Why Does a Business Need Finance? (Junior Cert Business Studies): Revision Notes
Why Does a Business Need Finance?
Understanding business finance
Every business, whether just starting out or well-established, requires money to operate successfully. This money available to a business is called finance.
Finance is the money that is available to a business to meet its financial needs and obligations.
Businesses need finance for different reasons depending on their stage of development:
Start-up businesses face significant financial challenges because they have substantial setup costs but generate little or no income initially. These new ventures must invest money in essential items before they can begin trading:
- Purchasing or renting premises
- Buying equipment and machinery
- Covering daily running expenses like supplier payments and wages
- Building up stock levels
Worked Example: Start-up Finance Requirements
If someone wanted to open a new café in Dublin, they would need finance for:
- Rent the premises (€2,000/month deposit + first month)
- Buy coffee machines and furniture (€15,000)
- Purchase initial stock (€3,000)
- Pay staff wages (€8,000/month)
All these costs must be covered before serving their first customer and generating any income.
Established businesses that already generate regular income may still require additional finance when they want to grow or adapt. They might seek funding to:
- Expand into new markets or locations
- Purchase new technology or equipment
- Develop innovative products or services
- Increase their marketing efforts
Take Supermac's, the Irish fast-food chain - even though it's well-established, it still needs finance when opening new restaurants or updating existing locations to remain competitive.
Types of business expenditure
Business financial needs can be categorised into two main types of spending:
Capital expenditure
Capital expenditure refers to spending on assets that provide long-term benefit to the business, typically lasting more than one year.
Capital expenditure includes one-off or long-term purchases such as:
- Buildings and premises
- Machinery and equipment
- Vehicles
- Computer systems
- Furniture and fixtures
Worked Example: Capital Expenditure
When Penneys purchases new cash register systems for all their Irish stores at a cost of €500,000, this represents capital expenditure because:
- The systems will be used for several years (typically 5-7 years)
- They provide long-term benefit to business operations
- It's a significant one-off investment rather than a regular expense
Current expenditure
Current expenditure covers the day-to-day running costs that businesses face regularly to maintain their operations.
Current expenditure includes ongoing costs like:
- Employee wages and salaries
- Electricity and utility bills
- Raw materials and stock purchases
- Insurance premiums
- Rent payments
Worked Example: Current Expenditure
The monthly electricity bill for a Tesco store in Cork (approximately €3,500) represents current expenditure because:
- It's a regular, recurring monthly cost
- It's essential for immediate business operations
- The benefit is consumed within the current period
- It must be paid regularly to maintain operations
Sources of finance
When businesses need finance, they can choose from various options based on how long they need the money and what they plan to use it for. These sources are typically classified by timeframe:
Short-term finance (less than 1 year)
Short-term finance options help businesses manage immediate cash flow needs:
- Bank overdraft: Allows businesses to withdraw more money than they have in their account, up to an agreed limit
- Trade creditors: Suppliers who allow businesses to buy goods now and pay later (typically 30-60 days)
- Expenses due (accruals): Bills that have been incurred but not yet paid
Short-term finance is particularly useful for managing seasonal fluctuations in cash flow, such as retailers building up stock before Christmas or ice cream manufacturers preparing for summer demand.
Medium-term finance (1-5 years)
Medium-term options suit businesses needing finance for specific projects or equipment:
- Term loan: A bank loan for a fixed amount over an agreed period
- Leasing: Renting equipment or vehicles for a set period instead of buying
- Hire purchase: Buying equipment through instalments, with ownership transferring after final payment
Long-term finance (more than 5 years)
Long-term finance supports major business expansion and development:
- Retained earnings: Profits kept within the business rather than distributed to owners
- Grants: Financial assistance from government bodies or organisations (often non-repayable)
- Ordinary share capital: Money raised by selling shares in the company to investors
- Long-term loan: Bank lending over extended periods, often secured against business assets
- Sale and leaseback: Selling business assets (like property) then leasing them back
- Crowdfunding: Raising small amounts of money from many people, often through online platforms
Long-term finance sources often have lower interest rates than short-term options, but they typically require more detailed business planning and may involve giving up some control (in the case of share capital) or providing security (for long-term loans).
The matching principle
Successful businesses follow an important concept when selecting finance sources:
The matching principle states that businesses should match their source of finance to their specific financial need - short-term sources for short-term needs, medium-term sources for medium-term needs, and long-term sources for long-term needs.
This principle ensures that businesses don't create financial difficulties by using inappropriate funding sources. For example, it would be unwise for a business to use a short-term bank overdraft to purchase expensive machinery that will be used for ten years, as they would struggle to repay the overdraft quickly whilst the machinery provides benefits over many years.
Similarly, using a long-term loan to pay monthly wages would be inefficient, as the business would pay interest over many years for a cost that only provides one month's benefit.
Worked Example: Applying the Matching Principle
Correct approach:
- Use a 5-year term loan to purchase delivery trucks (medium-term finance for medium-term asset)
- Use trade credit to buy monthly stock supplies (short-term finance for short-term need)
- Use retained earnings to build a new factory (long-term finance for long-term asset)
Incorrect approach:
- Using an overdraft to buy delivery trucks (short-term finance for long-term asset)
- Using a 10-year loan to pay weekly wages (long-term finance for immediate need)
Key Points to Remember:
- All businesses need finance to cover startup costs, daily expenses, and growth opportunities
- Capital expenditure covers long-term assets whilst current expenditure covers day-to-day running costs
- Finance sources are available for different timeframes: short-term (under 1 year), medium-term (1-5 years), and long-term (over 5 years)
- The matching principle ensures businesses choose appropriate finance sources that align with their specific needs and timeframes
- Choosing the wrong type of finance can create serious cash flow problems for businesses