1. Start-up
New businesses need money before they can earn enough from customers. Finance may be needed for premises, machinery, vehicles, initial inventory, market research, promotion and everyday bills.
Cambridge International AS & A Level Business · 9609 · AS Level
5.1 Business Finance
Finance keeps a business operating, allows it to grow and can determine whether it survives a difficult period. This topic explains why finance is needed, why cash is not the same as profit, how financial failure can occur, and how working capital is managed.
Exam-focusedComplete Topic 5.1Interactive questions
What you need to know
For high-mark answers, separate finance, cash and profit. A profitable business can still fail if it cannot pay bills when they fall due. You should also be able to calculate working capital and explain how receivables, payables and inventory affect liquidity.
High-grade habit: when evaluating a finance problem, identify the time period involved. A short-term cash shortage needs a different response from a long-term need to finance buildings or expansion.
Subtopics
These subtopics follow the textbook table of contents. Select one to jump directly to it.
5.1.1
The need for business finance
CapitalMoney invested into a business by its owners or by outside organisations such as banks.
Businesses need finance to acquire assets, pay expenses and support business decisions. The amount and type of finance required depend on the situation and on how long the money will be needed.
Three major reasons businesses need finance
2. Growth
Expansion may require additional non-current assets, more employees, training, larger inventories and other resources needed to serve a bigger market.
3. Survival
A business may need finance during its early years or when a crisis reduces sales or unexpectedly raises costs. Extra finance can give the business time to recover and continue paying its debts.
Example: an online grocery business expanding into new cities may need finance for chilled storage, delivery vehicles, recruitment, training and additional inventory before the extra sales revenue arrives.
Assets and non-current assets
AssetAn item owned by a business that can help generate income.
Non-current assetAn asset expected to remain in the business for more than one year, such as premises, machinery or vehicles.
Short-term and long-term finance
| Type | Typical time period | Why it may be needed | Examples of finance mentioned in the topic |
|---|---|---|---|
| Short-term finance | Normally less than one year | To manage cash flow and day-to-day commitments when cash receipts are delayed or costs rise unexpectedly. | Working capital, retained profits and overdrafts. |
| Long-term finance | More than one year | To purchase major non-current assets, expand operations or finance a takeover. | Retained profits, sale of assets, sale and leaseback, loans, mortgages, debentures, shares, venture capital, government finance, crowdfunding and microfinance. |
Exam point: Topic 5.1 introduces why short- and long-term finance are required. The detailed advantages and disadvantages of individual sources are covered in Topic 5.2.
Cash is not the same as profit
ProfitThe surplus of sales revenue over total costs during a trading period.
ProfitMeasures financial performance over a period. A sale can contribute to profit even if the customer has not yet paid cash.
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CashMoney available to pay obligations when they fall due. Timing of inflows and outflows is crucial.
A profitable business can still face a cash shortage. Important reasons include:
- Customers buying on credit: sales are recorded, but cash may not arrive for 60 or 90 days.
- Large inventories: cash may be tied up in raw materials or finished goods waiting to be sold.
- Buying non-current assets: a large cash payment may be made now even though the asset will benefit the business for several years.
Example: a manufacturer sells $500,000 of goods at profitable prices but gives customers 90 days to pay. Wages and suppliers must still be paid now. The business can therefore report a profit and still be short of cash.
Exam warning: do not write about profit when the question is specifically about cash flow. Profitability and liquidity are connected, but they are not the same.
Business failure and insolvency
InsolvencyA situation in which a business cannot meet its debts because its liabilities exceed the assets available to pay them.
A shortage of finance can cause a business to fail even if its products are good or it has made profits in the past. The legal process depends on the type of business.
Business is insolvent
Debts cannot be settled as required.
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Debts cannot be settled as required.
Unincorporated business → bankruptcy
A sole trader or partnership may have business and personal assets sold to help repay creditors because the owners do not have limited liability.
A sole trader or partnership may have business and personal assets sold to help repay creditors because the owners do not have limited liability.
Company → administration or liquidation
Administration gives time to restructure and try to continue trading. Liquidation involves selling company assets and ending the company.
Administration gives time to restructure and try to continue trading. Liquidation involves selling company assets and ending the company.
Bankruptcy, administration and liquidation
| Process | Meaning | Key consequence |
|---|---|---|
| Bankruptcy | A court judges an individual, sole trader or partnership unable to pay debts. | Assets may be sold to pay creditors; owners of unincorporated businesses may risk personal assets. |
| Administration | A company receives legal protection while an administrator tries to reorganise finances and settle debts. | The aim is to keep the business trading if possible; if rescue fails, liquidation may follow. |
| Compulsory liquidation | A creditor seeks a court order because it has not been paid. | A receiver may take control, sell assets and distribute available funds to creditors. |
| Voluntary liquidation | The company owners choose to liquidate. | Assets are sold and the company is brought to an end. |
Evaluation: administration can be valuable when the underlying business is viable but has a temporary financial problem. It is less likely to succeed when the business model itself is weak and cannot generate enough future cash.
5.1.2
Working capital
Working capitalThe finance available for day-to-day operations after immediate liabilities have been taken into account.
Working capital is often described as the lifeblood of a business because it helps pay regular expenses such as fuel, raw materials, wages and other short-term bills.
Working capital = Current assets − Current liabilities
Positive working capital means current assets exceed current liabilities. Negative working capital means current liabilities are greater.
Current assetsAssets that can be converted into cash relatively quickly, including cash, trade receivables and inventories.
−
Current liabilitiesDebts due in the short term, including overdrafts or other short-term bank debt, trade payables and tax due.
Worked example: current assets are $25.0 million and current liabilities are $19.9 million. Working capital = $25.0m − $19.9m = $5.1 million.
Second step: if current assets fall by 5%, they become $23.75m. If current liabilities rise by $1.1m, they become $21.0m. New working capital = $23.75m − $21.0m = $2.75 million. The business still has positive working capital, but its short-term financial cushion has weakened.
Managing working capital
A business can improve its working-capital position by controlling the timing of cash tied up in inventory and credit transactions.
Collect receivables promptly
Customers should pay within agreed credit periods. Faster collection brings cash into the business sooner.
Avoid excessive inventory
Inventory is a current asset, but too much of it ties up cash that could be used elsewhere.
Manage payables carefully
Where possible, a business may negotiate longer credit from suppliers so that cash remains in the business for longer.
Balance matters: delaying supplier payments can improve cash temporarily, but paying too late may damage supplier relationships, reduce future credit and harm reliability.
Trade receivables, trade payables and trade credit
Trade receivablesMoney owed to the business by customers for goods or services already supplied.
Trade payablesMoney the business owes suppliers for goods or services already received.
Supplier deliversGoods or services are provided now.
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Credit periodPayment is delayed for an agreed time.
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PaymentCash is paid when the credit period ends.
Trade credit is therefore a period allowed by a supplier before payment is required. From the buyer's viewpoint, it creates a trade payable and can act like a short-term, interest-free source of finance. From the seller's viewpoint, the same transaction creates a trade receivable and delays cash inflow.
Example: an airline buys $5 million of fuel in March but pays in June. For the airline, the $5 million is a trade payable. For the fuel supplier, it is a trade receivable until payment is received.
Revenue expenditure and capital expenditure
Revenue expenditureSpending on goods and services that are used up in the short term as part of normal trading, such as wages, fuel, raw materials and components.
Capital expenditureSpending on non-current assets that will be used over a long period, such as premises, vehicles, machinery and major computer systems.
| Feature | Revenue expenditure | Capital expenditure |
|---|---|---|
| Time horizon | Used up relatively quickly. | Provides benefits over several years. |
| Examples | Fuel, materials, components, wages. | Property, vehicles, production equipment. |
| Financial statement | Recorded as an expense in the income statement. | Recorded as a non-current asset in the statement of financial position. |
| Effect on profit | Directly contributes to current-period costs and therefore affects profit. | The purchase itself is not treated as an immediate operating expense in the same way; the asset supports future operations and profits. |
Exam technique: classify the purpose of the spending, not merely its size. A very large purchase of raw materials is still revenue expenditure, while a smaller machine expected to last several years is capital expenditure.
5.1 revision checklist
Explain why businesses need finance at start-up.
Explain why growing businesses need additional finance.
Explain why finance may be needed for survival.
Distinguish short-term from long-term finance needs.
Explain why cash and profit are different.
Explain how credit sales can create a cash shortage.
Explain how inventory can tie up cash.
Define insolvency and liabilities.
Distinguish bankruptcy, administration and liquidation.
Explain the difference between compulsory and voluntary liquidation.
Calculate working capital.
Identify current assets and current liabilities.
Explain how trade receivables affect cash.
Explain how trade payables can support working capital.
Explain why excessive inventory weakens cash availability.
Distinguish revenue expenditure from capital expenditure.
Questions open in a pop-up. Each answer is marked immediately, with an explanation so you know why it is correct or incorrect.