the distinction between short and long term need for finance

5.1 Business Finance – The Need for Finance

Learning Objectives

• Explain why businesses need finance and distinguish between short‑term and long‑term needs.
• Understand the cash‑vs‑profit distinction.
• Define working capital, calculate a working‑capital requirement and recognise the difference between capital and revenue expenditure.
• Identify appropriate sources of short‑term and long‑term finance and match them to the specific need.
• Evaluate the factors that influence the choice of finance.

5.1.1 Why Do Businesses Need Finance?

Finance is required whenever a business wants to turn an idea into a cash‑generating operation. The main reasons are:

• Start‑up capital – purchase of land, plant, equipment and covering the first months of operating costs.
• Capital (investment) expenditure – acquisition of fixed assets (machinery, buildings, vehicles) that will be used for several years.
• Revenue (operating) expenditure – day‑to‑day costs such as stock, wages, utilities, rent and marketing.
• Research & Development (R&D) – creation of new products or improvement of processes.
• Business expansion – opening new branches, entering overseas markets or increasing production capacity.
• Cash‑flow management – covering seasonal gaps, paying suppliers before customers pay, or dealing with unexpected emergencies (equipment breakdown, legal claims).

Cash vs. Profit

• Cash is the actual money that flows in and out of the business. It is needed to meet immediate obligations (pay salaries, suppliers, rent, etc.).
• Profit is the difference between total revenue and total expenses over an accounting period. A business can be profitable but still run out of cash if receipts are delayed.
• Both are essential: profit shows long‑term viability, cash ensures the business can survive day‑to‑day.

Financial Distress & Business Failure

• Insufficient cash → inability to pay creditors.
• Persistent cash‑flow shortages can lead to bankruptcy, liquidation or administration.
• Loss of supplier confidence, tighter credit terms and damage to reputation.

5.1.2 Working Capital

Definition

Working capital is the finance required to fund the day‑to‑day operating cycle of a business.

Formula

Working Capital = Current Assets – Current Liabilities

Components

Current Assets	Current Liabilities
Stock / inventory	Trade payables (amounts owed to suppliers)
Trade receivables (money owed by customers)	Short‑term borrowings (overdrafts, short‑term loans)
Cash & cash equivalents	Accrued expenses (wages, taxes, interest)

Capital vs. Revenue Expenditure

• Capital expenditure creates or enhances a fixed asset and provides benefits for more than one accounting period (e.g., buying a machine).
• Revenue expenditure is incurred in the normal course of business and is fully expensed in the period it occurs (e.g., raw material purchases, wages).

Working‑Capital Requirement – Example

A retailer purchases £50 000 of stock on 30‑day credit, sells it for £80 000 on 60‑day credit. Cash is received 30 days after the sale, but the supplier must be paid after 30 days.

1. Cash outflow to supplier at Day 30 = £50 000.
2. Cash inflow from customers at Day 60 = £80 000.
3. During Days 31‑60 the retailer needs £30 000 (£80 000 – £50 000) to bridge the gap.

Thus the working‑capital requirement for the 30‑day gap is £30 000. The gap can be reduced by:

• Negotiating longer credit terms with the supplier.
• Offering early‑payment discounts to customers.
• Using a short‑term overdraft to cover the temporary shortfall.

5.2 Short‑Term Finance (≤ 12 months)

Typical Uses

• Purchasing raw materials and stock.
• Paying wages, salaries and utility bills.
• Covering seasonal cash‑flow gaps.
• Financing short‑term projects, promotions or urgent repairs.

Sources of Short‑Term Finance

Source	Internal / External	Typical Form	Security
Retained earnings (re‑invested profit)	Internal	Cash reserves	None
Bank overdraft	External	Revolving credit facility	Usually unsecured; may be secured on stock or receivables
Trade credit	External	Supplier‑granted credit terms	None (supplier’s risk)
Factoring	External	Sale of receivables to a factor	Receivables used as security
Short‑term loan	External	Bank or finance‑company loan (≤ 12 months)	Often secured on current assets
Commercial paper	External	Unsecured promissory notes (large firms)	None

Key Characteristics

• High liquidity – can be accessed quickly.
• Generally higher interest rates (reflects liquidity risk).
• Repayment due within a year, often on demand or in instalments.
• Usually unsecured or secured against current assets.

5.3 Long‑Term Finance (> 12 months)

Typical Uses

• Purchasing plant, machinery, land or buildings (capital expenditure).
• Funding large‑scale R&D projects.
• Business expansion – new branches, overseas operations, product diversification.
• Long‑term restructuring or refinancing existing debt.

Sources of Long‑Term Finance

Source	Internal / External	Typical Form	Security
Retained earnings	Internal	Re‑invested profit	None
Equity finance	External	Share issue, venture capital, private equity	Shares – no collateral required
Long‑term loans	External	Bank term loans, debentures	Usually secured on fixed assets or the whole company
Hire purchase & leasing	External	Asset‑finance arrangements	Asset itself serves as security
Corporate bonds	External	Fixed‑interest securities sold to investors	Often secured on company assets

Key Characteristics

• Lower cost of capital over the life of the investment (interest rates usually lower than short‑term rates).
• Repayment spread over many years (commonly 5–20 years).
• Usually secured against fixed assets or the whole company.
• Provides stability for strategic, long‑term planning.

5.4 Comparison of Short‑Term and Long‑Term Finance

Aspect	Short‑Term Finance (≤ 12 months)	Long‑Term Finance (> 12 months)
Typical period	Up to 12 months	More than 12 months (often 5–20 years)
Purpose	Working‑capital needs, cash‑flow gaps	Capital investment, strategic growth
Sources	Overdrafts, trade credit, factoring, short‑term loans, retained earnings	Equity, term loans, debentures, hire purchase, bonds, retained earnings
Interest / Cost	Generally higher (reflects liquidity risk)	Generally lower (reflects longer repayment horizon)
Security	Often unsecured or secured on current assets	Usually secured on fixed assets or whole‑company assets
Repayment	Within a year, on demand or instalments	Spread over many years, fixed schedule
Control	Debt – no dilution of ownership	Equity dilutes ownership; debt retains control

5.5 Factors Influencing the Choice of Finance

• Cost of finance – interest rate, fees, dividend expectations.
• Security requirements – collateral demanded by the lender.
• Control – equity finance may dilute ownership; debt retains control.
• Flexibility – ability to vary repayments, draw down amounts or refinance.
• Risk – fixed repayments (debt) vs. profit‑sharing (equity).
• Time horizon – match the finance to the length of the need (short‑term vs. long‑term).
• Availability – what the market or the business can realistically obtain.
• Impact on financial ratios – e.g., debt‑to‑equity, current ratio, interest‑covering ratio.

5.6 Financial Planning: Matching Finance to Need

1. Identify the purpose of the finance (operational vs. investment).
2. Determine the time horizon required (short‑term ≤ 12 months or long‑term > 12 months).
3. Calculate the amount needed and prepare a cash‑flow forecast.
4. Consider the working‑capital requirement (WC = Current Assets – Current Liabilities).
5. Compare the cost, security, control, flexibility and impact on ratios of each source.
6. Check the business’s existing debt levels and overall risk appetite.
7. Select the most appropriate source and structure the financing accordingly.

5.7 Illustrative Calculations

Working‑Capital Requirement (WCR) Example

Assume a manufacturing firm has the following projected figures for the next month:

• Stock required: £120 000
• Trade receivables (30‑day credit): £80 000
• Trade payables (45‑day credit): £70 000
• Cash & cash equivalents: £20 000

Working capital = (Stock + Receivables + Cash) – Payables

$$\text{WC} = (120{,}000 + 80{,}000 + 20{,}000) - 70{,}000 = £150{,}000$$

The firm therefore needs £150 000 of short‑term finance to cover the operating cycle.

Pay‑Back Period for a Long‑Term Investment

Investment: £150 000 in new machinery
Expected additional cash inflow: £45 000 per year for 5 years

$$\text{Pay‑back period} = \frac{£150{,}000}{£45{,}000} \approx 3.33\text{ years}$$

Since the pay‑back period (3.33 years) is less than the asset’s useful life (5 years), the investment is financially viable and justifies the need for long‑term finance.

5.8 Summary – Key Takeaways

• Finance is required for both cash (day‑to‑day operations) and profit (long‑term viability).
• Working capital bridges the gap between cash outflows and inflows; it is the core of short‑term finance.
• Short‑term finance meets immediate operating needs; long‑term finance funds capital‑intensive, strategic projects.
• Distinguish between capital expenditure (creates a fixed asset) and revenue expenditure (consumed within the period).
• Choosing the right source depends on cost, security, control, flexibility, risk, time horizon and availability.
• Effective financial planning aligns the type and amount of finance with the specific business need, minimising cost and the risk of financial distress.