Short-term finance is used to fund daily operations

Short-term finance refers to sources of finance needed for the day-to-day running of a business, i.e., its revenue expenditure. It is also often used to solve cash flow (working capital) problems. Short-term sources of finance are funds that do not last longer than one year from the balance sheet date.

Examples (or sources) of short-term finance include:

Long-term loans are used to purchase premises and buildings

Long-term finance refers to sources of finance of more than one year from the balance sheet date. The finance is used mainly to pay for fixed assets, i.e. capital expenditure such as the purchase of capital equipment, machinery, and motor vehicles. It is used to purchase long-term fixed assets (such as property) or to fund the growth of a business in overseas markets (such as setting up factories or production facilities in other countries).

Examples (or sources) of long-term finance include:

Machinery and vehicles are often leased

This section of the IB Business Management syllabus examines the appropriateness, advantages and disadvantages of different sources of finance for a given situation (AO3).

The appropriateness of different sources of finance depends on numerous factors, which can be remembered by the acronym SPACED, as explained below.

Size of the business

The larger the size of a business, the greater the choice of finance there tends to be. For example, public limited companies can obtain finance from selling shares, whereas sole traders cannot. A larger business is also likely to have more retained profit. It is also easier for a large business to obtain bank loans and mortgages to finance its growth, especially as it has more collateral that can be used to qualify for lower interest rates (financial  economies of scale - click the hyperlink here to read more about this in Unit 1.5).

The larger the business, the more sources of finance it is able to access

Purpose (use) of funds

The purpose of funds refers to what the finance is specifically to be used for. For example, if finance is needed for the purchase of a new factory or office building, then long-term sources of finance are more appropriate, such as mortgages. The sale of assets, such as computer equipment, would be suitable if a business wishes to upgrade its obsolete fixed assets.

For short-term, day-to-day running costs of the business, trade credit and overdrafts would be more appropriate. Loan capital might be more appropriate if the organization faces a major liquidity issue so needs access to a large amount of cash, especially if it cannot immediately get the money owed by its debtors. Capital from business angels might also be used for similar reasons if the business has high earnings potential.

Amount required

If a business only needs a small amount of finance, it is likely to consider short-term sources of finance, such as bank overdrafts. By contrast, for larger amounts, the business is likely to use long-term sources such as loan capital from commercial banks, mortgages, or even a share issue. Therefore, the appropriateness of different sources of short- and long-term sources of finance will depend on the amount required.

Cost

Costs have an implication on all business decisions, such as the choice of sources of finance. So, businesses need to consider the costs associated with obtaining a certain source of finance. For example, an IPO will be relatively expensive, whereas using personal funds or retained profits will not be.

In the long term, leasing (hiring) assets is more expensive than an outright purchase. Mortgage costs include administration costs and interest payments over the duration of the loan and these can add a significant amount of costs for businesses in the long term.

The purchase of premises are expensive so long-term sources of finance are appropriate

External environment

The  external environment refers to factors that affect a business but which it has no control of. For example, the central bank or monetary authority is responsible for interest rates in the economy. Higher interest rates make loan capital (such as overdraft, bank loans and mortgages) more expensive. Hence, this is likely to reduce the demand for loan capital to finance business expenditure.

Governments set up their own criteria for subsidies and grants. Economic factors might also affect the amount of finance that business angels and venture capitalists are willing to make available for investment purposes.

Duration

The longer the finance is needed, the more likely the firm will need to provide a guarantee (collateral or security) to the lender, in case the borrower defaults on the loan. For example, a mortgage is secured on the commercial property for which the borrowing is used for - in the case of defaulting on the loan, the lender can liquidate the commercial property to get as much of its money back as possible.

By contrast, an overdraft would be more suitable for firms needing a small amount of money for only a short time period, usually to deal with short-term liquidity issues.

• Long-term finance refers to sources of finance of more than one year from the balance sheet date. The finance is used mainly to pay for fixed assets, i.e. capital expenditure.

• Short-term finance refers to sources of finance needed for the day-to-day running of a business, i.e. its revenue expenditure.

 Exam Practice Question - Cash crisis at London Zoo

Giraffes at London Zoo, England, UK

During the global coronavirus pandemic in 2020, London Zoo had to close twice (March and November) during the two rounds of national lockdowns (when all 'non-essential' bushinesses had to close their doors to customers in an attempt to control the COVI-19 virus. Non-profit organizations like the Zoological Society of London (ZSL), which runs London Zoo, rely on admissions tickets for their sources of finance, but the lockdown proved devastating for its cash flow position. Whilst some businesses could reduce their operational costs by being closed, London Zoo had to continue feeding more than 19,000 animals, which the ZSL reported to be around £1,000,000 ($1.344m) per month. The organization had put off its plans for capital expenditure.

During the first national lockdown in the UK, the zoo was forced to close for an unprecedented three months due to the pandemic. London Zoo says a loss of income from ticket sales has put a “huge financial pressure” on its operation. The zoo usually welcomes 1,25 million of visitors and tourists each year (that's more than 3,400 paying customers each day).

In early November 2020, as London Zoo had been looking forward to welcoming guests for the December holiday season, the zoo's website stated "While we understand this national action is necessary to curb the spread of Coronavirus, it adds a huge burden to an incredibly tough year for us. Our focus throughout has always been keeping our animals happy and well cared for, and knowing we would be able to share the joy of the zoo with visitors again."

Dominic Jermey, ZSL director general, said: “The impact of coronavirus on ZSL cannot be understated. Lockdown saw us closed for longer than any time in our history with fixed costs of more than £1 million a month just on food and care for our animals, let alone our conservation and science and almost no income. This has been catastrophic for us and we are seeking funding from a range of places.”

To prevent possible collapse of London Zoo, which first opened in April 1828, celebrities including Sir David Attenborough, Jonathan Ross, and Catherine Tate have fronted videos aiming to raise funds for the Zoological Society of London.

Sources: adapted from https://www.zsl.org/news/our-zoos-will-close-on-thursday-5-november and https://www.itv.com/news/london/2020-08-27/london-zoo-weigh-in-more-than-19000-animals-step-on-the-scales-as-zoo-warns-of-catastrophic-covid-impact

Questions

 Teacher only box

Answers

(a)  Define the term capital expenditure.  [2 marks]

Capital expenditure refers to an orgaization's sources of finance being used for spending on fixed assets or capital equipment. It is the investment expenditure of an organization for its future growth and development. Examples for ZSL include spending on its buildings (such as animal sanctuaries), capital machinery, and tools.

Award [1 mark] for a limited response that shows some understanding of capital expenditure.

Award [2 marks] for an accurate response that shows good understanding of capital expenditure, similar to the example above. Note: application is not required for [2 marks], but has been included for illustrative purposes of the key term.

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(b)  Define the term fixed costs.  [2 marks]

Fixed costs are the expenditures of an organization that do not change with the level of output. Typical examples include loan repayments (and the interest charges associated with these) and salaries paid to managerial staff. In the case of ZSL, its fixed costs are the $1.344m+ required for its animal feed, irrespective of the number of customers/visitors to its zoo.

Award [1 mark] for a limited response that shows some understanding of fixed costs.

Award [2 marks] for an accurate response that shows good understanding of fixed costs, similar to the example above. Note: application is not required for [2 marks], but has been included for illustrative purposes of the key term.

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(c)  Apart from admissions tickets, explain two other appropriate sources of finance for ZSL.  [4 marks]

Students can suggest any appropriate source of finance as long as they explain the suitability. Possible sources of finance could include:

• Donations - They could come from the general public and/or from celebrity-endorsed schemes, such as those mentioned in the case study.

• Grants and/or subsidies - Given the economic and social benefits that London Zoo brings to the city, and the financial problems caused by the pandemic and lockdowns, this source of finance could be particularly helpful for ZSL. For example, the government had furloughed many people (paid their wages and salaries during the lockdown period). The government is also more inclined to provide financial assistance to non-profit organization (such as ZSL) rather than for-profit companies.

• Overdrafts – If agreed, the finance fom bank loans can be given quickly to help ZSL's current situation, with the need to spend over £3 million on animal feed alone during the three months of lockdown (without any paying visitors).

• Long term bank loans - Similarly, long term loans from banks could also be used to improve ZSL's liquidity position, especially if it intends to proceed to with capital expenditure projects to improve facilities at the zoo for when visitors and tourists are allowed to visit again.

• Sale of assets - despite plans for London Zoo to expand or upgrade its facilities, during such crises, it is more realistic for ZSL to survive. Hence, there may be a need to sell some of its fixed assets (e.g. office equipment such as desks, tables, chairs, and printers) and to raise necessary finance to pay for its fixed costs.

• Accept different arguments for the above scenario, if fully justified. Do not accept answers that suggest shares or an IPO (initial public offering) as ZSL is a non-profit organization.

Mark as 2 + 2.

Award [1 mark] for each source of finance that is identified, and [1 mark] for the explanation of each of these sources, in the context of the case study, up to a maximum of [2 marks].