Business Finance: Sources, Needs & Management

TAKEAWAYS:

• Business finance ensures a company has enough funds to start, grow, and operate smoothly.
• Sources of finance include internal (retained profits) and external (loans, shares, grants).
• Short-term finance (e.g., trade credit) is for daily expenses, while long-term (e.g., debentures) funds major projects.
• Financial ratios (like liquidity or profitability) help assess a business’s health.
• Poor financial management can lead to bankruptcy, but smart planning avoids this.
• NEB exams test definitions, comparisons (e.g., equity vs. debt), and scenario-based problems.

What is Business Finance?

Business finance is the lifecycle of money in a business:

1. Raising funds (where does the money come from?).
2. Allocation (how is it spent?).
3. Control (how is it managed to avoid waste?).

Why is it important?

• Starting a business: Needs money to buy land, machines, or stock.
• Daily operations: Pays salaries, rent, and bills.
• Expansion: Opens new branches or buys new technology.
• Emergencies: Covers unexpected costs (e.g., fire damage).

Sources of Business Finance

Finance comes from two main places: inside the business (internal) or outside (external).

1. Internal Sources

These are funds generated within the business itself.

pie
    title Internal Sources of Finance
    "Retained Profits" : 40
    "Depreciation Fund" : 30
    "Sale of Assets" : 20
    "Owner’s Capital" : 10

• Retained Profits:

  • Profits not distributed as dividends but kept in the business.
  • Example: If a company earns ₹1,000,000 and pays ₹600,000 as dividends, ₹400,000 is retained.
  • Advantages:
    • No interest or repayment pressure.
    • Shows investors the business is profitable.
  • Disadvantages:
    • May reduce shareholder returns.
    • Not available if the business is loss-making.

• Depreciation Fund:

  • Money set aside to replace worn-out assets (e.g., machines, vehicles).
  • Example: A factory’s machine costs ₹500,000 and lasts 10 years. Each year, ₹50,000 is saved for replacement.
  • Advantages:
    • Prepares for future expenses.
    • Reduces taxable income (in some countries).
  • Disadvantages:
    • Money is "locked" and not usable for other needs.

• Sale of Assets:

  • Selling unused assets (e.g., old computers, extra land).
  • Example: A shop sells an unused delivery van for ₹200,000 to buy new stock.
  • Advantages:
    • Quick access to cash.
  • Disadvantages:
    • Reduces business assets.

• Owner’s Capital:

  • Money invested by the owner(s) from personal savings.
  • Example: A sole trader uses ₹500,000 from savings to start a bakery.
  • Advantages:
    • No debt or repayment.
  • Disadvantages:
    • Risky if the business fails.

2. External Sources

Funds borrowed from outside the business (banks, investors, government).

A. Short-term Finance (Needed for less than a year)

Used for daily expenses like salaries, rent, or raw materials.

B. Long-term Finance (Needed for more than a year)

Used for major investments like buying land, buildings, or new technology.

Financial Needs of a Business

Businesses need money at different stages of their lifecycle.

timeline
    title Business Lifecycle & Financial Needs
    Phase 1: Startup
        Needs: Land, machinery, initial stock, registration.
        Sources: Owner’s capital, loans, grants.
    Phase 2: Growth
        Needs: Expansion, new technology, marketing.
        Sources: Retained profits, debentures, venture capital.
    Phase 3: Maturity
        Needs: Replacement of assets, R&D, dividends.
        Sources: Loans, shares, trade credit.
    Phase 4: Decline
        Needs: Restructuring, cost-cutting.
        Sources: Sale of assets, liquidation.

Example:

• Startup: A café needs ₹2,000,000 for:
  • Rent: ₹500,000
  • Kitchen equipment: ₹800,000
  • Initial stock: ₹400,000
  • Marketing: ₹300,000 Sources: Owner’s ₹1,000,000 + bank loan of ₹1,000,000.

Financial Management Tools

Businesses use ratios and budgets to stay healthy.

1. Financial Ratios

Ratios compare financial statements to assess performance.

2. Budgeting

A budget is a financial plan for the future.

• Types of Budgets:
  • Revenue Budget: Estimates income (e.g., sales).
  • Expenditure Budget: Plans spending (e.g., salaries, rent).
  • Capital Budget: For long-term investments (e.g., new factory).

Example: A shop’s monthly budget:

Common Financial Problems & Solutions

Exam Tip: How to Score Full Marks

NEB exams test concepts, comparisons, and applications. Here’s how to ace Unit 6:

1. Definitions:

   • Always define key terms clearly.
   • Example:

     "Trade credit is a short-term source of finance where a business buys goods or services on credit, paying the supplier at a later date (usually 30-90 days)."

2. Comparisons:

   • Use tables to compare sources of finance (e.g., loans vs. shares).
   • Example Question:

     "Distinguish between debentures and shares." Answer:

     Feature	Debentures	Shares
     Nature	Debt (must be repaid)	Equity (ownership)
     Dividend	Fixed interest	Variable dividend
     Voting	No voting rights	Voting rights
     Risk	Lower risk for investors	Higher risk

3. Scenario-Based Questions:

   • Example Question:

     "A small business needs ₹500,000 to expand. Suggest two sources of finance and explain why." Answer:

     1. Bank Loan: Provides a large amount (₹500,000) for 5 years at 10% interest. Suitable for long-term needs like machinery.
     2. Retained Profits: If the business has saved ₹300,000 from past profits, it can use this to reduce loan dependency. Shows financial strength to banks.

4. Ratio Calculations:

   • Example Question:

     "From the following, calculate the current ratio: Current Assets = ₹800,000; Current Liabilities = ₹200,000." Answer: Current Ratio = Current Assets / Current Liabilities = ₹800,000 / ₹200,000 = 4:1 (Interpretation: The business can pay its short-term debts 4 times over.)

5. Advantages/Disadvantages:

   • Always give at least two points for each.
   • Example:

     "What are the advantages of using retained profits?"

     • No interest or repayment pressure.
     • Shows investors the business is profitable.
     • Improves the company’s creditworthiness.

6. Diagrams:

   • Draw simple flowcharts or pie charts to explain sources of finance.
   • Example:

NEB-Style Practice Questions

Short Answer (5 marks each)

1. "Explain any three internal sources of business finance with examples."
2. "Differentiate between a bank loan and a debenture."
3. *"Calculate the liquidity ratio if:
   • Current Assets = ₹1,200,000
   • Current Liabilities = ₹400,000 Interpret the result."*

Long Answer (10 marks) 4. "A startup bakery needs ₹2,000,000 to begin operations. Suggest four sources of finance, explaining their suitability. Also, prepare a simple budget for the first month." 5. "‘Poor financial management can lead to business failure.’ Justify this statement with examples of financial problems and their solutions."

Key Formulas to Remember

Real-World Example: Nepal’s Small Businesses

Many small businesses in Nepal (e.g., tailors, tea shops) use:

• Internal: Retained profits, owner’s savings.
• External:
  • Short-term: Trade credit from suppliers (e.g., fabric shops).
  • Long-term: Bank loans for expanding (e.g., buying a sewing machine).

Challenge: High interest rates on loans can make repayment difficult. Solution: Some businesses join cooperatives to get better loan terms.

Common Mistakes to Avoid

1. Mixing short-term and long-term sources:

   • ❌ Using a loan for daily expenses (e.g., rent).
   • ✅ Use trade credit or overdraft instead.

2. Ignoring financial ratios:

   • ❌ Not checking liquidity before taking a loan.
   • ✅ Always calculate ratios to avoid cash crises.

3. Over-relying on one source:

   • ❌ Depending only on bank loans (risky if sales drop).
   • ✅ Mix internal (retained profits) + external (loans + grants).

Summary Checklist

Before the exam, ensure you can: ✅ Define business finance and its three main functions. ✅ List 4 internal and 4 external sources of finance. ✅ Compare loans vs. shares vs. debentures. ✅ Calculate liquidity and profitability ratios. ✅ Explain budgeting with an example. ✅ Solve scenario-based problems (e.g., "Where would a startup get funds?"). ✅ Draw a simple flowchart of sources of finance.

Final Tip: Business finance is like managing your pocket money—but on a larger scale! Always ask:

• Where is the money coming from?
• How will it be spent?
• How will we ensure we don’t run out?

Good luck with your NEB exams! 🚀