Why business activity requires finance
- Setting up a business will require cash injections. (start-up capital)
- To finance their working capital – the day to day finance needed to pay bills and buy stock.
- For expansion of the business – increasing the capital assets held by the business.
- Finances to enable take overs or mergers.
- Finances to cover special situations, example finances held to make sure a business survives a recession.
- Start-up capital =
Capital needed by an entrepreneur to set up a business
- Working capital =
The capital needed to pay for raw materials, day-to-day running costs and credit offered to customers.
In accounting terms working capital = current assets – current liabilities
- Current assets =
Inventory, bank, debtors or accounts receivable, petty cash and cash float
- Current liabilities =
creditors or accounts payable and short term loans and overdrafts
- Liquidity =
The ability of a firm to be able to pay its short-term debts.
- Liquidation =
When a firm ceases trading and its assets are sold for cash to pay suppliers and other creditors.
Capital and revenue expenditure
- Capital expenditure =
Involves the purchase of assets that are expected to last for more than one year, such as buildings and
- Revenue expenditure =
Is spending on all costs and assets other than fixed assets and included wages and materials bought for stock.
Some distinctions between capital and revenue expenditure:
- They will almost certainly be financed in different ways.
- In accountancy terms, they will be recorded differently; all revenue expenditure will be recorded on each year’s Income Statement and will, therefore, reduce that year’s profits; capital expenditure is recorded on the Balance
Sheet as a depreciation item on each year’s Balance Sheet.
- Capital expenditure is more likely to increase the earning capacity of a business (its non-current assets) while revenue expenditure merely maintains the assets’ earning capacity.
- Capital expenditure increases a business’s asset position.
- Improper asset classification can skew the financial position of a business.
How much working capital is needed?
Sufficient working capital is essential to prevent a business from becoming illiquid and unable to pay its debts.
Too high a level of working capital is a disadvantage, the opportunity costs of too much capital tied up in inventories, accounts receivable and idle cash is the return that money could earn elsewhere in the business- invested in fixed assets perhaps.
The working capital requirements for any business will depend upon the length of its working capital cycle.
The longer the time period from buying materials to receiving payment from customers, the greater will be the working capital needs of the business.
Credit to customers given by the business will lengthen the time before a sale is turned into cash.
Credit received by the business will lengthen the time before stock bought has to be paid for.
To give more credit than is received is to increase the need for working capital.
To receive more credit than is given is to reduce the need for working capital.
Sources of Finance