5.1.1 The need for business finance (3)
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1.
Question 3: Explain how a business can calculate its working capital. Discuss the factors that can affect a business's working capital requirements. Provide examples of how a business might manage its working capital effectively.
Calculating Working Capital:
Working capital is calculated using the following formula:
| Cell |
| Current Assets | = | Current Liabilities |
Therefore, Working Capital = Current Assets - Current Liabilities
Factors Affecting Working Capital Requirements:
- Seasonality: Businesses with seasonal sales need higher working capital to cover increased inventory needs during peak periods.
- Growth: Expanding businesses often require more working capital to finance increased production and sales.
- Credit Policy: Offering credit to customers increases the amount of receivables and thus working capital requirements.
- Supplier Credit: Taking advantage of supplier credit reduces the amount of payables and improves working capital.
- Industry: Different industries have different working capital needs. For example, a retail business typically requires more working capital than a service-based business.
Effective Working Capital Management Examples:
- Inventory Management: Implementing just-in-time (JIT) inventory systems to minimize stock levels.
- Debtors Control: Offering discounts for early payment, setting credit limits, and implementing effective credit control procedures.
- Creditors Control: Negotiating extended payment terms with suppliers.
- Cash Flow Forecasting: Developing accurate cash flow forecasts to anticipate working capital needs and plan accordingly.
- Factoring: Selling accounts receivable to a factoring company to receive immediate cash.
2.
Explain the difference between equity finance and debt finance. Give an example of each and discuss the potential impact each type of finance could have on a business's financial stability.
Equity Finance vs. Debt Finance
Equity Finance: This involves raising capital by selling shares in the business to investors. The investors become part-owners of the company. The business does not have to repay the money.
- Example: A small tech startup sells shares to venture capitalists in exchange for funding.
- Impact on Financial Stability: Equity finance does not create a liability on the balance sheet. However, it dilutes the ownership of the existing shareholders. The business must share profits with shareholders and may have to consider the interests of shareholders when making decisions. If the business performs poorly, the value of the shares may fall.
Debt Finance: This involves borrowing money from a lender (e.g., a bank) that must be repaid with interest over a specified period. The business incurs a liability on its balance sheet.
- Example: A manufacturing company takes out a loan from a bank to purchase new equipment.
- Impact on Financial Stability: Debt finance creates a liability on the balance sheet, which increases financial risk. The business is obligated to make regular repayments, regardless of profitability. Interest charges reduce profits. If the business is unable to repay the debt, it could face financial difficulties or even bankruptcy. However, interest payments are often tax-deductible, which can improve the overall financial position.
In summary, equity finance does not create a liability but dilutes ownership, while debt finance creates a liability and increases financial risk. The choice between the two depends on the business's specific needs and circumstances.
3.
A business owner is unsure whether to use a bank loan or to issue shares to finance a new production line. Outline the key differences between these two methods of raising finance, considering the advantages and disadvantages for the business.
Bank Loan vs. Share Issue: Key Differences
Both bank loans and share issues are methods of raising finance, but they differ significantly in terms of ownership, risk, and financial implications.
| Feature | Bank Loan | Share Issue |
| Ownership | No ownership is given up. The business retains full control. | Ownership is shared with investors. The business owner gives up a portion of the company. |
| Cost of Finance | Interest charges. The interest rate can vary depending on the business's creditworthiness. | No direct interest payments. However, profits are shared with shareholders. |
| Risk | The business is responsible for repaying the loan, regardless of profitability. This creates financial risk. | The business is not obligated to repay the money. However, profits are reduced due to the share distribution. |
| Advantages | Retains full control of the business. Interest payments are tax-deductible. | Access to a larger amount of capital. No repayment obligations. Can bring in valuable expertise and connections. |
| Disadvantages | Requires a good credit rating. Can be difficult to obtain a loan. | Dilution of ownership. Shareholders have voting rights and can influence business decisions. |
Conclusion:
The best option depends on the business's circumstances. If the business wants to retain full control and has a strong credit rating, a bank loan might be preferable. If the business needs a large amount of capital and is willing to share ownership, a share issue might be a better option. The business must carefully weigh the advantages and disadvantages of each method before making a decision.