Section 9: Finance

IGCSE – OL Business Studies

Instructor: Khaled Nabil
 Why businesses need finance:
FINANCIAL MARKETS 1) Setting up a new business to purchase
necessary equipment, premises and initial
working capital.
• People and businesses today are searching for ways to borrow money as well as finding 2) Day to day financing of running expenses
good uses for their investments. The Financial Markets provide the link between suppliers and working capital
of finance and those in need of finance. Financial Institutions, like banks, are
organizations that operate in financial markets by bringing borrowers together with 3) Business expansions to other countries or
lenders. Such markets also bring businessmen together with investors. expanding production capacity
• A stock market, is an organization in any country that helps companies and government 4) Business acquisitions for vertical or
authorities to sell their stocks and shares to people and other organizations that want to horizontal integration
buy them. The interaction of the market demand for shares in a particular company and 5) Unfavorable conditions leading to low
their market supply will determine the market price and quantity traded of those shares. liquidity and low demand for business
People and other companies buy stocks and shares because they hope their price will rise products
so they can sell them at a profit, and also receive a dividend paid from the profits of the
company that issued the shares. Without stock exchanges, companies would find it very 6) To pay for research and development
difficult to raise the finance they need for their activities. costs for new products
7) To launch advertising campaigns

The finance department of the business is

Investors Businesses incharge of providing needed sources of
finance (whether internal or external) to meet
the current and future cash needs. It is
important that careful plans are set to repay
this financing (in case of debts) or provide
Financial returns (in case of equity). It is also important
Suppliers of Finance Demanders of Finance to match the tenor of finance sources with
Markets finance needs. i.e. long term investment
needs should be financed with long term
sources of finance, while short term cash
needs of running the business should be
Lenders/ Individuals financed with short term debts or short term
internal sources.
Savers
Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 2
 • The Difference Between Cash and
CASH FLOWS Profits: Profits are the difference
between revenues and costs. Such
profits could be accounting profits
• Cash Flows are the sum of cash receipts to a business (inflows) less the sum of cash
and not available in cash. For
payments made by the business (outflows). This is also referred to as
example a business could make large
Net Cash Flow = Cash Inflows – Cash Outflows sales with high profit margins, still
• A business needs to prepare a cash flow forecast, which details the expected cash those sales could be on credit and
outflows and planned cash inflows to cover them. The cash flow forecast will help a collection may come a month or two
business identify in which future months there will be a shortage in cash. The business can after. This company could face cash
then start to plan on how to provide more inflows of cash through internal or external flow problems if it does not have
finance sources. similar grace periods for payments to
Causes of Cash Flow Problems: suppliers as it is giving debtors. Also
1) Lack of Planning a business might have a lot of cash
tied up in stocks or fixed assets
2) Most of sales on credit with long credit period given to customers
causing it to borrow and not be able
3) Expanding too rapidly by buying fixed assets without necessary finance to repay loans although its sales
4) Unexpected Events could be profitable. Therefore,
5) High overheads owners and managers should not
6) No credit from suppliers only consider profits when planning
for the future, but should also make
7) Business is holding too much stock
sure that the business is always
solvent and does not run out of cash.
To avoid cash flow problems, a business must find ways to come up with cash to support its • An insolvent business is one that
operations and expansion plans, this is called Financing. There are many sources of finance cannot meet its short-term debts as a
available to a business, some of those sources are Internal Finance and some are External result of cash flow problems.
Finance. Efficient financial managers will first try to utilize all available internal sources of
finance, then if not sufficient, it can turn to external finance.

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 3

 The first step a business should do to
INTERNAL FINANCE provide for internal financing, is to
decrease unnecessary cash outflows.
Internal Sources of Finance: There are ways to decrease cash
outflows and their disadvantages:
1. Reducing Overheads will include laying-off unwanted labour or cutting down on
other expenses. This however can cause a lower level of motivation and negative 1) Delay payments to suppliers
reputation. (creditors). This will cause
loosing discounts and deprive
2. Retained Profits are profits ploughed back into the business after payment of
business of supplier confidence in
taxes to the government and distribution of dividends to shareholders. Are a
extending credit terms.
source of expanding the business. It is a source of ongoing finance year after year
which is also permanent (i.e. does not have to be re paid immediately to 2) Delay Capital Expenditures (delay
shareholders). Not available for a newly formed business or a business that has machine purchases). This may
been making a loss. Not all retained profits are cash profits as cash could be tied negatively impact efficiency and
up in debtors or inventories. quality if the business continues
using outdated equipment.
3. Sale of Assets that are no longer fully employed or sale of assets that could be
leased back. It could be used to generate cash from owned assets by selling them 3) Lease instead of buying. Assets
and leasing them back. There is a fixed cost on the business which adds to its are not owned by the business
overheads (rent). and leasing charges reduce
profits.
4. Reduction in Working Capital particularly stocks and debtors. A business could
increase its efficiency by correctly managing the levels of working capital to free 4) Cut overhead spending: this
up cash needed by the business. Cutting down on working capital however will reduces spending on promotion
reduce the liquidity position of the business by jeopardizing its ability to pay short and advertising which negatively
term debts. Reduction in stock levels could also cause the business to miss out impacts future sales.
on many opportunities in the market. Also reduction in debtor levels requires
less grace periods for collection, this could cause the business to lose market
share to competitors.

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 4

 Bank Overdrafts: It is a short term (but usually
EXTERNAL FINANCE revolving) credit line opened by the bank to a
business to allow it to draw more than its
deposits for a short period of time. The business
Capital: This is a form of long term equity finance which the Grants: Those are long term sums of money given can borrow up to an agreed limit when required.
company does not need to repay back. Such equity finance to the business by charity or government It is the most flexible source of finance. This kind
could be the initial issuing of shares or could be a further organizations to help the business expand into of borrowing often comes with interest rates
shares issued to existing or new shareholders. A company socially important activities. Those grants are not which reduces profits of the business. Also the
could also ‘go public’ by selling / issuing shares on the stock easily obtained. They could indicate inefficiency of credit limits might not be sufficient to cover cash
market to allow the public to participate in its capital. Share the business. Such grants might also have deficits faced by the business. Has to be repaid
capital issuing could lead to loss of control for the founders conditions on business activities. quickly.
of the company and decisions are now taken through an
elected board of directors. Going public could cause the Trade Credit: It is a short term financing provided
Debt Factoring: a business could sell/assign future
company to abide by strict rules of the stock market. Also by the suppliers of materials or goods to the
receipts from its debtors to financial institutions
listing on the stock market and selling shares to the public is business whereby a grace period is allowed to the
(banks) who will give the cash to the business now
expensive as it requires a lot of advisors and preparations. business to delay payment. Therefore it will
after discount. This finance methods causes loss of
profits given to those banks since the business will purchase its stock without payment, and delay
Debentures: Those are long term debt instruments issued
be collecting a smaller sum than original debtor this payment until it makes some collections from
by the business (usually companies) to raise debt finance
amount. customers. If the business fails to pay on time,
from the public or other businesses. Such bonds /
this will cause loss of confidence by the suppliers
debentures usually carry fixed interest. Bonds are
as well as lost discounts.
attractive for investors since they can be resold in the Venture Capital: This is a type of capital/equity
market for bonds if the investor does not wish to wait till finance (long term), where investors finance a risky
Hire Purchase: This type of financing is used to
‘maturity’ of the bond upon which the business has to repay new project or enterprise with a new idea or
buy fixed assets over a medium term life span 2
the principal (value of the bond). This financing requires innovation. Not all investors want to take high risks,
to 5 years. This avoids paying a large lumpsum at
regular interest payments. Only Ltds & Plcs can issue them. and if they do, they will require a high return/profit.
the beginning of the asset’s life. Such financing is
easier to obtain than a loan, as the asset itself
Leasing: is a contract to have an asset used by the business for a medium term. Payments are made for the asset,
could serve as a collateral/security. Here assets
but there is no obligation for the business to purchase the asset at the end of the contract. Usually those agreements
could be tied up until payments/installments are
involve repairs to the asset. This avoids the business from raising long term capital to buy the asset. Ownership
completed. High interest cost.
does not get transferred to the business, it remains with the leasing company. This also lowers the profitability of the
business due to lease expenses. i.e. the rent cost. Mortgages: a type of bank loans (long-term)
which financing the purchase of properties over
Bank Loans: Those are long term loans from banks that involve repayments at least once a year. But the whole loan very long repayment periods. The property itself
is payable over several years could be up to 20 years even. Such loans carry either variable or fixed interest or a becomes the collateral, which is confiscated if
combination of both. Such financing requires providing security or collateral for the loan. This allows the bank to there is no repayment. If the business stops
liquidate those collateralized assets in case of delayed repayments by the business. Therefore a business with few repayment, the property will be confiscated by
assets might find it difficult to raise such financing. the bank.

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 5

 Before deciding on the sources of finance, a
SELECTING FINANCE SOURCE business must have in place a detailed
Business Plan which is a document of the
forecasted sales and operations of the
Factors Influencing the choice of finance sources: business which also includes a cash flow
forecast that illustrates how the new
• Finance Costs: Interest expenses are the cost of getting finance such as debentures, bank
financing will be used by the business. The
loans or overdrafts. Such interest rates change with economic cycles. Even raising capital
business plan also includes market analysis
on the stock market involves high costs. and research supporting the view of the
• Finance Term/Tenor: Short term cash needs will require short term sources of finance. E.g. business that there will be demand for its
a business could take an overdraft to increase stocks or pay overdue creditors. Long term products. The business plan is important as
finance requires long term debts or permanent equity it gives a direction and action plan for the
• Existing Finance/Leverage: When the business already has a lot of existing debts on its business which will encourage investors to
balance sheet, it will be difficult to convince banks to lend it more. In this case the lend the business either loan or share
business should look for internal financing methods or getting share capital. capital. A Business Plan is a document that
summarizes all future financial and
• Legal Structure: Share issues as only available to limited companies (Ltds or Plcs). Issuing operational plans of the business along
shares causes owners to loose control, except if rights issue is used. Owners that wish to with a cash flow forecast.
retain control will resort to loan capital. Unincorporated businesses do not have access to
issuing shares or large capital sources. Also, only companies can issue debentures.
• Finance Amount: The administrative costs of issuing shares or debentures only justifies
such sources of finance for large capital sums. For small asset purchases like vehicles or It is also important for a business to match
machines could be financed by loans. Overdrafts are used to cover temporary cost its long term finance needs with long term
overruns or cash deficits. finance sources as well as matching short
term operating needs to be financed by
Cash Need Appropriate / Suitable Finance Source short term sources. This matching allows
Purchasing stocks for resale Trade Credit from Suppliers smooth operation of finance activities and
optimized the use of cash in a business. It is
Buying new machinery Hire Purchase / Leasing risky to borrow long term finance to pay for
Building a new factory / production line / new large Equity Share Issue / Debentures / Bank Loans short term cash needs. Long term business
project / joint venture / takeover another business expansions require permanent capital such
as equity. Short term financing is suitable to
Paying expenses Bank Overdraft increase stocks or pay overdue creditors.
Buying properties (land/building) Mortgage (a type of bank loan)

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 6

 Importance of Cash Flow Forecasting:
CASH FLOW FORECAST New business start-ups are tight on
cash and need external financing from
investors, banks and venture capitalists
A business is planning to construct a cash flow forecast for the first six to support the business in the first year
months of 2013. The ending cash balance for Dec-2012 was $13,000. or two. Those investors / lenders need
Fixed monthly costs include Rent $5,000; Salaries and Wages $2,000; to make sure that the business has a
Electricity $500. There is also an outstanding loan for which careful plan to repay its debts and not
run out off cash. Many businesses fail
installments are required every quarter starting March of $26,000. The especially at startup due to lack of
business plans to sell an existing van it owns at a price of $7,000 and it careful financial planning and cash flow
will receive the money in February. It also plans to buy a new machine problems. Cash flow planning /
forecasting also allows a business to
in April costing $10,000 for which it will pay in cash. The business has a identify months in which there is a cash
policy of allowing its debtors a month to repay sales. However, its flow shortfall (deficit) to provide
purchases are instantly paid for in cash. Purchases costs are 60% of financing for those month(s).
sales value of each month. The table below shows the sales planned for Limitations to Cash Flow Forecasting:
the six months. December 2012 sales were $40,000 1. Mistakes could happen in preparing
the revenue and cost forecasts
including no consideration for
inflation or exchange rate
fluctuations or market price
declines.
Jan Feb Mar Apr May Jun 2. Unexpected cost increases due to
wars or oil prices
Sales $ 30,000 40,000 50,000 30,000 20,000 40,000
3. Poor market research does not
indicate the true demand in the
future.

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 7

 Solution
Jan Feb Mar Apr May Jun
Cash Inflows
Collection of Sales 40,000 30,000 40,000 50,000 30,000 20,000
Selling Fixed Assets (van) 7,000
Total Inflows 40,000 37,000 40,000 50,000 30,000 20,000
Cash Outflows:
Payment for purchases 18,000 24,000 30,000 18,000 12,000 24,000
Rent / Salaries / Electricity 7,500 7,500 7,500 7,500 7,500 7,500
Loan Installment 26,000 26,000
Machine purchase 10,000
Total Outflows 25,500 31,500 63,500 35,500 19,500 57,500
Net Cash Flow 14,500 5,500 (23,500) 14,500 10,500 (37,500)
Opening Balance 13,000 27,500 33,000 9,500 24,000 34,500
Ending Balance 27,500 33,000 9,500 24,000 34,500 (3,000)

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 8

 REVIEW QUESTIONS

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 9

 Cash Flow Problem A business wants to prepare a
cashflow forecast for the first six
Sales forecast Jan Feb Mar Apr May Jun
months of 2018. The table below
Sales $ 10,000 11,000 13,000 12,000 14,000 10,000 shows the monthly sales forecast
for the period. The business takes
a one month credit from its
suppliers and purchases are 40%
of the same month’s sales.
Customers are allowed two
months to pay their dues. The
business must pay a monthly rent
of $2,000 and salaries of $3,000.
There is also a monthly loan
installment of $500. The business
is also planning to buy a van on
hire purchase by paying $1,000
each month. The sales for Nov-
2017 and Dec-2017 were $12,000
and $8,000 respectively. The
ending cash balance of Dec-2017
was $5,000. Prepare the cash flow
forecast.

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 10

1) Gurinder Singh runs a small business that manufactures office furniture. His best selling products are Notes

office desks and chairs. Sales turnover has risen but profits have stayed constant. The business is also
experiencing cash flow problems.
a) Identify and explain two possible causes of his cash flow problem.

b) Gurinder helps to finance his business activities by borrowing from a bank. His business has a secured
loan. What are the disadvantages to a business of using bank loans to finance their activities?

2) Easy Chairs is a private limited company that manufactures furniture. The business has recently had
financial problems. The management thought that these had been caused largely by an economic recession.
Important decisions needed to be made to solve these problems. The management are thinking about
making employees redundant. Identify and explain possible solutions to the financial problem at Easy Chairs
other than reducing labour costs.

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 11

3) Khan Clothing Ltd manufactures a range of clothing. The company’s products are sold to other businesses Khan Clothing Ltd
such as retailers. Khan Clothing Ltd is profitable but has cash flow problems. The Managing Director, Imran, Balance Sheet for 2003
is concerned about the large sum of money owed by debtors. He is not sure how to deal with the problem.
Fixed Assets 800,000
He could arrange a bank overdraft, as suggested by his accountant. Imran thinks that a long term loan might
be more suitable. Current Assets 1,200,000
a) Explain what is meant by debtors. How can a profitable business have cash flow problems? Current Liabilities 1,500,000
Net Assets 500,000
Financed by:
Long term Liabilities 400,000

b) What is an overdraft? Shareholders’ Funds 100,000

Total Capital Employed 500,000

Notes

c) What would you advise Imran to do about the cash flow problem? Explain your answer.

d) The company’s bank manager asked to see the balance sheet. Why do you think he would find this
useful? Use the balance sheet of the company to support your answer.

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 12

4) Carlton is the Managing Director of a company that owns twenty cafes. Carlton wants this business to Carlton
grow by opening another ten. He knows that the company will need to raise capital to finance this Balance sheet as at 21.12.2004
expansion. $000’s
a) Identify and explain two sources of INTERNAL finance that Carlton could use to finance the expansion. Fixed assets 1200
Current assets 600
Current liabilities 400
Net assets 1400
Share capital 300
Long term liabilities 1100
Capital employed 1400
Notes
b) Do you think that Carlton should increase its debt to finance the expansion? Explain your answer.

c) Explain how a profitable business could run out of cash.

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 13

5) Giovanni had been to see his bank manager to talk about ways of financing the growth of his business. He Notes

wanted to open five new shops selling electrical goods such as televisions and radio equipment. The bank
manager told him that he must think very carefully about the capital needs of this expansion which would
involve both fixed and current assets. The bank manager told Giovanni that he would need to see the
accounts of the business including a cash flow forecast before the bank could increase its lending.
a) What is meant by a cash flow forecast?

b) Explain two reasons why the bank manager would want to see the accounts of the business before
increasing the bank’s lending to Giovanni.

c) Discuss the factors Giovanni should consider for selecting a finance source best suited for this expansion.

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 14

6) Lloyd Samuel owns a meat wholesale business. He buys his supplies from local farmers and sells to Notes

private customers and retail shops. He pays for his supplies when they are delivered but sells to the retailers
on one month’s credit. The table shown is an incomplete cash flow forecast for the last three months of the
year. Cash Flow Forecasts ($000’s)
October November December
Opening Balance 5 ? 10
Cash In
Cash from sales to private customers 8 8 13
Cash from debtors 10 11 11
Cash Out
Purchases 5 9 19
Wages 6 6 6
Overheads 3 3 3
Monthly Net Cash Flow 4 1 ?
Closing Balance 9 ? 6

a) Calculate the missing values:

b) Explain one reason why Lloyd gives credit terms to the retail shops.

c) Why might a cash flow forecast be of use to Lloyd in managing his business?

d) Suggest one source of finance that Lloyd might use to expand his business.

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 15

Lopez is a medium sized business that produces a wide range of chocolate bars. It is located
in Country A and currently only sells chocolate bars in that country. It has been in business
for 6 years and has grown rapidly. Jennifer is the Managing Director of the company and her
Case Study: Lopez
brother, Miguel, is the Marketing Manager. They sell most of their chocolate bars to small Notes
shops. These shops pay cash two months after the goods are delivered.

Lopez manufactures chocolate bars using batch production methods. Jennifer is considering
changing to flow production if the company expands and sells its products to other
countries. Jennifer wants the business to continue to grow rapidly. However, she worries
about buying more raw materials to manufacture the chocolate bars because the present
supplier cannot supply any more. Lopez pays cash for supplies on delivery. Also, more
workers will need to be recruited to increase production and they may need to be trained.’
1,000,000 shares of $1 each were issued when the company was founded. The shares are
owned as shown in the figure below. Jennifer said, ‘Profitability of the company is good.
However, the cash flow has been a problem over the last two years and is still a problem.’

Summary of the sales and raw material costs for Lopez in 2005 in $’000 Summary of the cash flow for Lopez in 2005 in $’000
August September October
August September October
Cash From Sales 60 80 100
Sales for the month 100 150 200 Total In 60 80 100
Raw material costs 20 30 40
Raw Materials 20 30 40
Wages 50 60 55
Ownership of shares in Lopez Expenses 5 5 5
Jennifer
Purchase Of Machinery 1000
Total Out 75 95 1100
Miguel Net Cash Flow (15) (15) (1000)

4 other family members Opening Balance 20 5 (10)

Closing Balance 5 (10) (1010)

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 16

Identify the cash flow problem of Lopez and suggest ways in which it can be solved using finance.

Reconstruct the cashflow forecast for Lopez showing the effect of a new Summary of the cash flow for Lopez in 2005 in $’000
finance source that you suggest. August September October

Section 9: Finance IGCSE - OL Business Studies – Instructor: Khaled Nabil 17