Unit 2 Lecture 1: Planning a business and raising finance

1 Planning
A business plan: is a document containing the business objectives and important details about the
operations and finance of the firm.
 Most loan provider will ask for a business plan before providing any loan to the business.
 Without a detailed business plan the bank will not be interested to lend money to the business.

Business plan example-

Name of the business Pizza Place Ltd
Type of organisation Private Ltd company
Business aim To sell pizza
Product pizza
Price Average price £8
Market aimed for Young people and family
Market research undertaken and results Research carried out using questionnaire in the local
area.
Human resource plan Two staff and owner manager
Details of senior staff and business owners Mr. T chef 15 years’ experience
Mr. Y- manager of restaurant for three years
Production details and business costs Main suppliers- Wholesale ltd.
Fixed cost- £10000 per annum. Variable cost- £3 per unit
sold
Location of business Leasehold house at YZ avenue.
Main equipment required Kitchen equipment-£5000
Forecast profit Forecast revenue £50000 and cost £30000 and profit
£20000. BEP is 2000 unit per year
Cash flow Negative cash flow in the first year
Finance £10000 invested by the owner and loan required £10000.

Evaluation of business plan

For Against
1. It helps to plan the future activities of the 1. Most of the data used in a business plan is
business which helps to manage and future estimation which can be wrong due to
coordinate the business resources and changes in variables like market conditions.
activities 2. Many businesses have become successful
2. Business plan needs to be added with the without a proper business plan.
application for finance 3. A lot of information need to be collected and
3. The business can evaluate its performance analysed to prepare a business plan which
by comparing the actual results with targets can be time consuming and expensive.
set in the business plan.
4. It helps to determine the requirement of
startup capital and competition and prices to
be charged by the business

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 Sources of finance
What is finance?
Arranging money or capital for the business is financing.
Why businesses need finance?
1. To start up a business
2. To expand an existing business
3. To solve cash shortfall problems of a business
4. To purchase fixed assets such as equipment, land, vehicles etc.
5. To purchase raw materials
6. To pay for wages, rent and other regular expenses.

Startup capital: is the finance needed by a new business to pay for fixed and current assets before it can
begin trading.

Capital expenditure: is the money spent on fixed assets which will last for more than one year.
Expenditure: purchasing land, plant, vehicles, furniture etc.

Revenue expenditure: is money spent on day to day expenses which do not involve the purchase of a long
term asset. Example: rent, wages, telephone, electricity, purchase of inventory or stock etc.

Sources of finance
Internal source: Money arranged from within the business itself is internal sources of finance. Example-
retained profits, sale of assets, sale and lease back of important noncurrent assets , running down stock to
raise cash, owner’s savings for unincorporated businesses.

External source: Money arranged from outside of the business is external sources of finance. Example-
issue of share capital and debentures only for incorporated business, loans, factoring debts, venture
capital, overdrafts, leasing, trade credit, business angels, peer to peer, crowd funding.

Internal sources of finance- evaluation

For:
1. No interest expense and no repayment are required.
2. Finance arranged by selling fixed assets ensures better use of the capital tied up in business.
3. Running down stocks save high storage costs.
4. The finance is available to the business very quickly.
Against:
1. New businesses do not have retained profit or assets to sell
2. Selling assets may take some time
3. Finance may not be enough for business’s requirement
4. Using profits for finance reduces payments to owners which can demotivate entrepreneurs.
5. Owners risk will be increased if retained profit is used.

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External sources of finance
Family and friends- A common source of finance for small businesses is to borrow from close friends or
family members.
Advantages
1. It is a suitable for small business and first time entrepreneurs.
2. It is easier to obtain by new entrepreneurs as friends and family might have faith in the individuals.
3. There is lower pressure on repayment compared to banks
4. The interest rate can be very low or none in some cases.
5. They may not want a share in the ownership and not interfere in the decision making.
Disadvantages
1. The money available from friend and family might not be sufficient to set up the new business.
Further finance may still be required from other sources.
2. If the loan is not paid in time, the relationship with friends and family might deteriorate.

Issue of share capital: A limited company can divide its capital in to many equal portions which are known
as shares. These shares can be sold to many people to arrange large amount of capital.
For
1. Permanent source of capital and no repayment is required.
2. No interest expense
Against
1. Dividends will be expected by the shareholders.
2. The ownership and control of the company could change hand
3. It is more expensive to issue as advertisements and underwriters are required

Debentures: these are long term loan certificate issued by limited companies.
For: long term finance source such as for 25 years.
Interest rates are lower than other types of loan
Against:
1. Must be repaid and interest must be paid.
2. It is more expensive to issue as advertisements and underwriters are required

Bank loans:
For:
1. usually quick to arrange
2. Can be of varying length of time
3. Large businesses can get loans at low interest cost for large sums.
Against:
1. Must be repaid and interest cost.
2. Security or collateral usually required for loans. Such as fixed asset of the company or sole trader’s
own house.

Factoring of debts: debt factors are specialist agencies that buy the debts (trade receivables) of firms for
immediate cash. They may offer up to 90% of an existing debt. The debtors will then pay the debt factor
agency. It is a short term source of finance.
For:
1. Immediate cash is available
2. The risk of debt collection might be transferred to the debt factor.
Against:
1. The business does not receive 100 percent of the value of its debtors.

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Overdrafts: is a facility granted by a bank to a business which enables a business to draw more money than
it has in its accounts. It is a type of short term loan.
For:
1. Overdraft can be obtained any time once the bank grants for a certain period.
2. Any amount up to the agreed limit can be overdrawn which makes it very flexible for the business.
3. Interest is only paid on the overdrawn amount.
Against:
1. Interest rates on overdrawn amount is higher than other types of loan
2. Interest rate is not fixed. It varies with time and market condition.
3. The bank may ask for repayment of overdrawn amount to the business at a very short notice which
can make cash flow planning difficult.

Trade credit: is buying inventories from supplies on credit or time

For:
1. No interest is paid on due amount up to the time agreed by the supplier.
2. It can help resolve cash flow problem without taking bank loans.
Against:
1. No discount on price is available if purchased on credit
2. Suppliers may refuse to supply more goods unless payment is not made quickly.

Leasing: is renting an asset. It allows the firm to use an asset without purchasing it. Monthly leasing
payments are made. The business can decide to purchase the asset at the end of the leasing period. Some
businesses decide to sell off some fixed asset for cash and lease them back from a leasing company. This is
called sale and lease back.
For:
1. Large amount of cash is not needed by the business.
2. Maintenance of the asset is carried out by the leasing company.
3. Leasing companies can offer the most up-to-date equipment
4. Leasing agreement is generally easier to obtain by a new business than other forms of loan finance.
Against:
1. The total cost of the leasing charges will be higher than purchasing the asset.
2. Leased asset cannot be used as collateral for loan.

Grants- are non-repayable funds or products given by one party often a government department,
corporation, foundation or trust, to a profit or not for profit business.
Most grants are made to fund a specific project and require some level of compliance and reporting.
Grants can be given to individuals who seek to open a small business. Government often provides grants to
encourage a business to set up new factories in an economically underdeveloped area.
One of the drawbacks of grant is that a business has to follow the conditions of the grant which can
interfere with business’s independence in decision making.

External alternative sources of finance-

Business angels: Business angels are wealthy, entrepreneurial individuals who provide startup capital for
small business in return for a proportion of the company equity. They take a high personal risk in the
expectation of owning part of a growing and successful business.
Business angels provide modest amount usually between £10000 to £250000 to businesses willing to sell a
shareholding in return for financing.

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Venture capital: Money provided by investors to startup firms and risky small businesses with perceived
long-term growth potential. Equity finance of over £250,000 is usually provided by venture capital firms
rather than business angels.
This is a very important source of funding for startup businesses that do not have access to capital markets.
It typically entails high risk for the investor, but it has the potential for above-average returns.
Most venture capital comes from a group of wealthy investors, investment banks and other financial
institutions that pool such investments or partnerships. This form of raising capital is popular among new
companies or ventures with limited operating history, which cannot raise funds by issuing debt.
The drawback for entrepreneurs is that venture capitalists usually get a say in company decisions, in
addition to a portion of the equity.

Peer-to-peer lending (P2PL)- involves lending money to unrelated individuals or peers and therefore
avoiding the use of bank. Transactions are undertaken online and are organised by specialists such as
Lendbox in India, Zopa in the UK and Pandai in China. This source of finance is available for both business
and individuals. It is very similar to traditional borrowing from a bank, except that you borrow from lots of
investors. Peer to peer finance method removes the middleman from the process; it also involves more
time, effort, and risk than usual investment through financial institution.
The key feature of peer to peer finance are-
 All loans are unsecured
 All transactions take place online.
 Peer to peer sites charge usually 1 percent for the arrangement.

Crowd funding: is similar to peer to peer lending where only money is only borrowed to business
ventures. It is the practice of funding a project or venture by raising small amounts of money from a large
number of people, typically via the Internet sites like- kickstrater.com, gofundme.com Ulule.com etc. In
2015, over US$34 billion was raised worldwide by crowd funding.

Short and long term finance

Short term finance: Businesses uses this type of finance for day to day operation and resolving cash
shortfall (working capital problem). This types of finance are usually available for up to a year.
Ex: overdraft, trade credit, factoring of debts etc.

Long term finance: This type of finance available for more than one year and used to purchase long term
fixed asset, to upgrade or to expand the business.
Ex: share capital, long term loans or debt finance, debentures.

Secured and unsecured loan – cost of borrowing

Secured loan: is any loan secured against businesses’ or personal assets. It means if the business is unable
to pay the loan the loan providers can sell the asset and realise their money. Businesses can provide land,
building, shares, and equipment as collateral or mortgage. The business will be able to use the asset
despite giving it as a security to the bank or other finance providers.
Usually this type of loan is long term loan and regular installment is paid to the finance provider.
Business may get up to 90% of the value of the asset as loan.
From loan providers point of view secured loan is less risky as they can always sell the asset to get their
money back.
The interest rate on secured loan is usually lower than unsecured loan.

Unsecured loan: are more risky for the loan provider and are usually given for short term and has a high
interest charge.

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Appropriate Source of finance for different company structure
Sole trader: internal source, business angels, friends and family, secured loan from banks, new capital
introduction by the owner etc.
Partnership: new partner, loan by any partner, internal source, secured loan etc.
Private limited company: issue of new share, secured or unsecured loan, overdraft, internal source, leasing
etc.
Public limited company: issue of new share, debentures, secured or unsecured loan, overdraft, internal
source, leasing etc.

Factors that affect the choice of finance:

1. Status and size of the business
2. Amount needed
3. Financial situation of the business- gearing ratio -high or low
4. Cost- Interest rate
5. Use of the fund
6. Availability of collateral
7. Duration of the fund requirements
8. Control of the business

 Unlimited liability means that the owner of a sole trader or the partners of a partnership are
personally liable for the business debts in excess of the capital they have invested. They may need
to sell personal assets to pay of the debts of the business.
 Limited Liability- means that the shareholders or the investor are only liable for business debts up
to the amount they have invested in a limited company.
.
Evaluation of limited liability
For Against
1. It reduces the risk of the shareholders in 1. Sometimes unlimited liability makes people
case of a business failure work harder to achieve success.
2. Investors are encouraged to purchase shares
in business because of limited liability
3. Private and public limited companies can
collect capital easily by offering limited
liability.
Questions
1. Explain the differences between revenue and capital expenditure? [4]
2. What is meant by startup capital? [2]
3. Assess the importance of retained profit as a source of finance. [6]
4. Evaluate the importance of internal sources of finance? [8]
5. State the advantages and disadvantages of using sale of assets to raise finance. [4]
6. What is the difference between crowd funding and peer to peer lending. [4]
7. What are the differences between business angels and venture capital? [4]
8. What is meant by capital gain? [2]
9. State two advantages of leasing as a method of finance. [2]
10. Evaluate the importance of share capital as a source of finance. [8]
11. Explain the difference between secured and unsecured loan. [4]
12. Assess the importance of bank overdraft as a source of finance. [8]
13. Evaluate the importance of external source of finance to a business. [8]
14. Explain the difference between short term and long term finance. [4]

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 Forms of business
 Unincorporated businesses- where there is no legal difference between the owner and the
business. Example- Sole trader and Partnership businesses.
 Incorporated businesses are those that have separate legal identity from the owners. Example-
private and public limited companies.

Sole trader: is a business owned by just one person. It is also known as sole proprietorship. This the most common
form of business structure in the world.
Advantage: Disadvantage:
 Enjoys all the profit  Lower capital than other types of businesses as
 It is easy to set up as there are few legal owner's saving is the main source.
requirements.  May not be able to arrange loan as banks often
 Own boss. Complete control over business. considers sole traders as too risky.
 Freedom of choice to take holidays and  A sole trader will have unlimited liability means
determining working hours. the owner can lose personal asset if his business
 Can have close contact with customers and can is unable to pay its debts.
respond quickly to customers’ requirement.  Independence can create too much pressure.
 Can offer personal services because they are  Long hours and very hard work
small.  Decision making cannot be shared with others
 Business information remains confidential and which can sometimes lead to wrong decisions.
only shared with tax authority.  There is no continuity for the sole trader
 May qualify for government help as a small business which means the business will shut
business. down with the retirement or death of the owner.

 Unlimited liability that the owners of a business can be held responsible for the debts of the business they
own. Their liability is not limited by to the investment they made in the business.
 Limited liability means that the liability of shareholders in a company is only limited to the amount they
invested.

Partnership: a partnership is a group or association of between 2 and 20 people who agree to own and to run a
business together.
Advantages Disadvantages
 More capital than sole trader as more than one  Profit is shared among partners.
owner will contribute capital.  Unlimited liability.
 The responsibility of running the business can be  No separate legal identity.
shared among partners.  Disagreement among partners may occur and
 Losses are shared among partners. can cause the business to shut down.
 The partners can be specialised in different areas  Other partners may suffer losses for one
of expertise which can help the business to be inefficient or dishonest partner.
more effective and efficient.  The number of partners is limited by law in most
 Financial information is not published -remains countries.
confidential  One partner is responsible for another partner’s
action.
 As partnership businesses are not considered as
safe by the banks, it is difficult to obtain a loan
from bank.

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Partnership agreement: is a verbal or written and legal agreement among business partners. Written agreement is
recommended.

Terms usually included in a partnership agreement:

1. Amount of capital invested by each partners
2. The tasks or roles to be undertaken by each partners
3. Profit sharing ratios among partners
4. The length of the partnership business
5. Whether interest will be charged on capital or drawings
6. How new partners could be admitted in the partnership.
7. Arrangements for absence and retirements of partners.

Limited partnership- is where some partners contribute capital and enjoy a share of the profit and limited liability
but do not take part in the running of the business. The partners who do not take part in running of the partnership
are known as sleeping partners. In a limited partnership at least one partner will suffer unlimited liability who is
responsible for making all the decision and running the business.

Limited Company- Incorporated business

Limited companies are businesses that are owned by shareholders whose liabilities are limited by the
amount they have invested in the business. These businesses have separate legal identity from their
owners. There are specific laws known as company acts under which these businesses are established.
Therefore setting up and running a limited company is more difficult and expensive than a sole trader or a
partnership.

 Limited liability: means the owners are liable up to the amount they have contributed as capital.
 Shareholders: are the owners of a limited company. They buy shares which represent part
ownership of a company.
 Dividends: are payments made to the shareholders from the profits of a company.
 Annual general meeting (AGM): is a legal requirement for all companies where all shareholders
may attend and vote to elect directors for the coming year.
 Stock exchange or market: is where second hand shares of a public limited company are traded.

Required legal document for a limited company:

 A memorandum of associations- is a document that sets out the constitution and states key
external details about a limited company. It contains important information like-
 the name and registered address of the company,
 the objectives of the business,
 the amount of capital to be raised and the number of share to be issued

 An article of association- is a document that provides details of the internal running of a limited
company. It includes details such as –
 Rights of the different types of shareholders
 Procedures for appointing directors
 Length of time directors should serve before re-election
 Timing and frequency of company meeting
 Arrangements for auditing company accounts.

 A certificate of incorporation is a document issued by the company registrar office of the

government that declares a business is allowed to trade as a limited company.
 Stock market floatation or Initial public offering (IPO) is the process of a company going public
which means the business is making its shares available to the public for the first time.
IPO is an expensive process, because-
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  The company must have a £50000 share capital
 The company has to bear advertising and administrative expenses of issuing shares
 The company going public needs to hire lawyers to publish legally correct prospectus and
investment banks to process share application.
 The share must be underwritten (insurance to sell all shares) for a fees

There are two forms of limited company- Private limited company and public limited company.

Private Limited Company: is a business with separate legal entity and owned by shareholders with limited
liability whose shares cannot be traded in a stock exchange. This type of company must use “Ltd” in its
name.
Advantages:
 Can raise more capital by selling shares than a sole trader or a partnership as it can sell its shares to
up to 50 shareholders to raise capital.
 Limited liability of shareholder which means that they will not lose their personal assets to pay off
the liabilities of the business.
 Separate legal entity- which means the company can own asset and sue others using its own name.
 Business will continue regardless of any changes in ownership.
Disadvantages:
 Cannot sell shares to the public, so the amount of capital raised by a private limited company is
usually lower than a public limited company.
 A private limited company has to obey more legal formalities than a sole trader and partnership.
 Accounting information is not confidential as annual reports must be submitted to the company
registrar office.
 Not easy to transfer shares as these cannot be traded in the stock exchange. So few people are
interested to buy shares in a private limited company.

Public limited company: is a business with separate legal entity and owned by shareholders with limited
liability whose shares can be traded easily in a stock exchange. This type of company uses “Plc.” in its name
and also known as quoted or listed company.
Advantages:
 A Plc can sell shares to public, so it can arrange more capital than any other form of businesses
 Shares in a Plc can be easily traded in the stock exchange.
 Professional managers are used to run the company, who are more component to make right
decisions and can manage the business more efficiently.
 Limited liability of the shareholders- hence selling shares are easier.
 Business will continue regardless of any changes in ownership.
 Higher status due to larger assets and capital, hence arranging loan is easier.

Disadvantages:
 Too many legal formalities
 Ownership and control are separate as the managers who control the business might not make
decisions for the best interest of the shareholders.
 Selling share to public and running as PLC is very expensive
 Accounting and other information must be made public

Franchise
 Franchise: is a business based upon the use of the brand names promotional logos and trading methods of
an existing successful business.
 Franchisor: sells the license giving permission to use brand names promotional logos and trading methods.
Example- Pizza Hut, MacDonald's etc.
 Franchisee: buys the license to use brand names promotional logos and trading methods.

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Advantages and disadvantages to a franchisor
Advantages Disadvantages
 License fee is earned from franchisee.  Potential profit will be shared with franchisees.
 Expansion of the business is faster without much  Poor management of any store can lead to bad
investment from the franchisor. reputation for the whole business.
 The management of the store is the  Franchisees may get raw materials from
responsibility of the franchisee. elsewhere.
 Franchisee may be contracted to buy all  The cost of supporting franchisees may be high.
materials and products from the franchisor.
 Franchisee are more motivated than employees
 Franchisee takes some of the risk on behalf of
the franchisor.

Advantages and disadvantages to franchisee:

Advantages: Disadvantages:
 Chance of business failure is very low as  Less independence as operating decisions are
successful product is being sold. guided by franchisor.
 The franchisor bears the cost of national  License fees are paid to franchisor.
marketing.  Setting up a franchise can be an expensive way
 All material is supplied by the franchisor. to start a business.
 Franchisor provides training for staff and  Franchisee’s profit is shared with franchisor.
management.
 Loans from banks can be easily obtained due to
low risk.

Social enterprise
 Social enterprise businesses aim to improve human or environmental wellbeing rather than to make profit.
Example- charities, cooperatives etc.
 These businesses are often known as not for profit or non-profit organisation.
 Social enterprises generate most of their income by trade or donation.
 These businesses also reinvest most of their profit.
 Charities are organisations that give money, goods or help to people who are poor, sick or in need.
 Cooperatives- are businesses in which all the people working are equal owner of those businesses.
Cooperatives can be a consumer cooperatives, retail cooperatives and worker cooperatives.
 Mutual organisations- businesses are owned by their members who are customers not shareholders. Profits
are returned to members in the form of better and cheaper products.

Lifestyle business- is a business that aims to make enough money to provide the flexibility needed to support a
particular lifestyle for the owner.
Features-
 The business will often be small and is likely to have just one owner.
 The personal interests of the entrepreneurs are likely to influence the nature of the business, so that time
spent is enjoyable.
 Running the business is likely to be much less stressful than other forms of business.
 The business is likely to be home based.
 Lifestyle businesses are sometimes considered to be an alternative to retirement.
 Advantages and disadvantages are similar to sole trader businesses

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Online business- uses the internet to sell its goods and services.
Features-
 Customer access the business via internet.
 All online businesses have websites which gives information about their products, their prices and general
information about the company.
 Online businesses collect payments for goods and services electronically through credit cards, debit cards or
PayPal etc.
 There are no formal or legal procedures to following to set up an online business.
 Online businesses have low setup costs
 Many on-line businesses are also run from home.

Questions
1. What is meant by a sleeping partner? [2]
2. Assess the importance of a sole trader business. [8]
3. Evaluate the importance of a partnership business. [8]
4. Explain the importance of partnership agreement. [2]
5. What is the difference between limited and unlimited liability? [4]
6. What is the difference between incorporated and unincorporated business? [4]
7. What are the main differences between private and public limited companies? [4]
8. State four financial costs of incurred when forming a public limited company. [4]
9. A private limited company decided to raise more capital by converting itself in to a public limited
company and selling share to the public. Discuss this decision. [8]
10. What is meant by stock market floatation or Initial Public Offering? [2]
11. What is meant by stock exchange or market?[2]
12. State three features of a lifestyle business. [3]
13. What are advantages and disadvantages to a franchisor? [4]
14. What is meant by a social enterprise? [2]
15. State two advantages and two disadvantages of an online business. [4]

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