the relationship between the form of business ownership and availability of sources of finance

5.1 Business Finance – Why Finance Is Needed

Purpose of finance

• Start‑up finance – purchase of land, plant, equipment, licences, initial working capital.
• Expansion finance – new product development, larger premises, additional staff, overseas markets.
• Working‑capital finance – bridge the gap between cash outflows (payables, wages, rent) and cash inflows (sales receipts).
• Cash‑flow management – ensure the business can meet its short‑term obligations.
• Risk mitigation – finance can be used to hedge against price changes, seasonal demand, or unexpected breakdowns.

Cash versus profit

• Profit = total revenue – total expenses (accounting concept). It shows whether the business is making a surplus over a period.
• Cash is the actual money that flows in and out of the business. A profitable business can still run into cash problems if receipts are delayed or outflows are front‑loaded.
• Example: a retailer sells £100 000 of goods on 60‑day credit. In the month the sales are recorded as profit, but no cash is received until two months later – a cash shortfall may arise.

Working‑capital cycle

Stage	Typical time (days)	Cash impact
Purchase of stock	0‑30	Cash outflow
Holding inventory	30‑60	No cash movement
Sale on credit	0‑30	Revenue recorded, cash not received
Collection of receivables	30‑90	Cash inflow

Common causes of business failure related to finance

• Insufficient working capital – inability to pay suppliers or staff.
• Poor cash‑flow forecasting – unexpected gaps between outflows and inflows.
• Over‑reliance on high‑cost debt – interest payments erode profit.
• Inadequate capital structure – too much equity dilutes control, too much debt raises risk.
• Failure to reinvest retained profits – limits growth and competitiveness.

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5.2 Sources of Finance – Ownership and Availability

Learning objective

Explain how the form of business ownership influences the range, accessibility and cost of finance available to a business, and evaluate the most suitable finance options for different circumstances.

1. Forms of business ownership

• Sole trader
  • One individual owns and runs the business.
  • Unlimited liability – personal assets are at risk.
  • Fast decision‑making; finance largely depends on personal credit.
• Partnership
  • Two or more individuals share ownership.
  • Usually unlimited liability (unless a limited partnership is formed).
  • Decisions require agreement; finance is based on the combined credit of partners.
• Private limited company (Ltd)
  • Separate legal entity; shareholders own the business.
  • Limited liability – shareholders risk only the amount unpaid on their shares.
  • Shares are not offered to the public; transfer of ownership requires agreement.
• Public limited company (PLC)
  • Separate legal entity; shares are listed on a stock exchange.
  • Limited liability and easy transfer of ownership.
  • Subject to stricter reporting and regulatory requirements.

2. Internal sources of finance

Source	Typical use	Advantages	Disadvantages
Owner’s capital (personal savings / capital introduced)	Start‑up costs, emergency cash	No interest or dividend; full control retained	Limited amount; ties up owner’s personal wealth
Retained profits (or retained earnings)	Re‑investment, expansion, debt repayment	Cheapest source; no external approval needed	Depends on profitability; may reduce dividends payable to shareholders
Sale of surplus assets	Raising cash quickly, disposing of obsolete plant	Immediate cash; reduces maintenance costs	Reduces future productive capacity; may fetch less than market value

3. External sources of finance

External finance is obtained from parties outside the business. It can be classified as short‑term (≤ 12 months) or long‑term (> 12 months). The table below includes all sources listed in the Cambridge 9609 specification.

Source	Short‑term example	Long‑term example	Typical users (ownership form)	Key advantages	Key disadvantages
Bank overdraft / short‑term loan	Overdraft up to £50 k (renewable each year)	5‑year term loan at 5 % p.a.	All forms (sole trader, partnership, Ltd, PLC)	Quick access; interest only on amount used	Requires security or personal guarantee; interest can be high
Trade credit	30‑day credit from suppliers	Extended 90‑day or 120‑day terms	All forms	No cash outlay; improves cash flow	May lose cash discounts; supplier relationships can be strained
Hire purchase (HP)	12‑month HP for office equipment	5‑year HP for plant machinery	All forms (more common with Ltd/PLC)	Spreads cost; ownership at end of agreement	Higher total cost due to interest; asset can be repossessed
Finance lease	12‑month lease for IT hardware	7‑year lease for production line	All forms (especially Ltd/PLC)	No large upfront payment; can upgrade equipment	No ownership unless lease‑to‑own option; ongoing lease charges
Factoring / invoice discounting	Sale of £20 k of receivables for immediate cash	Long‑term factoring agreement (renewable annually)	Partnerships, Ltd, PLC	Immediate cash; no additional debt recorded	Fees reduce profit; customers may notice a third‑party involvement
Debentures (fixed‑interest securities)	–	10‑year 5 % debenture issue	Ltd, PLC	Long‑term capital without diluting control	Interest must be paid; credit rating influences cost
Equity finance – issuing shares	–	Rights issue, private placement of ordinary shares	Ltd (private), PLC (public)	No repayment; strengthens balance sheet	Dilutes existing ownership; shareholders expect dividends
Venture capital / angel investors	–	Equity stake in a high‑growth start‑up (usually 20‑40 %)	Ltd (especially start‑ups)	Large capital plus expertise and networks	Loss of control; high return expectations
Public issue of shares / corporate bonds	–	Flotation on a stock exchange; corporate bond issue	PLC	Access to very large pools of capital; enhances profile	Regulatory compliance; market pressure; dilution
Government grants & subsidies	Research grant for prototype development	Capital grant for plant expansion	All forms (often limited to Ltd/PLC)	Non‑repayable; reduces overall project cost	Highly competitive; may have strict eligibility criteria
Micro‑finance / crowd‑funding	Online campaign raising £10 k	Micro‑loan for 3‑5 years at 12 % p.a.	Sole trader, partnership, early‑stage Ltd	Accessible for small businesses; minimal collateral	Higher cost than traditional bank finance; limited amounts
Sale‑and‑lease‑back	12‑month lease‑back of premises after sale	10‑year lease‑back of plant equipment	Ltd, PLC	Releases cash tied up in fixed assets	Ongoing lease payments; loss of asset ownership

4. Relationship between ownership form and finance availability

Form of ownership	Internal finance (owner’s capital + retained profit)	Bank loans / overdrafts	Trade credit	Hire purchase / finance lease	Equity (shares)	Venture capital / angels	Public issue (shares / debentures)
Sole trader	Owner’s savings + retained profit	Limited – depends on personal credit & collateral	Usually available	Available but often requires personal guarantee	Not applicable	Rarely accessed	Not applicable
Partnership	Partners’ savings + retained profit	Limited – assessed on combined personal credit	Usually available	Available with joint guarantees	Not applicable	Possible for high‑growth partnerships	Not applicable
Private Ltd (Ltd)	Shareholder capital + retained profit	Readily available – corporate credit record used	Widely used	Readily available	Possible – private placement or rights issue	Accessible for innovative start‑ups	Not applicable (unless later converts to PLC)
Public Ltd (PLC)	Large shareholder base + retained profit	Easily accessed – strong corporate credit & reputation	Standard	Standard	Frequent – rights issue, secondary offering	Often accessed for rapid expansion	Available – flotation on a stock exchange, corporate debentures

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5.3 Forecasting & Cash‑Flow Management

Purpose of a cash‑flow forecast

• Predict whether the business will have enough cash to meet obligations.
• Identify periods of surplus (possible investment) or deficit (need for finance).
• Assist in budgeting, pricing decisions and risk assessment.

Simple cash‑flow forecast format (monthly for one year)

Month	Opening cash balance	Cash inflows	Cash outflows	Closing cash balance
Jan	£20 k	£45 k	£40 k	£25 k
Feb	£25 k	£50 k	£55 k	£20 k

When the closing balance falls below a pre‑determined minimum (e.g., £15 k), the business must arrange additional finance.

Improving cash flow – the “four‑step” approach

1. Speed up receivables – offer a small discount for early payment, use invoice discounting, enforce stricter credit control.
2. Delay payables (where possible) – negotiate longer credit terms with suppliers, use trade credit wisely.
3. Reduce inventory levels – adopt just‑in‑time purchasing, improve stock turnover.
4. Control overheads – review fixed costs, consider temporary staff or outsourcing.

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5.4 Costs – Full Costing, Contribution Costing & Break‑Even Analysis

Full (absorption) costing

• All manufacturing costs (direct materials, direct labour, variable overheads, fixed overheads) are allocated to units produced.
• Used for external reporting and inventory valuation.

Contribution (variable) costing

• Only variable costs are attached to units; fixed costs are treated as period costs.
• Highlights the contribution each unit makes toward covering fixed costs and generating profit.

Key formulas

• Contribution margin per unit = Selling price per unit – Variable cost per unit
• Total contribution = Contribution margin per unit × Quantity sold
• Break‑even point (units) = Fixed costs ÷ Contribution margin per unit
• Break‑even point (value) = Break‑even units × Selling price per unit

Break‑even example

Item	Amount (£)
Selling price per unit	£120
Variable cost per unit	£70
Contribution margin per unit	£50
Fixed costs (annual)	£250 000
Break‑even units	£250 000 ÷ £50 = 5 000 units
Break‑even sales value	5 000 × £120 = £600 000

Graphically, the break‑even point is where the total‑cost line meets the total‑revenue line.

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5.5 Budgets & Variance Analysis

Types of budgets

• Static (fixed) budget – based on a single level of activity; useful for control but not for flexible environments.
• Flexible budget – adjusts costs for actual activity levels; provides a more realistic comparison.
• Incremental budget – starts from the previous year’s figures and adds a set percentage.
• Zero‑based budget – every expense must be justified each period; promotes cost awareness.

Preparing a simple sales & production budget

1. Forecast sales (units) for the period.
2. Add desired closing stock of finished goods.
3. Subtract opening stock to obtain required production.
4. Multiply production units by standard cost per unit to get the production budget.

Variance analysis

Variance type	Formula	Interpretation
Revenue (sales) variance	(Actual price × Actual volume) – (Budgeted price × Budgeted volume)	Positive = favourable (higher revenue); Negative = adverse.
Cost variance	Budgeted cost – Actual cost	Positive = favourable (costs saved); Negative = adverse.
Profit variance	Actual profit – Budgeted profit	Explained by combination of revenue and cost variances.

Example of a favourable material price variance

Budgeted material cost = 10 kg × £5 = £50 per unit.
Actual material cost = 10 kg × £4.5 = £45 per unit.
Variance = £50 – £45 = £5 favourable per unit.

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5.6 Factors Influencing the Choice of Finance

• Cost of finance – interest rates, dividend expectations, arrangement fees.
• Control and ownership – equity dilutes ownership; debt retains control but adds repayment obligations.
• Risk and security – collateral required, personal guarantees, fixed‑interest commitments.
• Flexibility – ability to repay early, convert debt to equity, vary repayment schedule.
• Availability & suitability – what lenders or investors are willing to provide to a particular ownership form.
• Impact on ratios – debt‑to‑equity, interest‑coverage, liquidity – which affect future borrowing capacity.

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5.7 Evaluating Finance Options – When to Use Which Source?

1. Short‑term working‑capital needs (e.g., seasonal stock, receivables gap)
   • Trade credit, bank overdraft, invoice discounting, short‑term loan.
   • Prioritise low‑cost, quick‑access options; avoid long‑term debt for temporary gaps.
2. Medium‑term equipment or expansion (1‑5 years)
   • Hire purchase, finance lease, medium‑term bank loan, debenture.
   • Compare total interest cost with asset ownership benefits.
3. Long‑term growth or diversification (≥ 5 years)
   • Equity issue, venture‑capital investment, public share/debenture issue, long‑term loan.
   • Weigh loss of control against the size of capital required and the risk profile of the project.
4. High‑risk, high‑return start‑up
   • Venture capital, angel investors, crowd‑funding.
   • Owners accept higher expected returns and possible dilution for rapid scaling.
5. Businesses with limited assets for security
   • Micro‑finance, government grants, equity finance.
   • Secured bank loans are less realistic; look for unsecured or grant‑based funding.

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5.8 Key Points to Remember

1. Finance is needed for start‑up, expansion, working capital and risk mitigation.
2. Cash flow, not profit, determines a business’s ability to survive in the short term.
3. Internal finance is cheapest but limited; external finance provides larger sums but usually carries cost or dilution.
4. Limited liability in companies makes equity and long‑term debt more attractive to external investors.
5. Sole traders and partnerships rely heavily on personal capital and credit, restricting the size of external finance they can obtain.
6. Choosing finance involves balancing cost, control, risk, flexibility and the specific needs of the project.
7. Accurate cash‑flow forecasting and regular variance analysis help avoid cash crises and guide finance decisions.
8. Understanding full costing, contribution costing and break‑even analysis is essential for evaluating the profitability of projects financed by different sources.
9. Budgets (static, flexible, zero‑based) provide the framework for measuring performance against financial targets.

5.9 Link to Other AS Business Topics

• Marketing (Section 1‑3) – Pricing decisions affect cash inflows; market research can justify the need for finance.
• Operations (Section 2‑4) – Production planning determines working‑capital requirements and influences the choice between HP, leasing or outright purchase.
• Human Resources (Section 3‑2) – Recruitment and training costs are often funded from retained profits or long‑term loans.
• Strategic planning (Section 4‑5) – Growth strategies (e.g., diversification, market development) dictate whether equity, debt or a mix of both is most appropriate.