Business Finance, Financial Planning and Capital — notes

Business finance is the money a business needs for its activities. It is called the lifeblood of business because it is needed:

• to start (land, buildings, plant, licences);
• to run day-to-day operations (materials, wages, rent, power);
• to expand, diversify or modernise;
• to meet contingencies and use sudden opportunities.

Sources by form of business:

• Sole proprietorship: owner's savings, ploughed-back profit, loans from friends and relatives, bank loans on personal security, trade credit.
• Partnership: partners' capital, admitting a new partner, loans from partners, bank loans, trade credit.
• Joint stock company: equity and preference shares, retained earnings, debentures, public deposits, loans from commercial banks and financial institutions, trade credit and other short-term sources.

The wider the ownership base, the larger the funds that can be raised.

Financial planning is the preparation of a financial blueprint of an organisation's future operations: an estimate of the funds required, their timing and their sources.

Objectives: (i) ensure funds are available when required; (ii) see that the firm does not raise resources unnecessarily.

Features of a sound plan: simplicity; foresight (long-term view); flexibility; optimum use of funds; liquidity; economy (low cost of raising funds); provision for contingencies.

Importance: avoids shortage and surplus of funds; links investment and financing decisions; prepares the firm for surprises; reduces waste and duplication; coordinates departments; provides standards for financial control.

Capital structure is the mix of owners' funds (equity) and borrowed funds (debt) used to finance a business.

Debt is usually cheaper (interest is tax-deductible) and does not dilute control, but it carries a fixed charge and raises financial risk. Equity has no fixed charge but is costlier and dilutes control.

Factors: cost of debt; cost of equity; tax rate; return on investment (trading on equity); cash flow position; business and financial risk; control; flexibility; floatation costs; stock-market conditions; regulatory framework.

Trading on equity: using fixed-cost debt to raise EPS. It works only when return on investment > rate of interest; otherwise EPS falls.

EPS = (EBIT − interest − tax) ÷ number of equity shares.

Fixed capital is the investment in long-term assets such as land, buildings, plant, machinery and vehicles. Such decisions involve large sums, last many years and are difficult to reverse.

Factors affecting fixed capital requirements:

• Nature of business (manufacturing and utilities need more than trading or service firms).
• Scale of operations.
• Choice of technique (capital-intensive versus labour-intensive).
• Technology upgradation (fast-changing machines need frequent replacement).
• Growth prospects.
• Diversification.
• Financing alternatives (leasing reduces the need).
• Level of collaboration (sharing facilities reduces the need).

Working capital is the investment in current assets — stock, debtors, bills receivable, cash — used for day-to-day operations.

• Gross working capital = total current assets.
• Net working capital = current assets − current liabilities.
• Permanent (fixed) working capital: the minimum level needed throughout the year.
• Temporary (variable or seasonal) working capital: the extra needed at peak times.

Factors: nature of business; scale; business cycle; seasonal factors; production cycle; credit allowed; credit availed; operating efficiency; availability of raw material; growth prospects; level of competition; inflation.

Fixed versus working capital: purpose (long-term assets vs daily operations); period (many years vs within a year); sources (long-term vs mainly short-term); liquidity (low vs high).