel should choose.

  1. 1

    Knowledge: a bank loan is a long-term external source for buying non-current assets. [1]

  2. 2

    Application: two coaches at textdollar180 000 cost far more than the textdollar20 000 of retained profit. [1]

  3. 3

    Analysis: the loan can raise the full amount, so both coaches are bought at once and more school trips can be run. [2]

  4. 4

    Analysis: interest is 0.06 × 180 000 = textdollar10 800 a year, and the repayments raise Delta’s expenses. [2]

  5. 5

    Knowledge: shares are permanent capital with no repayment. [1]

  6. 6

    Application: Delta is a private limited company, so it can sell shares to the family friend. [1]

  7. 7

    Analysis: there is no interest to pay, but Manuel would share ownership and lose some control of Delta. [2]

  8. 8

    Evaluation: I recommend the bank loan. The textdollar10 800 a year stops when the loan is repaid, and Manuel still owns all of Delta. [1]

  9. 9

    Evaluation: shares are rejected. They save the interest, but the friend’s share of ownership never ends. [1]

Recap

  • Internal sources come from inside the business: retained profit, sale of non-current assets. External sources come from outside: bank loan, share issue, leasing, crowdfunding.
  • Short-term finance pays day-to-day expenses (overdraft, trade credit). Long-term finance pays for expansion and non-current assets (bank loan, shares).
  • Microfinance offers small loans to people on a low income. Stating that governments provide it is an error.
  • Crowdfunding: no or low interest, but no guarantee of raising the full amount.
  • Factors: size and legal form, amount required, length of time, existing loans. Name factors, not sources.
  • Recommend one source with a reason, then reject the alternatives. Do not repeat earlier points.
  • Apply every point to the named business.

End-of-chapter exercise

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

  1. Define 'working capital'.2 marks
  2. Ife owns a business that makes candles by hand. State two reasons why a business such as Ife's might need finance.2 marks
  3. Okoro Print pays its staff every Friday. State whether paying these wages is a short-term or a long-term finance need. Give a reason for your answer.2 marks
  4. Tunde is starting Fresh Wheels, a mobile car-wash business. He will wash cars at his customers' homes. He has no pressure washer, and he must buy fuel and cleaning products before any customer pays him. Outline two reasons why Tunde needs finance to start Fresh Wheels.4 marks
  5. Laila sells jewellery online through her business, Gem Gate. Orders have doubled. She pays her suppliers when she orders stock, but her customers pay when their parcel arrives. Outline two reasons why Gem Gate needs additional working capital.4 marks
  6. Sam runs Zest Juice Bar and is opening a second bar. He must buy a juicing machine for $8 000. He must also pay two new workers every week from the day the bar opens. Explain one short-term and one long-term finance need of Zest Juice Bar.6 marks
  7. Nia owns Cedar Joinery, which makes wooden tables. She plans to buy a cutting machine for $25 000. A friend tells her that short-term finance is the best way to pay for it. Do you think Nia's friend is right? Justify your answer.6 marks
  8. Rosa is starting Petal Post, a flower delivery business. She needs a delivery van, and she must buy fresh flowers every morning. Her customers are shops that pay at the end of each month. Rosa says that start-up capital for the van is the only finance she needs. Do you think Rosa is right? Justify your answer.6 marks
  9. Tide Line runs passenger ferries to three islands. It earns 80% of its revenue in four summer months, but it pays crew wages and fuel bills in every month. The engine of one ferry is 20 years old and must be replaced now, at a cost of $900 000. The owner says: 'The engine is urgent, so it is a short-term need. Wages go on for years, so they are a long-term need.' Explain why the owner is wrong about both finance needs.8 marks
  10. Karim owns Atlas Tiles, which cuts floor tiles and sells them to builders. He pays his tile suppliers within 30 days, but the builders pay him after 60 days. Orders have risen by 40% this year, and twice he has paid his suppliers late. Karim has 50 000 in the bank and two options. Option A is to spend40 000 on a second tile-cutting machine. Option B is to keep all of the cash as additional working capital. Consider both options. Which option should Karim choose? Justify your answer.12 marks
  11. Brightway Laundry has traded for 15 years and needs more money to buy washing machines. Define ‘external source of finance’.2 marks
  12. Zara is a sole trader who is about to open a new nail bar. Identify two sources of finance she could use.2 marks
  13. Ravi repairs bicycles at a roadside stand and lives on a low income. He needs a small loan to buy tools. Explain one reason why microfinance is suitable for Ravi.2 marks
  14. Ridge Bakery wants to buy a delivery van costing textdollar30 000. The owner suggests using an overdraft. Explain why a bank loan suits this purchase better than an overdraft.4 marks
  15. Sunrise Taxis leases five cars from a leasing company. Outline one advantage and one disadvantage of leasing to Sunrise Taxis.4 marks
  16. Mei is opening a board-game café in a town that has never had one. She must pay rent for three months before it opens. She is using crowdfunding. Outline two advantages of crowdfunding to Mei.4 marks
  17. Okafor Printing has made a profit for 12 years. It wants a printing press costing textdollar60 000 and has textdollar25 000 of retained profit. Explain one advantage and one disadvantage to Okafor Printing of using retained profit.6 marks
  18. Greenfield Gym is a sole trader that already has a bank loan of textdollar40 000. The owner needs textdollar15 000 for running machines and wants to repay it over four years. Explain two factors the owner should consider when choosing a source of finance.6 marks
  19. Harbour Ferries is a private limited company. It needs textdollar12 000 to pay for fuel in March, before ticket income of textdollar45 000 arrives in April. It also needs textdollar300 000 for a new ferry that it will use for 15 years. The finance director suggests an overdraft for the ferry and a share issue for the fuel. Do you agree with the finance director? Justify your answer.8 marks
  20. Coral Divers is a partnership of two diving instructors. It already has a bank loan of textdollar50 000. The partners want a dive boat costing textdollar80 000. Retained profit is textdollar20 000 and grows by textdollar20 000 a year. They can take a second bank loan of textdollar80 000 at 8% interest a year, lease the boat for textdollar1 400 a month for five years, or wait until retained profit covers the cost. Justify which option the partners should choose.12 marks

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