Component 1: Finance – Business finance — Eduqas A-Level Business
Test yourself on Component 1: Finance – Business finance with EDUQAS A-Level practice questions.
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Component 1: Finance – Business finance explained
Size and legal form set the menu. A well established private limited company can approach its bank, its existing owners and its own retained profit, while a public limited company can also issue shares on the stock market, sell corporate bonds or run a rights issue to current shareholders, and can raise sums no sole trader could reach. Fit is then decided by four questions: what is the money for, how long is it needed, what does it cost, and what does it do to control and to risk. The matching principle answers the first two, long lived assets funded by long term finance and day to day working capital by short term facilities. Gearing, non current liabilities divided by capital employed and multiplied by one hundred, answers the last, because above roughly fifty per cent a firm is highly geared and interest becomes a fixed charge that must be met in a bad year.
Understand that sources of finance can be internal and/or external
The division is about where money comes from, not what it buys. Money generated by the business itself, out of profit, out of assets it already owns or from the proprietors already involved, sits on one side; money supplied by outside parties, banks, new shareholders, factors, lessors and suppliers, sits on the other. Most funding packages blend the two, and a lender or investor expects the owners to commit their own money first because that signals confidence. Funds raised inside carry no interest and dilute nobody, yet they are capped by past profitability and carry an opportunity cost, since profit kept is a dividend not paid and an asset sold is capacity given up. Money raised outside can be scaled to the project, but brings interest, covenants, security taken over assets, or a share of ownership and of future profit.
Explain internal sources of finance including owner’s capital, retained profit and sale of assets
Profit kept back after tax and dividends is the cheapest large fund an established firm has: no interest, no repayment date and no loss of control, although it is limited by how profitable the firm has been and by shareholders who expect income now. Money put in by the proprietors themselves, from savings or a further injection of equity by the people who already own the firm, keeps ownership inside the existing group but ties personal wealth to a single business. Selling something the firm owns turns a dormant machine, a spare warehouse or a surplus delivery vehicle into cash, and sale and leaseback does the same with a building the firm still needs, at the price of a rent bill for years afterwards. All three are capped or one off, so none of them funds sustained expansion on its own.
Explain external sources/methods of finance including overdrafts, loans, share capital, venture capital, leasing, trade credit and debt factoring
Each of these solves a different problem, and the marks are in the match. An overdraft covers a short gap between paying suppliers and being paid, charging only on the amount used, yet the rate is high and the bank can demand repayment at any time. A bank loan funds a specific asset over a fixed term with a known repayment schedule, is usually secured, and lifts gearing. Share capital is permanent, needs no repayment and pays a dividend only when profit allows, but dilutes control. Venture capital brings equity and expertise to a high risk, fast growing firm at the price of a large stake, a board seat and pressure to exit within about five years. Leasing spreads the cost of equipment and avoids a large outlay while costing more across the asset life. Trade credit delays payment for perhaps sixty days at no interest, and factoring sells invoices for cash now, less the fee.
Explain the advantages and disadvantages of different sources of finance to a business and the importance of choosing appropriate sources
Every option trades one thing for another, and the comparison is what earns credit. Borrowing is normally cheaper than equity because interest is an allowable expense and lenders carry less risk, yet it has to be serviced whether trading is good or bad, and each new facility lifts gearing towards the level at which a bank says no. Equity never has to be repaid and cushions a downturn, but it dilutes control, spreads earnings over more shares and is expensive to issue. Short term facilities are quick and flexible, long term ones are dearer to arrange and far safer for a large asset. Getting the choice wrong is not neutral: funding a factory on an overdraft lets the bank call the money back in the worst month, while issuing shares to cover a seasonal stock build hands away permanent ownership to meet a temporary need.
Evaluate the impact of different sources of finance to a business and its stakeholders
Judgement here means following the money through to the people it touches. A large loan raises gearing and interest, cuts the profit available for dividends, tightens covenants that restrict what managers may spend and can threaten jobs if trade weakens, so owners, managers, employees and the lender all read the same decision differently. New equity removes that pressure but spreads future profit over more shares, so earnings per share falls and existing owners lose voting weight. Factoring pays suppliers on time and protects that relationship while shaving the margin on every invoice. The test worth applying is affordability against flexibility, and interest cover, operating profit divided by interest paid, measures how many times earnings meet the charge, with a figure close to one leaving no margin for a poor year.
Your focus
- Explain the sources of finance available to established and large businesses and consider their appropriateness for different circumstances
- Understand that sources of finance can be internal and/or external
- Explain internal sources of finance including owner’s capital, retained profit and sale of assets
Show all 6 objectives
- Explain external sources/methods of finance including overdrafts, loans, share capital, venture capital, leasing, trade credit and debt factoring
- Explain the advantages and disadvantages of different sources of finance to a business and the importance of choosing appropriate sources
- Evaluate the impact of different sources of finance to a business and its stakeholders
Component 1: Finance – Business finance exam tips
Marking Points
- Matches the money to the purpose and the timescale, so a long lived asset is funded long term and a seasonal stock build by an overdraft.
- Recognises that legal structure limits the options, since only a public limited company may sell shares to the general public through the stock market.
- Uses gearing, non current liabilities as a percentage of capital employed, to judge whether further borrowing is affordable, with above fifty per cent treated as high.
- Compares at least two realistic options for the case business and justifies one on cost, control and risk rather than asserting it.
- Separates the two by origin, money generated within the business against money supplied by outside parties, rather than by the sum involved.
- Places named examples on the correct side, for instance retained profit inside the business and trade credit outside it.
- Explains that a real funding package usually blends both, and that lenders expect owners to put their own money in first.
- Identifies the opportunity cost of money raised inside, such as dividends forgone or an asset no longer available to use.
- Defines retained profit as profit after tax and dividends kept in the business, needing no interest payment and no repayment.
- Explains money from the proprietors as funds injected by existing owners, preserving control while concentrating personal risk in one firm.
- Treats selling something the firm owns as a one off inflow, and separates disposing of a surplus item from sale and leaseback, which creates a continuing rental cost.
- Recognises the ceiling, since what can be raised this way is limited by past profits and by what the business actually owns.
- Matches each method to a purpose, short term working capital covered by an overdraft or supplier credit and a long lived asset by a loan, a lease or new equity.
- States the cost of each, interest on borrowing, dividends and dilution on equity, a settlement discount given up on supplier credit and a percentage fee on factoring.
- Notes that borrowing is usually secured against assets, so failure to keep up repayments puts those assets at risk.
- Explains factoring as selling trade receivables at a discount to release most of the invoice value immediately rather than waiting for the customer.
- Pairs each benefit with the matching drawback, for instance no repayment obligation on equity set against permanent dilution of control.
- Explains that borrowing is normally cheaper than equity because interest is tax deductible and lenders hold security, at the cost of a fixed servicing burden.
- Applies the matching principle and shows the consequence of ignoring it, such as a facility being withdrawn while a long lived asset is only part paid for.
- Judges fit against the circumstances given, the profit record, existing gearing, the cash position and the owners attitude to control.
- Traces the effect through to named groups, owners, employees, lenders, suppliers and managers, rather than stopping at the business itself.
- Supports the judgement with a ratio such as gearing or interest cover and interprets what the figure means for risk.
- Weighs immediate relief against longer term cost, for example the cash released by factoring against the fee paid on every invoice.
- Reaches a conclusion that depends on the circumstances in the case and states what would change it.
Examiner Tips
- 💡Check the legal form and the balance sheet figures in the case before naming anything, because both rule options in and out.
- 💡An answer that names one option and gives a reason it fits this firm scores far above an answer that lists six of them.
- 💡Where the case shows existing borrowing, work out gearing and use the figure to support your choice.
- 💡A short definition question rewards one clear clause plus one correctly classified example taken from the case.
- 💡In longer answers state the split first, then argue which side suits this business given its profit history and its gearing.
- 💡Use the accounts in the case, since retained profit and non current assets are normally printed there and turn a generic answer into an applied one.
- 💡When asked to recommend, say why this route fits the size of the sum needed, and admit plainly where it falls short.
- 💡Name one method, then give the reason it suits this business, rather than writing out every method you can remember.
- 💡Where the case problem is liquidity, factoring and an overdraft are usually the relevant pair, and the judgement is cost against speed.
- 💡Comparing two options for one named need scores higher than describing six options for no need at all.
- 💡Use the figures printed in the case, gearing, profit and interest, to support the choice instead of asserting that one is better.
- 💡Sort the groups into those who gain and those who lose, then judge which effect matters most to this business at this moment.
- 💡A conclusion saying it depends earns nothing unless the answer says what it depends on, such as how stable sales revenue is.
Common Mistakes
- Proposing a public share issue for a private limited company or a partnership, which cannot sell shares to the public at all.
- Recommending an overdraft to buy premises, which sets a facility repayable on demand against an asset the firm will hold for decades.
- Ignoring interest and the security a lender will demand, so the recommendation reads as though the money were free.
- Calling money raised inside the business free, when retained profit belongs to shareholders and using it costs them a dividend.
- Classifying an overdraft or a government grant as internal because the directors chose it, confusing the decision with the origin of the funds.
- Assuming retained profit is cash sitting in the bank, when it may already be tied up in inventory, receivables or equipment.
- Proposing the disposal of an asset the firm needs to trade, which raises money now and cuts capacity and output later.
- Forgetting that shareholders may resist a dividend cut, so profit is not automatically available to be kept back.
- Describing a leased asset as owned, when an operating lease leaves ownership with the lessor and leaves nothing the firm can later sell.
- Calling supplier credit free, when many suppliers price in an early settlement discount that the buyer gives up by paying late.
- Proposing venture capital for a small stable family firm, when venture capitalists want rapid growth and a clear exit route.
- Writing generic points that would suit any firm, with no reference to the case business gearing, profit history or legal form.
- Treating dilution as a technicality, when a founder who loses majority control also loses the power to set strategy.
- Assuming a bank will lend because the business wants to borrow, ignoring security, interest cover and the lender view of the risk.
- Describing the method rather than its consequences, so the answer never reaches the stakeholder effects the question asks about.
- Assuming shareholders always prefer equity and lenders always prefer debt, when each depends on the return and the security on offer.
- Ignoring that a highly geared firm meets rising interest rates through cost cutting, which reaches employees before it reaches owners.