Examination card №7

In order to illustrate the money movements in a business, we will use a business model.

The model illustrates that every business starts with capital (Circle 1) and that this is introduced into the business as cash (Circle 2). This in turn is invested either into items which are:

1. not intended for resale (Circle 3), the fixed assets, also called the capital expenditure or

2. into items intended for resale. These are set out as Circles 4, 5, 6, 7, 8 less 9, and its is these items which go into the investment area termed the working capital

Capital - Circle 1- stands for the sources of money invested in business. These are either the owner's own funds - for example in the case of a corporation share capital - or funds obtained from lenders - loan capital. The significance of these two sources are:

In the case of the owner's capital the amount invested is not repayable and the rewards - dividends - are only payable when the business's prosperity allows this to happen.

In the case of loan capital the amount invested is repayable at a fixed future point in time, and the reward - the interest as it is known - is payable however the business has prospered.

From this it can be seen that the more obtained from bor­rowed sources, the greater the pressure is on the business to pay the necessary interest and eventually to repay the loan itself when it becomes due.

This leads to two questions. Can the business take the pres­sure? or should there be more pressure? After all just as business needs to be able to take the pressure, so it may also need at times to have pressure put upon it. It has been found that pressure upon a business created by borrowing, may make the business, and everyone employed within it, work that little bit harder.

The proportion of capital obtained from these two sources is termed the leverage of a business. More than 50 per cent of capital obtained from owners is termed low gearing, and more than 50 per cent of the capital obtained from lenders is termed high leverage.

The business models shown set out the facts of business finance namely:

a) That a business obtains money from owners and lenders

b) That it invests such money in:

Fixed assets, also referred to as capital expenditure, things it does not purchase for resale, and

Working capital - things it does purchase for sale, either as they are - e.g. bread purchased by a retail grocer for sale as bread to its customers, or in their converted form - e.g. planks of timber purchased by a furniture manufacturer for conversion into sideboards, or labour employed to provide a service such as in a TV repair shop.

c) Finally, business may invest in outside investment.

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