Choosing Appropriate Finance (Edexcel A-Level Business): Revision Notes
Choosing appropriate finance
When businesses need funding, they must carefully select the most suitable source of finance. The choice depends on several key factors, including the business's legal structure, financial position, and the purpose of the funding. Understanding these factors helps businesses make strategic financial decisions that support growth while managing risk effectively.
Factors influencing the choice of finance
Several important factors determine which finance sources are most appropriate for a business. These factors must be carefully evaluated before committing to any funding method.
Time period required
The length of time for which finance is needed significantly affects which sources are suitable.
Long-term finance (more than one year) is appropriate for substantial investments that will benefit the business over many years. Suitable long-term sources include:
- Mortgages – can extend up to 25 years
- Debentures – can be issued for up to 30 years
- Unsecured bank loans – typically granted for one to five years
- Share capital – permanent capital that is never repaid, making it the most long-term method available
Short-term borrowing (12 months or less) suits temporary funding needs or working capital requirements. Appropriate short-term sources include:
- Trade credit – allowing delayed payment to suppliers
- Bank overdrafts – providing flexible access to additional funds
- Leasing – spreading the cost of equipment over shorter periods
Using short-term finance for long-term needs creates financial pressure, as the business must repay or renew funding frequently. Conversely, using expensive long-term finance for short-term needs wastes resources on unnecessary interest payments.
Financial position of the business
A business's current financial health directly impacts its ability to raise finance and the cost of borrowing.
When a business faces financial difficulties, lenders become reluctant to provide funding. At the same time, the cost of borrowing rises because lenders perceive greater risk. Businesses in poor financial positions may struggle if they are:
- Losing money
- Experiencing cash-flow problems
- Encountering trading difficulties
- Already owing money to other lenders
- Holding few assets
Financial institutions prefer lending to secure businesses with substantial collateral (assets that can be sold to repay loans if necessary). A strong balance sheet with valuable assets makes it easier to negotiate favorable lending terms.
Type of expenditure
The purpose of the funding determines which sources are most appropriate.
Capital expenditure involves purchasing long-term assets such as buildings, machinery, or vehicles. This heavy expenditure should be funded by long-term sources because:
- The assets generate returns over many years
- Matching the repayment period to the asset's useful life reduces financial strain
- Examples include financing factory construction through share issues or mortgages
Revenue expenditure covers day-to-day operating costs such as wages, utility bills, and raw materials. This regular expenditure is better suited to short-term sources because:
- The expenses are recurring and predictable
- Short-term funding provides flexibility
- Examples include funding raw material purchases through trade credit or bank overdrafts
Cost considerations
Businesses naturally prefer cheaper finance sources, but cost involves more than just interest rates.
When evaluating cost, businesses must consider:
- Interest payments – the rate charged on borrowed money
- Administration costs – fees for arranging and managing the finance
For example, share issues can carry high administration costs due to legal requirements, regulatory compliance, and marketing expenses. However, they avoid interest payments entirely since shareholders receive dividends rather than interest.
Bank overdrafts typically charge relatively low interest rates compared to other borrowing methods, making them cost-effective for short-term needs.
Businesses must balance the total cost against the benefits provided by each finance source. Sometimes paying slightly higher costs is worthwhile if the finance source offers greater flexibility or longer repayment terms.
Legal status of the business
Whether a business has unlimited or limited liability fundamentally affects which finance sources are accessible. This distinction creates two different categories of appropriate finance, discussed in detail below.
Finance appropriate for unlimited liability businesses
Unincorporated businesses such as sole traders and partnerships have unlimited liability, meaning there is no legal difference between the owner(s) and the business. These businesses face more restricted finance options than their limited liability counterparts.
Available sources for unlimited liability businesses
Unlimited liability businesses typically access the following finance sources:
Personal savings represent the most common starting point for small business owners. Using their own money demonstrates commitment to potential lenders and avoids interest costs. However, this source is limited by the owner's personal wealth.
Retained profit becomes available once the business becomes established and profitable. The business must generate sufficient profit to support both the owner's income and future investment. For many unlimited liability businesses, the scope for using retained profit remains restricted because profits are modest and owners need to draw income.
Mortgages provide long-term finance by using the owner's house as collateral. This allows access to substantial funding at relatively low interest rates. However, this creates significant personal risk – if the business fails and debts cannot be repaid, the owner may lose their home. This direct threat to personal assets reflects the fundamental nature of unlimited liability.
Unsecured bank loans may be available to established and successful businesses, though banks carefully assess applications. Approval depends on:
- The business's trading history and financial performance
- The current financial climate (during credit crunches, criteria become stricter)
- The quality and detail of the business plan presented
Peer-to-peer lending connects small business owners directly with individual lenders through dedicated websites, avoiding traditional banks. However, some peer-to-peer platforms exclude business borrowing, so owners must check each platform's terms carefully.
Crowd funding allows businesses to raise money from many small investors, typically through online platforms. As this relatively new concept develops and proves reliable, it may become increasingly popular with unlimited liability businesses seeking long-term finance.
Bank overdrafts are accessible to most businesses, though the size of the overdraft limit varies considerably. Established, profitable businesses can negotiate much larger overdraft facilities than new or struggling enterprises.
Grants provide "free" finance from government bodies, local authorities, or other organizations. However, businesses must prove they qualify for specific grants, and the lengthy application process may deter some owners despite the potential benefits.
Why these sources suit unlimited liability businesses
These finance sources are appropriate for unlimited liability businesses because they are accessible to small enterprises. Unlimited liability businesses tend to be small and often struggle to raise substantial funding because:
- They have fewer assets to use as collateral
- Many are new start-ups with no trading record, which discourages lenders
- They lack the legal structure to issue shares or debentures
However, an important exception exists: because owners of unlimited liability businesses must meet business debts from their personal resources, lenders may actually be more likely to be reimbursed if a business collapses. This can make some lenders view unlimited liability businesses as more credible, since owners have strong personal incentives to manage the business cautiously.
Finance appropriate for limited liability businesses
Incorporated businesses (particularly public limited companies) enjoy much wider funding opportunities than unlimited liability businesses. Limited liability means shareholders can only lose the original amount they invested – their personal assets are protected from business debts.
Available sources for limited liability businesses
Limited liability businesses can access all the sources available to unlimited liability businesses, plus several additional methods:
Share capital allows limited companies to raise very large amounts of funding by selling ownership stakes. This method has several advantages:
- Once shares are purchased, the money raised is not normally repaid, so capital remains permanently in the business
- The business can raise additional money in the future by selling more shares
- Share capital is provided by owners from their own resources, avoiding interest costs
A rights issue offers existing shareholders the opportunity to buy new shares at a discounted price before they are offered to others. This method:
- Is cheap and simple to arrange
- Creates free publicity for the company
- Allocates shares proportionally based on current holdings
For example, in a one-for-five rights issue, shareholders can buy one new share for every five they currently own. Rights issues are regarded as a cost-effective way of raising fresh capital while rewarding loyal shareholders.
Worked Example: Rights issue calculation
RSA Insurance planned to raise $748 million through a rights issue, offering shareholders three new shares for every eight held at 56p per share.
If a shareholder owned 240,000 shares:
- Share entitlement = shares
- Cost of purchase =
Debentures allow public limited companies to raise large amounts through long-term loans (up to 30 years). Unlike shareholders, debenture holders have no control over business decisions – they are simply creditors entitled to regular interest payments. This allows companies to raise substantial funds without diluting ownership control.
Retained profit provides approximately half of all business finance across the economy. Large limited companies may accumulate hundreds of millions of pounds in cash reserves over the years, which can be deployed for future investments without any external borrowing costs.
Venture capitalists invest primarily in limited companies, usually taking an equity stake that gives them some control over key decisions. They typically invest larger amounts than business angels (sometimes several million pounds) and prefer businesses with high growth potential. However, they also invest in small and medium-sized enterprises, not just large corporations.
Business angels are wealthy individuals who invest their own money in businesses, usually at earlier stages than venture capitalists. While they often take equity stakes, this doesn't prevent them from investing in sole traders and partnerships. One challenge is that business angels can be difficult to locate, meaning entrepreneurs may waste valuable time searching for suitable angels rather than focusing on business development.
Other sources used by limited liability businesses include bank overdrafts, trade credit, leasing, unsecured bank loans, mortgages, and grants. Larger limited companies are much less likely to use crowd funding or peer-to-peer lending, as these sources better suit smaller enterprises.
Why these sources suit limited liability businesses
These finance sources are appropriate for limited liability businesses for several reasons:
Legal requirements – only limited companies can issue shares or debentures to raise finance. The incorporated structure provides the legal framework for these funding methods.
Business size – limited liability businesses tend to be larger than unlimited liability businesses, with more resources to support loans. This makes them less risky for lenders and investors.
Asset base – larger businesses typically own more valuable assets that can serve as collateral, making lenders more willing to provide funding on favorable terms.
Investor protection – the limited liability structure attracts investors because they know their maximum possible loss is limited to their investment. This makes it easier to raise large amounts from multiple investors.
Key considerations when selecting finance
When evaluating different finance sources, businesses must consider their specific circumstances carefully. While many sources are theoretically available depending on legal status, the reality is that current financial position is crucial.
Businesses will struggle to raise finance from any source if they:
- Are losing money consistently
- Have cash-flow problems
- Are encountering trading difficulties
- Already owe substantial money to other lenders
- Have few valuable assets
Even businesses with limited liability may face challenges if their financial position is weak. Banks and investors assess risk carefully, and poor financial health restricts access to funding regardless of legal structure.
The issue of undercapitalisation (not raising enough capital when setting up) affects many UK businesses, particularly small and medium-sized enterprises. This problem arises because:
- Most start-ups are funded by personal finance, family, friends, and house re-mortgaging
- New businesses have low or zero revenues but high expenditure
- Bank loans and overdrafts are unsuitable for new firms because debt servicing costs come when cash is scarce
- Lending terms from banks are often demanding and subject to change
The advantage of capital finance (such as share capital) is that it is permanent – it cannot be withdrawn and does not drain cash through regular repayments. The development of crowd funding may help address undercapitalisation by allowing many individuals to invest small amounts in start-ups and early-stage companies.
Key Points to Remember:
Key factors in choosing finance:
- Match the time period of finance to the purpose – use long-term sources for capital expenditure and short-term sources for revenue expenditure
- Legal status determines which sources are accessible – only limited companies can issue shares or debentures
- Financial position affects both availability and cost – strong finances mean better access and lower costs
- Consider total cost including both interest payments and administration expenses
For unlimited liability businesses:
- Fewer sources available but personal liability may actually reassure some lenders
- Must rely heavily on personal savings, retained profit, bank overdrafts, and secured lending
- Face greater personal risk, especially when using homes as collateral
For limited liability businesses:
- Much wider range of sources available, especially share capital and debentures
- Easier to attract investors because personal assets are protected
- Rights issues provide a cost-effective way to raise additional capital from existing shareholders
- Size and asset base make them less risky for lenders
Critical exam point:
Always consider the specific financial circumstances of the business in question – theoretical availability of finance sources matters less than whether the business can actually access them given its current financial position, trading record, and asset base.