reasons why businesses need finance to start up, to grow and to survive

5 Business Finance – Full AS‑Level Coverage (9609)

Learning Objectives

• Explain why businesses need finance at the start‑up, growth and survival stages.
• Distinguish between cash and profit and describe the impact of insufficient finance.
• Calculate and manage working capital and produce basic cash‑flow forecasts.
• Identify and evaluate internal and external sources of finance required by the syllabus.
• Analyse the factors that influence the choice of finance.
• Apply a systematic approach to selecting the most appropriate source of finance.

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5.1 The Need for Business Finance

Why finance is required – three‑stage framework

• Start‑up – finance needed to:
  • Purchase fixed assets (e.g., plant, machinery, premises).
  • Cover pre‑operational costs such as licences, market research and staff recruitment.
  • Provide initial working capital for stock, raw materials and cash‑buffer.
  • Establish a credit history with suppliers and lenders.
• Growth – finance needed to:
  • Expand production capacity (new plant, additional equipment).
  • Introduce new products or services and enter new markets.
  • Finance acquisitions or strategic partnerships.
  • Meet higher working‑capital requirements as sales volumes increase.
• Survival – finance needed to:
  • Cover cash‑flow gaps caused by seasonal fluctuations or delayed receivables.
  • Pay for unexpected costs (equipment breakdowns, legal expenses).
  • Refinance existing debt that is becoming unaffordable.
  • Invest in efficiency measures that can restore profitability.

Cash versus profit

Profit shows whether the business makes a surplus after all expenses have been deducted from revenue. Cash shows whether money is actually available to meet immediate obligations.

Profit ≠ Cash. A business can be profitable on the income‑statement but still fail if it cannot meet its short‑term cash commitments.

Business failure (syllabus wording)

Failure occurs when a business is unable to meet its liabilities as they fall due, leading to one or more of the following outcomes:

• Bankruptcy – legal declaration of inability to pay debts.
• Liquidation – assets are sold to repay creditors and the company ceases trading.
• Administration – an appointed administrator attempts to rescue the business or achieve a better outcome for creditors.

Consequences of insufficient finance

• Inability to purchase essential inputs → production stoppage.
• Late payments to suppliers → loss of trade credit and strained relationships.
• Default on loan repayments → legal action, increased borrowing costs or bankruptcy.
• Damage to reputation → loss of customers and market share.

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5.2 Working Capital

5.2.1 Components of Working Capital (ordered as per syllabus)

Component	Definition	Typical Management Issue
Inventory	Raw materials, work‑in‑progress and finished goods held for sale.	Too much ties up cash; too little can cause stock‑outs.
Accounts Receivable	Money owed by customers for credit sales.	Long credit periods increase cash‑conversion time.
Accounts Payable	Money owed to suppliers.	Delaying payments improves cash but may damage supplier relationships.
Cash & Bank	Liquid funds available for day‑to‑day payments.	Maintaining an adequate buffer for emergencies.

5.2.2 Working‑Capital Management

• Inventory – aim to minimise cash tied up while avoiding stock‑outs (e.g., just‑in‑time ordering).
• Receivables – shorten the credit period, tighten credit controls and use factoring where appropriate.
• Payables – negotiate longer credit terms without harming supplier goodwill; use trade credit strategically.
• Cash & Bank – keep a minimum cash reserve (often a % of monthly outflows) to meet unexpected expenses.

Net Working Capital (NWC)

NWC = Current Assets – Current Liabilities

A positive NWC indicates the business can meet its short‑term obligations; a negative NWC signals potential liquidity problems.

Cash‑Conversion Cycle (optional extra)

CCC = Inventory Period + Receivables Period – Payables Period

Shortening the CCC frees up cash and reduces the need for external finance. (Not required by the syllabus – included for extension.)

Illustrative Working‑Capital Calculation

Assume a small manufacturing firm has:

• Inventory: £45,000
• Receivables: £30,000
• Cash: £10,000
• Payables: £25,000

Net Working Capital = (£45,000 + £30,000 + £10,000) – £25,000 = £60,000.

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5.3 Sources of Finance

5.3.1 Internal Sources

Source	Typical Use	Cost (opportunity/interest)	Control Implications
Owner’s Capital / Savings	Start‑up set‑up costs, early working capital	Opportunity cost of funds (usually low)	Full control retained
Retained Earnings	Re‑investment for growth or equipment replacement	No explicit interest; opportunity cost	No dilution of ownership
Sale‑and‑Lease‑Back	Release cash tied up in owned assets	Lease payments (interest component)	Asset ownership transferred to lessor

5.3.2 External Sources (syllabus‑required)

Source	Typical Use	Cost (interest/dividend)	Control Implications	Short‑/Long‑Term
Bank Overdraft	Short‑term cash‑flow gaps	Variable interest (often high)	No ownership change	Short‑term
Bank Term Loan	Purchase of plant, expansion projects	Fixed or variable interest	No ownership change	Long‑term (1‑10 years)
Hire‑Purchase	Acquisition of equipment without large cash outlay	Interest embedded in instalments	Ownership usually transfers at end	Medium‑term
Leasing (Operating)	Use of equipment for a fixed period	Rental charge (interest component)	Ownership remains with lessor	Medium‑term
Debentures (Corporate Bonds)	Large‑scale capital projects	Fixed interest, generally lower than bank loans	No dilution of ownership	Long‑term
Equity Finance – Share Capital	Major growth, R&D, market entry	Dividends (if declared) – no mandatory interest	Shares dilute existing ownership and voting rights	Long‑term
Venture Capital / Angel Investors	High‑risk start‑ups, innovative products	High expected return (usually via equity)	Significant control & strategic input	Medium‑ to long‑term
Trade Credit	Short‑term purchase of stock/materials	Usually interest‑free if paid within agreed period	No ownership change; supplier relationship critical	Short‑term
Factoring / Invoice Discounting	Accelerate cash from receivables	Discount fee (typically 1‑3 % of invoice value)	No ownership change; may affect customer relationships	Short‑term

Optional modern sources (extension only)

• Crowd‑funding
• Government grants & subsidies
• Micro‑finance

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5.4 Factors Affecting the Choice of Finance

• Cost of finance – interest rate, dividend expectations, fees.
• Flexibility – ability to vary repayments, early‑repayment penalties.
• Control – impact on ownership, voting rights, strategic direction.
• Purpose of finance – working capital versus long‑term investment.
• Security requirements – collateral needed, asset‑backed vs. unsecured.
• Existing debt levels – covenant restrictions, debt‑to‑equity ratio.
• Market conditions – prevailing interest rates, investor appetite.
• Time to obtain finance – speed of approval, administrative burden.

Decision‑Matrix Example

Criteria	Bank Loan	Equity (Shares)	Trade Credit
Cost (interest/dividend)	Medium	Low (no mandatory dividend)	Low (often 0 % if paid on time)
Flexibility	Low (fixed repayments)	Medium (no repayment schedule)	High (pay when cash allows)
Control	None	Shares dilute ownership	None
Purpose suitability	Capital equipment	Large growth projects	Short‑term inventory purchase

Mini‑Case Study (Growth Project)

XYZ Ltd wants to launch a new product line costing £500,000. The management considers two options:

1. Bank term loan at 6 % p.a. for 5 years.
2. Issue new ordinary shares worth £500,000 (current share price £5, 100,000 new shares).

Using the decision matrix, students should evaluate:

• Cost – interest expense versus potential dividend expectations.
• Control – dilution of existing shareholders.
• Purpose – suitability of equity for a long‑term growth venture.

Students then justify the preferred source with reference to the criteria above.

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5.5 Selecting the Source of Finance – A Structured Approach

1. Identify the specific financial need – amount, timing and purpose.
2. Quantify the amount required – include all cash outflows and a contingency buffer.
3. Short‑list feasible sources – based on the business stage (start‑up, growth, survival) and internal policy.
4. Apply selection criteria – cost, flexibility, control, security, time to obtain.
5. Use a weighted scoring model – assign weights to each criterion, score each source, calculate the total.
6. Make a justified recommendation – state the chosen source and any conditions (covenants, performance targets).
7. Implement and monitor – set up repayment schedules, review cash‑flow forecasts regularly.

Weighted Scoring Example

Criterion (Weight)	Bank Loan (Score)	Equity (Score)	Trade Credit (Score)
Cost (30 %)	8	6	9
Flexibility (20 %)	5	8	9
Control (25 %)	10	4	10
Time to obtain (15 %)	6	7	9
Security required (10 %)	7	9	10
Total Weighted Score	7.2	6.0	9.3

In this example trade credit scores highest, indicating it is the most suitable short‑term source for the given criteria.

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5.6 Cash‑Flow Forecasting & Management

Simple Cash‑Flow Forecast Template

Month	Opening Balance (£)	Cash Inflows (£)	Cash Outflows (£)	Closing Balance (£)
Jan	20,000	15,000 (sales)	25,000 (stock + rent)	10,000
Feb	10,000	18,000	22,000	6,000
Mar	6,000	20,000	24,000	2,000
Apr	2,000	30,000	26,000	6,000

If the closing balance falls below a pre‑determined minimum (e.g., £5,000), the business should arrange short‑term finance (overdraft, loan) to bridge the gap.

Seasonal Cash‑Flow Gap Example

A retailer expects a £40,000 cash deficit in December due to high inventory purchases for the festive season. An overdraft of £50,000 at 7 % p.a. is arranged, providing a safety margin and covering the temporary shortfall.