Welcome to the Finance Chapter!
Hello future business leader! Don't worry if numbers make you nervous—this chapter isn't about complex mathematics. It’s about common sense and managing money!
Think of finance as the fuel that powers a business. Without the right fuel (money) at the right time, even the best idea will stop. In this chapter, we will learn where businesses get their money, how they manage it day-to-day, and how they calculate success.
Let’s dive into what makes a business tick financially!
1. The Need for Finance: Why Businesses Need Money
Every business, regardless of size, needs cash for different reasons. We can usually group these needs into three main categories:
A. Start-up Capital
This is the money needed before the business even opens its doors. It covers initial expenses.
- Examples: Buying machinery, paying for a shop lease, registering the company name, developing a website.
B. Working Capital (Day-to-Day Running Costs)
Working capital is the cash needed to keep the business running smoothly every single day. Businesses often receive cash (inflows) after they have to pay bills (outflows). Working capital bridges that gap.
- Examples: Paying electricity bills, buying inventory (stock) to sell, paying staff wages.
C. Expansion and Growth
When a business wants to get bigger, it needs significant finance.
- Examples: Opening a new store, launching a new product line, exporting to another country.
Quick Review: The Three Needs
Start-up, Working Capital, Growth. (S.W.G. – Remember the initial planning phase!)
2. Sources of Finance: Where Does the Money Come From?
This is a major decision point for any business owner. Should they use their own money or borrow from someone else? We classify sources in two key ways:
A. Internal vs. External Sources
i. Internal Sources (Money generated by the business itself)
This is generally preferred because the business doesn’t owe anyone interest or repayment fees.
- Retained Profit: Profit kept by the business from previous years (instead of paying it all out to owners). (Great source for expansion, but only available if the business is already successful.)
- Sale of Assets: Selling off old or unused equipment (like an old delivery van or unused computer). (Quick cash, but the assets are gone forever.)
- Personal Savings: Money the owner puts into the business (often used for start-ups).
ii. External Sources (Money borrowed or invested from outside the business)
These sources usually involve repayment or giving up a share of ownership.
- Bank Loan: A fixed amount of money borrowed for a specific period, usually with interest charged.
- Share Capital: Selling shares of the company to investors who then become part-owners (only for limited companies).
- Venture Capital: Money invested by firms specializing in funding new, high-growth businesses (they take a large share of the ownership).
B. Short-Term vs. Long-Term Sources
The decision on how long the finance is needed is critical. If you only need money for three months, you wouldn't take out a 20-year mortgage!
i. Short-Term Finance (Repaid within 1 year)
Used mainly for managing working capital (day-to-day cash flow problems).
- Overdraft: The bank lets the business spend more money than it has in its account, up to an agreed limit. (Very flexible, but high interest rate and only works for small amounts.)
- Trade Credit: A supplier provides goods now, and the business pays later (e.g., 30 days later). (This is like a short-term, interest-free loan from the supplier.)
ii. Long-Term Finance (Repaid over 5 years or more)
Used for major investments, such as buying buildings or large machinery.
- Mortgage: A large, specific loan used to buy property or land.
- Long-Term Bank Loan: Used for expansion or major purchases.
- Share Capital: Money raised by selling shares (this never needs to be repaid).
Key Takeaway: Choosing finance means balancing risk (e.g., owing interest) against control (e.g., keeping ownership).
3. Costs, Revenue, and Profit
Once the business is running, we need to know if it is successful. Success is usually measured by profit.
A. Revenue (Sales)
Revenue is the total income earned by the business from selling its products or services.
$$ \text{Total Revenue} = \text{Price per Unit} \times \text{Quantity Sold} $$
Did you know? Revenue is sometimes called "The Top Line" because it is the first figure on a financial summary.
B. Costs
Costs are the expenses a business has to pay. These are broken down into two essential types:
i. Fixed Costs (FC)
Costs that do not change regardless of how many items are produced or sold (at least in the short term).
- Analogy: Your monthly phone contract fee.
- Business Examples: Rent, management salaries, insurance.
ii. Variable Costs (VC)
Costs that change directly in proportion to the amount of goods produced.
- Analogy: The data usage cost on your phone (changes based on how much you use it).
- Business Examples: Raw materials, packaging, wages paid per item produced.
$$ \text{Total Costs (TC)} = \text{Fixed Costs (FC)} + \text{Variable Costs (VC)} $$
C. Calculating Profit
Profit is the reward for the risk taken by the business owners. It is what’s left after all costs are paid.
$$ \text{Profit} = \text{Total Revenue} - \text{Total Costs} $$
Common Mistake Alert!
Students often mix up high sales (revenue) with high profit. A business can sell millions of products (high revenue) but still make very little profit if its costs are too high!
4. Cash Flow Management
This is arguably the most important section for day-to-day business survival. Remember the crucial difference:
Profit is not the same as Cash Flow!
Analogy: Imagine you sell a product for £100 (Profit = £20). If the customer doesn't pay you for three months, you have high profit, but zero cash in your hand today!
A. Defining Cash Flow
Cash Flow tracks the actual movement of cash (money) both into and out of the business bank account over a specific period.
- Cash Inflow: Money entering the business (e.g., sales revenue, loans received).
- Cash Outflow: Money leaving the business (e.g., paying suppliers, rent, wages).
B. The Cash Flow Forecast
A Cash Flow Forecast is a plan that predicts the expected cash inflows and outflows over the next few months or years. Businesses use this to spot future shortages before they happen.
Here are the steps involved in creating and reading a basic cash flow forecast:
Step 1: Calculate Net Cash Flow
This is the difference between what comes in and what goes out each month.
$$ \text{Net Cash Flow} = \text{Total Cash Inflows} - \text{Total Cash Outflows} $$
If the Net Cash Flow is negative, the business has a temporary cash shortage!
Step 2: Calculate the Closing Balance
This tells us how much cash the business has left at the end of the month. This balance then becomes the Opening Balance for the next month.
$$ \text{Closing Balance} = \text{Opening Balance} + \text{Net Cash Flow} $$
A forecast shows a business exactly when it might need an overdraft or when it has spare cash to invest.
C. Managing Cash Flow Problems
If a forecast shows a business running out of cash (a negative closing balance), they need to act quickly!
Ways to Improve Cash Flow (Increase Inflows/Decrease Outflows):
- Speed up Inflows: Chase up debtors (customers who owe money) faster, or offer discounts for immediate payment.
- Delay Outflows: Negotiate longer trade credit terms with suppliers (e.g., pay in 60 days instead of 30).
- Control Stock: Don't hold too much inventory; it ties up cash.
- External Funding: Arrange a short-term overdraft facility with the bank to cover temporary shortages.
Key Takeaway: Cash is King!
A business can be highly profitable, but if it runs out of cash in the short term, it will fail. Good cash flow management is vital for survival.
Final Review Checklist: Finance
You should now be able to confidently explain:
- The three key reasons businesses need finance (Start-up, Working Capital, Growth).
- The difference between Internal (e.g., Retained Profit) and External (e.g., Loan) finance.
- The importance of matching the source of finance to the time frame (Short-term vs. Long-term).
- The difference between Fixed and Variable Costs.
- How to calculate basic Profit.
- Why Cash Flow is different from Profit, and how to use a Cash Flow Forecast to plan ahead.