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Transcript of Edexcel GCSE Business (9-1) Companion - Schudio
Edexcel GCSE Business (9-1) Course Companion
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1.3 - Putting a Business Idea Into Practice
Topicoverview
Inthistopicstudentsneedtocontinuetorelatetheconceptstothecontextsinwhichanenterpriseandanentrepreneurwillbeoperating.Theymustbeawarehowbusinessimplementationcanbeaffectedbythelocalandnationalbusinessenvironmentandhowthismightimpactonasmallbusiness.Studentsmustbeawareofthissectionsrelationshipwiththeotherareasinthisthemeandhowagain,thismayimpactonbusinessdecision-making.Section Keythingstolearn
Businessaimsandobjectives
DefiningbusinessaimsandbusinessobjectivesFinancialaimsforastart-upbusinessNon-financialaimsforastart-upbusinessDifferencesinbusinessaimsandobjectivesbetweenfirms
Businessrevenues,costsandprofits
UnderstandingandcalculatingbusinessrevenueUnderstandingandcalculatingbusinesscostsUnderstandingandcalculatingbusinessprofitandlossInterestBreakevenconceptandthemarginofsafetyInterpretingbreakevendiagramsChangesinbreak-evenvariables
Cashandcash-flow TheimportanceofcashinabusinessCashversusprofitInterpretingcash-flowforecasts
Sourcesofbusinessfinance
Shorttermfinanceoptionsforsmallandstart-upbusinessesLong-termfinanceoptionsforsmallandstart-upbusinesses
Businessaimsandobjectives
Whatmotivatessomeonetobecomeanentrepreneur?
Formanypeoplethiswillbemoney.Thechancetoearnsignificantprofits,buyayacht,takenumerousholidays,buydesignergoodsandsendthekidstothebestprivateschools.
Moneyandpersonalwealthmaywellhowever,notbetherealmotivation.Evidencesuggeststhattherearemanymorereasonswhysomeonewantstostartabusiness.
Everybusinessstartssmall.However,iftheentrepreneurtakessomecalculatedrisks,showsalotofdeterminationandhassomeluck,astart-upbusinesscanbecomeverylarge,profitableandvaluable.However,noteveryentrepreneurwantstobuildabigbusinessandearnafortune.
Theobjectiveswhenstartingabusinesscanbebroadlysplitintotwocategories:financialobjectivesandnon-financialobjectives.
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ThepurposeofbusinessaimsandobjectivesAimsandobjectivesprovideadirectionforanybusiness.Withoutclearobjectives,abusinessmayprovidegoodsandservicesthatarenotappropriatetowhythebusinesswassetup.Thismayresultinthebusinessnotbeingsuccessful.Havingobjectivesjustwrittendownhowever,isnotenoughtoensurebusinesssuccess.Inorderforobjectivestobeeffective,theymustbeimplementedandmonitoredovertime.Someofthebenefitstoabusinessofhavingclearobjectivesareasfollows:
Reason Explanation
Direction
Clearobjectiveswillallowabusinesstodecideonthedirectionitshouldtake,forexample,whetheritshouldexpandornot,whetheritshouldchangeitstargetmarketorperhapsincreaseordecreaseitsrangeofgoodsorservices.
Focusforemployees Itisimportantthatallemployeesareawareofthebusiness’sobjectivesandthattheyareattemptingtofollowandmeetthem.Ifallemployeesareworkingtogetherinthesamedirection,thiswillincreaseefficiency.
Allowsplanning Theoverallfirm’sstrategy,whatitplanstodointhefuture,willbeinitsbusinessplan.Havingclearobjectiveswillallowconsistentplanningforthebusinessasawholeandanydepartmentswithinthebusiness.Theplanwillbedesignedsothatthebusinessobjectivescanbemet.
Measurementofsuccess
Havingbusinessobjectivesallowsabusinesstomeasureitssuccess.Inotherwords,throughabusinessreviewingitsobjectives,itwouldbeabletoseeifithadachievedthemornotorwhetheritwasonthewaytoachievingthem.Thismeansthatthebusinesscanthencorrectorchangeitsbusinessstrategyifitisnotworking.Abusinessmightalsoneedtochangeitsbusinessobjectivesiftheyareprovingimpossibletomeetoriftheyarebeingachievedtooeasily.Theabilitytomeasuresuccessismucheasiertocarryoutforfinancialobjectives,whichareeasilyquantifiable,ratherthannon-financialobjectives,suchas“beingmoreethical”or“increasingcustomersatisfaction”,whichareverydifficulttomeasure.
Financialobjectives
• Survival–overhalfofnewbusinessesfailwithinfiveyearsandmanynewbusinessesdonotsurvivemuchbeyondtheirlaunch.Oftenentrepreneursdiscoverthattheirbusinessideawasnotasgoodastheyoriginallythoughtandthereforethebusinesscannotrunprofitablyoritrunsoutofcash.Changesinthebusinessenvironmentalsomaymakeitharderforabusinesstobesuccessful.Thefirstpriorityofabusinessisthereforealwaystosurvive.
• Profit–makingprofitisthemainobjectiveformostbusinesses.Thisistherewardtotheentrepreneurfortheirhardworkandtherisksundertaken,oftenwiththeirownmoney.Ideally,theprofitearnedissufficienttoprovidetheentrepreneurwithenoughincometoliveon.Profitsmayalsobekeptinthebusinesstoallowittoexpandordevelopfurther.Otherobjectivesbusinessesmayhavewhicharelinkedtoprofitmaximisationareincreasingrevenue,theamountmadefromsales,ordecreasingcosts.
• Anotherfinancialobjectiveisfinancialsecurityorpersonalwealth.Workingforsomeoneelsemightmeanthelossofasecurelypaidjob,whichmeanstheentrepreneurwouldhaveno
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financialsecurity.Someentrepreneurshavealongertermobjective.Theyaimtobuildavaluablebusinessthatcansubstantiallyincreasetheirfuturewealth.Theycouldbeaimingtobuildupthebusinessandsellit,ormakeitsoitwillprovideasubstantialfutureincomeforthem,withnorisktothemofbeingmaderedundant!
• Salesmaximisation/marketshare–somebusinesseswillbemoreconcernedwithincreasingtheirsalesandthereforetheirmarketshare.Theymayacceptlowerprofitsintheshortterm,inordertoincreasesales.
Non-financialobjectives
Althoughmostbusinesseswillbefocussedonfinancialobjectives,therearemanyotherprioritiesthatwillexistfornewandsmallbusinesses.Providingahighqualityservicewillbeparticularlyimportantforanewbusiness.Lookingafteritscustomersanditsemployeeswouldalsobeanobjectiveformanysmallbusinesses.
Inmanycases,non-financialobjectiveswilllinktoorbeconsistentwithfinancialobjectives,butnotalwaysassometimesevenforasmallbusinessqualitymightconflictwithprofit.Thereforewhenbusinessessetanduseobjectives,theywillprioritisetheareaswhicharemostimportanttotheirorganisationandtheowners.
Herearesomeofthenon-financialmotivesthatareoftenquotedbyentrepreneurs:
• Socialobjectivessuchasbenefitingtheenvironment• Morecontroloverworkinglife–wanttochoosewhatkindofworkisdone;theneedforgreater
independenceisamajormotivator• Amoreflexibleandconvenientworkschedule,includingbeingabletoworkfromorcloseto
home;thismotiveisanimportantreasonbehindthemanyhome-basedbusinessstart-ups• Skillsarebeingwastedandtheirpotentialisnotbeingfulfilled• Escapinganuninterestingjoborcareer• Pursuinganinterestorhobbythattheyenjoy• Wanttobetheboss,astheyarefedupwithbeingtoldwhattodo• Wantthefeelingofpersonalsatisfactionfrombuildingupabusiness• Fedupwithworkinginabusinesshierarchyorabureaucraticorganisation,wheretherearelots
ofrules;peoplewithentrepreneurialcharacteristicsoftenfeelstifledworkingwithandforothers!
• Majorchangeinpersonalcircumstancesforexampleredundancy,divorce,illness,bereavement
Differentaimsandobjectives
Differentbusinesseswillhavedifferentaimsandobjectives.Thisisparticularlythecasewithsmallbusinesses,whereeveryentrepreneurislikelytohavedifferentmotivesforstartinguptheirownbusiness.Forexample:
Entrepreneur1:hasrecentlybeenmaderedundantfromalargebuildingfirm.Hewouldliketoturnhisskillsandexperienceintobuildingmaintenanceinhislocalarea.Hewantsvariedworkandenoughmoneytoliveoff,butdoesnotwanttobuildupthebusinessortravelfar.
Entrepreneur2:hasanewbusinessideaforawebapplicationforfindingplacesforagoodnightout.Theideaisprovingverypopularinthelocaltrials.Theentrepreneurwantstodevelopthisapplicationandsellitallovertheworldinordertomakealotofprofit.
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Businessobjectiveswillalsobeaffectedbytheexternalenvironmentwhichfirmsoperatewithin.Asmalllowcosthairdressermayhavedirectcompetitioninonearea,indirectcompetitionfromanexpensivehairdressingnationalbrandinanotherareaandnocompetitionatallinafurtherarea.Theobjectivesofsuchasmallbusinesswillbedifferentbecauseofthesituationitfindsitselfin.
Businessrevenues,costsandprofits
Inorderforabusinesstocalculateitsprofit(orloss)itneedstoworkoutitstotalcostsandtotalrevenue.
Costsarethespendingthatabusinesshastoundertakeinordertomakegoodsandprovideservices.Everybusinesshascosts,buttheyvaryintermsoftheirtypeandamount.Foranewbusiness,estimatingwhatthelikelycostsaregoingtobeisoftenverydifficult.
Successfulbusinessesplacegreatimportanceoncosts.Inmostcasestheywanttoensuretheyarekeptaslowaspossible.Therearemanyreasonsforthisincluding:
• Increasesincostsreducethepossibleprofitsthatthebusinesscanmake• Theyarethemaincauseofcash-flowproblemsinasmallbusiness• Theywillchangeastheoutputoractivityofabusinesschanges
Costscanbedividedintotwotypes:fixedandvariable
Fixedcosts
Fixedcostsdonotchangeasoutputvaries.Inotherwords,theyarefixedevenifoutputmovesupordownfromperiodtoperiod.
Examplesoffixedcostsinclude:
• Rentandcounciltax• Salaries• Marketing,forexampleadvertising,marketresearch• Insurance• Interestrepayments• Leasedequipmentcharges
Itisworthrememberingthatjustbecauseacostisclassifiedas“fixed”,itdoesnotmeanthatthecostwillstaythesameforever.Afixedcostcanchangeovertime.Forexample,therentofanofficeorshopmaystaythesamefor5years.However,therentmaychange(upordown)whentherentalagreementisrenegotiatedwhendue.Theimportantpointaboutacost,likerent,being“fixed”isthatithastobepaid,whateverthelevelofsalesachieved.Fixedcostsareparticularlyimportantwhenitcomestocalculatingthebreakevenoutputofabusiness.Thehighertheleveloffixedcostsinabusiness,thehighertheoutputneededtocoverthesecostsandbreakeven.
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Variablecosts
Variablecostschangewhenoutputchanges.Inotherwordsthehighertheoutput,thehigherthevariablecosts.
Variablecoststendtobethoserelatingdirectlytotheproductionorsaleofaproduct.Goodexamplesinclude:
• Rawmaterialsandbought-instocksandcomponents• Wagesbasedonhoursworkedoramountproduced• Marketingcostsbasedonsales• Agentandothercommissions
Totalvariablecostscanbecalculatedbyasimpleformula:
Variablecostperunitxoutput
Totalcosts
Thetotalcostsofabusinesscanbecalculatedbysimplyaddingtogetherthevariablecosts,atdifferentlevelsofoutput,tothefirm’sfixedcosts.Theformulathereforeis:
Totalcosts(TC)=totalfixedcosts(TFC)+totalvariablecosts(TVC)
Example:
Graham’svanrepairbusinessisasmallbusinessthathasthefollowingcostsandsalesoutputforMarch:
Variablecostsperjob £75
Garagerentandrates £500
Salaries £1,500
Advertising £100
Otherfixedcosts £400
Expectednumberofjobsformonth 100
Tocalculatethetotalcostsforthebusiness,startwiththevariablecosts.Theseequal£75perunitx100jobs=£7,500
Fixedcosts=£500(garagerentandrates)+£1,500(salaries)+£100(advertising)+£400(otherfixedcosts)=£2,500
ThereforethetotalcostsforGraham’sbusinessequal£7,500(totalvariablecosts)+£2,500(totalfixedcosts)=£10,000
Asoutputincreasesthetotalcostswillnotincreaseasfast.Thisisbecausethefixedcostswillstaythesame.Thismeansthatabusinessmayhaveloweraveragecostsofproductionasitgrows.
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RevenueandProfit
RevenueRevenueisthemoneythebusinessreceivesfromitssales.Thiscanberepresentedsimplyusingtheformula:
Revenue=sellingpriceperunitxquantitysold
Inpractice,mostbusinessessellmorethanonedifferentproductandhavemorethanonesellingprice,whichmakesthecalculationmorecomplicated.However,themethodremainsthesame.
Intheaboveexample,ifGrahamcharges£100foreachjobthathecompletes,hisrevenuewillequal:£100(sellingpriceperunit)x100(quantitysold)=£10,000.
IsGraham’sbusinessmakingaprofit?
Profit
Havingcalculatedthetotalcostsandthetotalrevenueforabusiness,itcannowworkoutitsprofit.Profitisthefinancialreturnorrewardthattheownersofabusinessaimtoachievetorewardthemfortheriskthattheytake.Itwillmeasurethesuccessofthatinvestment.
Profitisalsoanimportantsignaltootherprovidersoffinancetoabusiness.Banks,suppliersandotherlendersaremorelikelytoprovidefinancetoabusinessthatcandemonstratethatitmakesaprofit,orislikelytodosointhenearfuture,andthatitcanpaydebtsastheyfalldue.
Profitisalsoanimportantsourceoffinanceforabusiness.Profitsearned,whicharekeptinthebusinessandarenotdistributedtotheownersviadividendsorotherpayments,areknownasretainedprofits.Retainedprofitsareanimportantsourceoffinanceforanybusiness,butespeciallystart-uporsmallbusinesses.Themomentaproductissoldformorethanitcosttoproduce,thenaprofitisearnedwhichcanbereinvested
Profitcanbemeasuredandcalculatedbythefollowingformula:
PROFIT=TOTALREVENUE-TOTALCOSTS
Hereisanexamplewhichillustratestheformulainaction:
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Sales Costs Profitorloss?
£100,000 £75,000 £25,000profit
£100,000 £125,000 (£25,000)loss
Note:negativefiguresareshowninbrackets
þ Totalsalesgreaterthantotalcosts=PROFITý Totalsaleslessthantotalcosts=LOSSØ Totalsales=totalcosts=BREAKEVEN
Whatevertheresult,profit,lossorbreakingevenabusinesswillalwaysneedtoreviewitsperformanceandlookathowitmightbeimproved.Cancostsbedecreased?How?Andbywhen?Canrevenuebeincreased?Shouldthepricestaythesame?Canmorebesold?Isthereaneedforfurtherinvestmenttodecreasecostsorincreaserevenue?
Interest
Aswellasthecostsinvolvedinrunningabusiness,abusinessownermayalsohavetopayinterest,ifthebusinessneededtoborrowmoneyintheformofaloanormortgagewhenitwassetup.Thebusinessmayalsoarrangeanoverdraftwiththebank,whichwillalsoinvolvethepaymentofinterest.Interestwillthereforeformpartofthefirm’stotalcosts.Theamountneededtobepaidmayvaryifinterestrateschange.Thisishowever,dependentonthetermsoftheloan/mortgage/overdraft,whichwouldhavebeenagreedwiththebankandthebusinessowner,whenthespecificsourceoffinancewasfirsttakenout.
Thefollowingformulacanbeusedtocalculatetheinterestrateonaloanasapercentage:
Interestonloans(%)=totalrepayment–borrowedamountx100
borrowedamount
Example:
Ifanewbusinessstart-upborrowed£50,000butrepaid£60,000intotal,theinterestpercentagewouldbe:£60,000-£50,000x100=20% £50,000
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BreakevenAbusinesswillcalculateitsbreak-evenpointinorderforittohaveanideaofhowmuchitwillneedtoproducetosurvive.Break-evenisthepointwheretotalrevenueisequaltototalcosts,whichmeansthebusinessisnotmakingaprofitoraloss.Throughcalculatingbreakeven,abusinessknowshowmanyunitsitwillneedtoproduceandsellinordertostartmakingaprofit.
Thisinformationcanberepresentedonabreakevendiagramorgraphandwillshowthepotentialprofitorlossthatcouldbemadeatdifferentlevelsofoutput,asrevenueandcostschange.
BreakevendiagramforBusinessA:
Thisbreakevendiagramshowsthatfixedcostsaredrawnasastraightline,whichisthecasebecausetheydonotchangewithoutput.Thetotalcostlineisalsoshown,insteadofthevariablecostlineonitsown,asthetotalcostlinetakesintoaccountbothfixedandvariablecosts.Thetotalcostlinestartsatthesamepointasfixedcosts,asevenifthebusinessismakingnooutput,fixedcostsstillneedtobepaid.Atzerooutputhowever,variablecostsarezeroresultinginfixedcostsandtotalcostsbeingthesamevalue.Therevenuelineislastlydrawn,whichstartsatzeroandgoesupdiagonally.Thisisbecauseasthebusinessmakesandsellsmore,itwillgainmorerevenue.
Inthisexample,BusinessA’sbreak-evenpointis10,000units,thepointwheretotalcostsandtotalrevenuecross.Thismeansthatifthebusinessmanagestoproduceandsellthisamountofoutput,itwillnotbemakingaprofitoraloss.
Marginofsafety
BusinessAcanalsocalculatethemarginofsafetyfromthebreak-evendiagram.Thisisthedifferencebetweenitscurrentlevelofoutput/salesandthebreak-evenpoint.IfBusinessAwascurrentlysellingorproducing15,000units,itsmarginofsafetywouldbe15,000(currentlevelofoutput)–10,000(break-evenpoint)=5,000units.BusinessAwouldwantthemarginofsafetytobeashighaspossible,asthisshowshowmuchoutputorsalescouldfallbeforeithitsitsbreak-evenpointandthenafterthis,thebusinesswouldbemakingaloss.
Variablecosts
Marginofsafety
Breakevenpoint
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Areminderoftheformulaformarginofsafetyisshownhere:
Marginofsafety=actualorbudgetedsales–breakevensales
Calculatingprofitandlossfromthebreak-evenchartAbusinesscandeterminetheamountofpredictedprofitorlosslevelitexpectstomakeatdifferentlevelsofoutputfromthebreak-evendiagram.Asalreadydiscussed,profitiscalculatedbydeductingtotalcostsfromtotalrevenue.Fromreviewingthebreak-evendiagramforBusinessB(onthenextpage)itcanbeseen,atanoutputlevelof80units,thebusinessismaking£160revenueanditstotalcostsequateto£140.Ifwesubtractthetotalcostsfromthetotalrevenuetheprofitatthislevelofoutputequals:£160-£140=£20.
Itisclearthebusinessismakingaprofitatthislevelofoutput,asthefirm’sbreak-evenpointis60units(thepointwheretotalrevenue=totalcosts)andasthebusinessisoperatingat80units,ahigheroutputlevelthanthebreak-evenpoint,thenthebusinessmustbemakingaprofit.
However,ifthebusinessisoperatingbelowthebreak-evenpointof60units,thebusinesswillbemakingaloss.LookingagainatthebreakevenchartforBusinessBandassumingthebusinessisproducing20units,thevalueoftotalcostsatthislevelofoutputis£80andthetotalrevenuefigureis£40.Rememberthatprofit=totalrevenue–totalcosts,sointhiscase,thebusinessismakingalossas:£40-£80=(£40).
Thismethodofcalculatingprofit/lossforabusinesscanbeappliedtoanylevelofoutputforabusinessthathasproducedabreakevendiagram.However,thedifficultyisthatsometimesvaluesaredifficulttoreadfromthediagramandthereforeifabusinessreliedonthismethodonlyofcalculatingprofit,inaccuratefiguresmaybecalculatedandthereforeusedindecisionmaking.Forexample,lookingagainatthebreakevenchartforBusinessB,cantheprofitorlossbeaccuratelyworkedout,purelyfromreadingthegraph,ifthefirmwasoperatingatanoutputlevelof55units?
MonthlybreakevenchartforBusinessB:
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Theimpactofchangesinrevenueandcostsonthebreak-evenpoint
Aswellascalculatingprofitandlossandidentifyingthebreak-evenpoint,thebreak-evendiagramcanalsobeusedtohelpbusinessownerswithdecisionmakingand“whatif”scenarios.Bychangingoneormorevariablesinthebreak-evendiagram,businessowners,orbusinessdecision-makers,canthenassesstheimpactofthischangeonthebreak-evenpoint.Thiswillallowworstandbestcasesituationstobepreparedforbythebusiness.Someexamplesareincludedheretoillustratethisfurther.
Example1:Breakevendiagramtoshowtheimpactonthebreak-evenpointofanincreaseinsellingprice
Intheabovesituation,abusiness’ssellingpricehasincreasedfrom£2to£3.Thishasresultedintheamountneededtobesoldtobreakeven(thebreak-evenoutput)decreasingfrom60unitsto30units.Inthiscase,thebusinessmaythenconductsomeresearchtoseeifcustomerswouldbewillingtopaytheincreasedsellingpriceorwhetherdemandwoulddropsignificantly,aseventhoughthebreakpointhaslowered,inthiscaseitwouldtakethebusinessasignificantlylongertimetoreachthispointduetoadropindemand.
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Example2:Breakevendiagramtoshowtheimpactonthebreak-evenpointofanincreaseinfixedcosts
Inthiscase,thefixedcostsofthebusinesshaveincreasedfrom£60to£70.Thishasincreasedthetotalcostswhichhasresultedintheamountneededtobesoldtobreakeven(thebreak-evenoutput)increasingfrom60unitsto70units.Inthecase,ifthebusinessanticipatesthatitsfixedcostsaregoingtorise,whichwouldultimatelymakeithardertobreakevenandthereforebecomeprofitable,itmaylookfordifferentwaystobecomemoreefficienttolowercosts,toovercomethischange.
CalculatingbreakevenusingtheformulaRatherthandrawingabreakevendiagramtocalculatethebreak-evenpointeachtime,aquickerandmoreefficientmethodofcalculatingbreak-evenistousetheformulae.Thebreak-evenformulaeareshowninthebox:
Breakevenoutput= fixedcost
(salesprice–variablecost)Thiswillgiveyouthenumberofunitsthebusinessneedstoproduceandselltobreakeven
Break-evenpointincosts/revenue=break-evenpointinunitsxsalesprice
Thisformulacanbeusedtocalculatetherevenue(orcosts!)atthebreakevenlevelofoutput
Breakevenoutputusingtheformula
Inordertocalculatethebreak-evenoutputusingtheformula,threevariablesarerequired.Thesearefixedcosts,salespriceandvariablecostperunit.
Inexample2,theoriginalfixedcostsofthebusinesswere£60.
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Thecurrentvariablecostperunitis£1.Variablecostsarenotdrawndirectlyontothebreak-evenchart.However,thisvaluecanstillbecalculatediftotalcostsandfixedcostsareknownandtheformulahereisused:
Totalvariablecosts=totalcosts–totalfixedcosts
Fromreviewingthechart,ataneasytoreadpoint,i.e.10units,theoriginaltotalcostswere£70andtheoriginaltotalfixedcostswere£60.Totalvariablecostsatthislevelofoutputtherefore=£70-£60=£10.
Tocalculatethevariablecostperunit,thenumberofunitsjustneedstobedividedintothisamount=£10/10=£1.
Inordertocalculatethesalespriceorthesellingpriceperunit,asimilarmethodcanbeapplied.Ataneasytoreadpointi.e.10units,thetotalsalesrevenue=£20.Tocalculatethesalespriceorsellingpriceperunit,thenumberofunitsjustneedstobedividedintothisamount=£20/10=£2.
Wenowhaveallthevariablesrequiredtocalculatethebreak-evenoutputlevelusingtheformulaasshown:
Breakevenoutput= fixedcost = £60 = 60units(salesprice–variablecost) £2-£1
Thisbeingthesameanswerasobtainedfromthebreak-evenchart.
Break-evenpointincosts/revenueusingtheformulaWewilluseexample2againtoillustratehowtocalculatethebreak-evenpointincosts/revenue.Areminderoftheformulais:
Break-evenpointincosts/revenue=break-evenpointinunitsxsalesprice
Theoriginalbreak-evenpointinunits=60unitsx£2(salesprice)=£120.Thisagainshowsthesamevalueonthe“y”axisforcosts/revenuein£sasthebreak-evendiagram,atthebreak-evenpoint.
Thebenefitofusingbreakevenanalysistoabusiness
þ Break-evenisaveryusefulbusinesstool,asitcanquicklyillustratewhathappenstoafirm’sprofitsatdifferentoutputlevels.Thiscanhelpabusinesswithdecision-makingaboutcostlevelsandsellingprices.
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þ Abusinesscouldcreateaseriesofbreak-evendiagramstoillustratetheimpactonthebreak-evenpointifoneofthevariablesonthegraphchanged.Thisiscalled“whatif”analysis.
Breakevendoeshoweverhavelimitations:
ý Itassumesthattheaveragepricethatgoodssellatwillstaythesame.ý Itgivestheimpressionthatjustbecauseproductsareproducedthattheywillbesoldatthe
averageprice.ý Itcanbecomeverycomplicatedtoabusinesswhichsellsmanydifferentproducts.ý Itassumesthatvariablecostsareproportionaltooutput,whereastheymaygetcheaperas
outputrisesormoreexpensiveifworkershavetobepaidovertime.ý Itmaymeanthatthebusinessfocusesonbreakingevenratherthanmakingaprofit!
Cashandcash-flow
Cash-flowdescribesthemovementofcashintoandoutofabusiness.Itisnotthesameasprofit.Manyprofitablebusinessesfailbecausetheydonothaveenoughcashtopaytheirbills.Thisisbecauseprofitisrecordedstraightafterasale,whereascashisrecordedwhenitiseitherspentorreceivedbythebusiness.Ifabusinessofferstradecredittoacustomerforexample,of30days,thenthesaleandthereforeprofitisdocumentedwhenthegoodsaretakenbythecustomer,butthecashwillnotberecordeduntilpaymenti.e.thecashisreceived30dayslater!
Inbusiness,cashisalwaysonthemove…
• Cash-flowsintothebankaccountwhencustomerspayfortheirsales,whenaloanisreceivedfromthebank,interestisreceivedorwhenassetsaresold
• Cash-flowsoutofthebankaccountwhensuppliersarepaid,employeewagesandsalariesarepaid,interestispaidtothebankandsoon…
Youneedtobeabletodistinguishbetween:
• Cashinflows:movementsofcashintoabusiness• Cashoutflows:movementsofcashoutofthebusiness
Thedifferencebetweenthecashinflowsandcashoutflowsduringaspecificperiod,forexampleaweekoramonthisknownasthe“netcash-flow”.
Netcash-flow=cashinflows–cashoutflowsforagiventimeperiod
Thechallengeforanybusiness,particularlynewbusinesses,istomanageitsnetcash-flowsuccessfully,sothatthebusinessdoesnotrunoutofmoney.
MaintypesofcashinflowandoutflowThemaintypesofcash-flowcanbesummarisedasfollows:
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Cashinflows CashoutflowsCashsales Paymentofoverheads,wagesandsalaries
Receiptsfromtradecustomers Paymentofsuppliers,forexamplerawmaterials,inventories
Saleofspareassets Buyingequipment
Investmentofsharecapital Interestonbankloanoroverdraft
Personalfundsinvested Paymentofdividends
Receiptofbankloan Repaymentofloans
Governmentgrants Incometax,VATandcorporationtax
Whybusinessessuffercash-flowproblems
Start-upandsmallbusinessesareespeciallyvulnerabletocash-flowproblems.Thereasonsforthiscanbedividedintotwotypes:
• notenoughmoneycomingintothebusinessfastenough• toomuchmoneygoingoutofthebusinesstooquickly
Inaddition,ifabusinessdoeshavecash-flowproblemsthennewbusinessesorbusinessesfacingfinancialdifficultieswilloftennothavereservesofretainedprofitstoseethemthroughuntilthingsimprove.Ifabusinessrunsoutofcashandisnotabletoobtainnewfinance,itwillbecomeinsolvent.
Ifabusinesshasapositivecash-flowitwillbuildupcashreserves.Thiscanbesavedincaseoffutureproblemsorusedforfutureinvestment.
Thecash-flowforecast
Thecash-flowforecastpredictsthenetcash-flowsofthebusinessoverafutureperiod.Itcanbeusedtoidentifylikelycash-flowproblemsandhelpavoidorsolvethem.
Theforecastestimateswhatthecashinflowsintothebankaccountandoutflowsoutofthebankaccountwillbe.Theresultofthecash-flowforecastisalsoanestimateofthebankbalanceattheendofeachperiodcovered(normallythisisforeachmonth).Anexampleofasimplecash-flowforecastisshownbelow:
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£'000 January February March April May June
Cashinflows 200 250 200 150 100 250
Cashoutflows 250 300 300 100 250 150
Netcash-flow(cashinflows–cashoutflows)
(50) (50) (100) 50 (150) 100
Openingbalance(samefigureastheclosingbalanceforthepreviousmonth)
250 200 150 50 100 (50)
Closingbalance(netcash-flow+openingbalance)
200 150 50 100 (50) 50
Ascanbeseenfromthetable,theclosingbalancebecomestheopeningbalanceforthenextmonth.Thisisthenaddedtothenetcash-flowforthatmonth,whichmaybeapositive(April)ornegative(May),inordertocalculatetheclosingbalanceforthatmonth.Theclosingbalanceeachmonthmightbeasurplus,whichmeansthebusinesshasapositivecashbalanceattheendofthemonth,oradeficit,whichmeansthatthebusinesshasanegativecashbalanceattheendofthemonth(oftenindicatedbybrackets,asinMay).
Lookingatthiscash-flowforecastalittlemorecarefully,itshowsthatthebusinesswillstarttheperiod,i.e.January,withacashsurplusoropeningbalanceof£250,000.Duringthefirstthreemonths,thenetcash-flowisnegative,asitispredictedthattherewillbemorecashoutflowsthaninflows,whichwillreducetheclosingbalancesurplusto£50,000inMarch.InAprilandJune,thecashoutflowsareestimatedtoreduceconsiderablymakingthemlessthanthecashinflows,resultinginasurplusintheclosingbalanceinthosetwomonths.InMayagain,theoutflowsarepredictedtobehigherthanthecashinflows.Theopeningbalance,of£100,isnotenoughtocoverthisincreaseandthereforethebusinessisforecastedtogointoadeficitof£50,000.
Businessesmustcarefullymonitorwhenthebusinessisforecasttoexperienceadeficit,asthishighlightsthebusinessmayrunoutofcash!
Torecapthekeyformulaeforcash-flowforecastsare:
Netcash-flow=cashinflows–cashoutflowsinagivenperiod
Openingbalance=closingbalanceofthepreviousperiod
Closingbalance=openingbalance+netcash-flow
Whythecash-flowforecastissoimportant
Abusinessusesacash-flowforecastto:
• Identifypotentialshortfallsincashbalancesinadvance–thinkofthecash-flowforecastasan“earlywarningsystem”.Thisisthemostimportantreasonforacash-flowforecastandenablesthebusinesstotakeaction,sothatitdoesnotexperienceanycash-flowissues,whichcanultimatelypreventthebusinessfromtradingandbecominginsolvent
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• Makessurethatthebusinesscanaffordtopaysuppliersandemployees-supplierswhichdonotgetpaidwillsoonstopsupplyingthebusiness;itisevenworseifemployeesarenotpaidontime,asinthiscasetherewouldbeno-onetoeitherproducethegoodsorprovidecustomerswiththelevelofservicethattheydemand
• Spotproblemswithcustomerpayments–preparingtheforecastencouragesthebusinesstolookathowquicklycustomersarepayingtheirdebts.Thisisonlyanissueinsomebusinessesandnotall.Forexample,mostretailerstakemostoftheirsalesincash/creditcardsatthepointofsalei.e.atthetimeofpurchase
• Compareactualfigurestoforecastfigures–thisallowsmanagementtospotifthereareanypotentialissuesandtakeappropriateaction,forexampleiftherearesignificantdifferencesbetweentheforecastedfiguresandtheactualfigures,abusinessownerwouldneedtoarrangeappropriatesourcesoffinancetocoveranyshortfallsincash
• Externalstakeholders,suchasbanks,mayrequirearegularforecast-certainlyifthebusinesshasabankloan,thebankwillwanttolookatthebusinesscash-flowcomparedtoitsforecastatregularintervals,toensurethatthebusinesswillcontinuetomakeitsrepayments
Maincausesofcash-flowproblemsAcash-flowproblemariseswhenabusinessstrugglestopayitsdebtsastheybecomedue.Whencash-flowisconsistentlynegativeandthebusinessusesupitscashbalances,thentheproblembecomesserious.Themaincausesofcash-flowproblemsare:
Factor Whyitcausesacash-flowproblem…
Lowprofitsor(worse)losses
Thereisadirectlinkbetweenlowprofitsorlossesandcash-flowproblems.Remember,mostloss-makingbusinesseseventuallyrunoutofcash
Over-investmentincapacity
Thishappenswhenabusinessspendstoomuchonmachinery,equipmentorpremises.Factoryequipment,whichisnotbeingused,doesnotgeneraterevenue,soisoftenawasteofcash
Toomuchstock Holdingtoomuchinventoryorstocktiesupcashandthereisanincreasedriskthattheseinventoriesbecomeobsoletei.e.cannotbesoldandthereforecannotgenerateanycashinflows
Allowingcustomerstoomuchcredit
Offeringcredittocustomers,i.e.buynowandpaylater,isagoodwaytobuildcustomerloyaltyandlong-termrevenue,butlatepaymentisacommonproblemandslow-payingcustomersputastrainoncash-flow
Overtrading Thisoccurswhereabusinessexpandstooquickly,puttingpressureonshort-termfinance.Forexample,aretailchainmighttrytoopentoomanystorestooquickly,beforeeachstartstogenerateprofits
Seasonaldemand Predictablechangesinseasonaldemandcreatecash-flowproblems,butbecausetheyareexpected,abusinessshouldbeabletohandletheseinanappropriateway
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SourcesofbusinessfinanceAstart-uporexistingsmallbusinesswillneedfinance.Theywillneeditforvariousreasons,shorttermandlongterm.Therearedifferentsourcesoffinanceavailableandtheactualsourcechosenbyabusinesswilldependontheamountandreasonthefinanceisrequired,aswellasthecircumstancesandthetypeoflegalstatusthebusinesshas.
Thechallengeofraisingmoney
Oftenthehardestpartofstartingabusinessisraisingthemoneytogetgoing.
Anentrepreneurmighthaveagreatbusinessideaandclearplanforhowtoexploitamarketopportunity.However,unlesssufficientfinancecanberaised,theentrepreneurwillstruggletomakethemostoftheopportunity.
Raisingfinanceforastart-uprequirescarefulplanning.Theentrepreneurneedstodecide:
• Howmuchfinanceisrequired?Raisingfinanceishardworkandexpensive–astart-upbusinessshouldavoidhavingtogothroughtheprocesstoooften!
• Whenandforhowlongthefinanceisneeded?Ausefuldistinctioncanbemadebetweenlong-termandshort-termfinance
• Whatsecurity(ifany)canbeprovided?Thiswillaffecttheabilityofthebusinesstoraiseabankorotherloanwherethelenderrequiressomesecurity(or“collateral”)
• Whethertheentrepreneurispreparedtogiveupsomecontrol(ownership)ofthestart-upinreturnforinvestment
• Whetherthecostofthefinance,forexampletheinterestcharged,isjustified
Thefinanceneedsofastart-upshouldalsotakeaccountofthesekeyareas:
• Set-upcosts:thecoststhatareincurredbeforethebusinessstartstotrade• Gettingreadytoproduce:thefixedorlongtermassetsthatthebusinessneedsbeforeitcan
begintotrade,suchasmachinery,equipment,vehiclesetc• Workingcapital:moneyrequiredforthedaytodayoperationofthebusiness.Moneywillbe
neededbythebusinesstobuythestocksrequiredbythebusiness,suchasrawmaterials,andallowanceshouldbemadeforamountsthatwillbeowedbycustomersoncesalesbegin,ifthebusinesschoosestoofferitscustomerstradecredit
• Growthanddevelopment:inthefuturethebusinessmaywishtogrowandexpandandthereforewillneedtoinvestinextracapacity,forexampleinextraspacetoproducemoreproducts
FinancetocoverdifferentperiodsAnimportantconsiderationwhenobtainingfinanceforabusinessiswhenandforhowlongthefinanceisneeded.Ausefuldistinctioncanbemadebetweenlong-termandshort-termsourcesoffinance.Thetablesummarisesthemainexamplesandusesofeachcategory:
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Long-term Short-term
Financesthewholebusinessovermanyyears Financesday-to-daytradingofthebusiness;repayableusuallywithinayear
Examples: Examples:
þ Personalsavingsþ Retainedprofitsþ Sharecapitalþ Venturecapitalþ Bankloansþ Crowdfunding
þ Bankoverdraftþ Tradecredit
Short-termsourcesofbusinessfinance:
Tradecredit
Thisisusedbymanybusinessesasashort-termsourceoffinance.Tradecreditessentiallymeansthatafirm’ssupplierswillallowittohavethegoodsandpayforthematalaterdate.
þ Thiscangivetimeforthebusinesstousethegoodsandsellitsproductsbeforeitpaysthesuppliers,whichwillimproveitscash-flowposition.
ý Ifthebillsarenotpaidontimehowever,thiscanleadtothebusinessgettingabadreputationandlosingfuturecreditarrangementswiththesupplier.
ý Itcanalsobeparticularlydifficultfornewstart-upbusinessestonegotiatetradecreditwithsuppliers,asthereisariskthatthebusinesswillfailandsuppliersmayendupnotgettingpaid!
Bankoverdraft
Businessesofallsizesusebankoverdraftsasameansoffinance.Asabusinessgetsbigger,itoftenfindsthatitsoverdraftfacilityalsoneedstogrow.Thatisbecauseanoverdraftisessentiallyashort-termsourceoffinancethatisavailabletohelpfundtheday-to-daypaymentsrequiredbyabusiness.Itallowsthebusinesstowithdrawfundsfromitsaccountthatarenotthere,uptoanagreedmaximumlimit,andisonlyusedwhenthebusinessrequiresadditional,temporaryamountsofmoney.
þ Thebigadvantageofabankoverdraftisitsflexibility.Ifabusinessexperiencesashort-termshortageofcashoranunexpectedcost,thenitcanbepaidbyusingsomeoftheoverdraftfacility.Interestisonlypaidontheamountused.
ý Themaindownsideofanoverdraftisthatitisrepayabletothebankatanytime.Abusinessmayhaveanoverdraftfacilityof£100,000i.e.itcanowethebankuptothatamount,butthebankmaylowerorevenwithdrawthatfacilityatanytime.Thishappenedtonumerousbusinesseswithbankoverdraftsduringthecreditcrunchof2007-8,manyofwhomwererelyingontheiroverdrafttostayinbusiness.
ý Theotherdrawbackofanoverdraftisthattheyusuallyhavehighlevelsofinterestattachedtothem,makingthemanexpensiveformoffinancewhentheyareused.
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Long-termsourcesofbusinessfinance:
Personalsavings
Anentrepreneurwillofteninvestpersonalcashbalancesintoastart-up.Thiscanbepersonalsavingsfromthebankorbuildingsociety.Thiscanalsobeintheformofprovidingassetsforthebusiness,forexampleusinganowncar,oritcanbeassimpleasworkingfornothing!Byusingthissourceoffinance,theentrepreneurisprovidingastrongsignal,tootherpotentialinvestorsandthebank,ofhis/hercommitmenttothebusinessventure.
þ Thisisacheapformoffinancethatisreadilyavailable.þ Investingpersonalsavingsmaximisesthecontroltheentrepreneurkeepsoverthebusiness.þ Theamountthatisavailablemaybelimited,resultinginthisbeingusedwithothersourcesof
financetofundthebusiness.
Loans
Thesemightbefromfriendsandfamilyorfromfinancialinstitutions,suchasabank.
Friendsandfamily:
Friendsandfamilywhoaresupportiveofthebusinessideamaybewillingtoprovidemoneyeitherdirectlytotheentrepreneurorintothebusiness.
þ Thiscanbequickandcheaptoarrange(certainlycomparedwithabankloan).þ Theinterestandrepaymenttermsmaybemoreflexiblethanabankloan.ý However,borrowinginthiswaycanaddtothestressfacedbyanentrepreneur,particularlyif
thebusinessgetsintodifficulties,asitcancausedisagreements.ý Theamountavailablemaybelimited,resultinginthisbeingcombinedwithothersourcesof
finance.
Bankloan:
Abankloanisanamountofmoneyborrowedforasetperiodwithanagreedrepaymentschedule.Therepaymentamountwilldependonthesizeanddurationoftheloanandtherateofinterest.Thisisacommonsourceoffinancethatasmallornewbusinesswouldchoose.However,bankloanstendtobemorereadilyavailableforwell-establishedandgrowingbusinesses,ratherthanstart-upbusinesses.Thereasonforthisisrisk–banksprefertoloantosuccessfulbusinesses,whichmakesthemmorelikelytobeabletorepaytheloanandinterest.
Ifabankloancanbeobtainedthenthereareseveraladvantagesforastart-uporanestablishedsmallbusiness:
þ Thebusinessisguaranteedthemoneyforacertainperiod-generallythreetotenyears(unlessitbreakstheloanconditions).
þ Loanscanbematchedtothelifetimeoftheequipmentorotherassetstheloanisbeingusedforþ Whileinterestmustbepaidontheloan,thereisnoneedtoprovidethebankwithashareinthe
business,sonocontrolislost.þ Interestratesmaybefixedfortheterm,makingiteasiertoforecastinterestpaymentsand
cash-flow.þ Repaymentsaremadeininstalments,resultinginthebusinesshavingaccesstosubstantial
amountsofcashthatdoesnotneedtobepaidbackallinone-go.
Therearealsosomedisadvantagesofabankloan:
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ý Timeconsuming-anewbusinesswouldneedtoproduceadetailedbusinessplantoshowtothebankinordertosecuretheloan,whichwouldtakeuptimeandresource;howeveritcouldbearguedinthelong-run,thatthiscarefulplanningwouldhelpthebusinesstohaveagreaterchanceofsuccessinthefuture.
ý Security-normallyhastobegiventothebankonsomeoftheassetsofthebusiness.Thebankwillhavecontrolovertheseassetsifthebusinessfails.
ý Lackofflexibility-asmallbusinessmighttakealoanoutfor£50,000butfindsitonlyneeded£30,000.Thatmeansthatinterestisbeingpaidon£20,000ofloanthatitdoesnotneed.
ý Interest–interestmustbepaidontheloanamount,whichincreasesthecostsofthebusiness.
Venturecapital
Venturecapitalistsofteninvestinsmallbusinesses.Venturecapitalcanbegainedfromprofessionalinvestorsorcompanieswhotypicallyinvestbetween£10,000to£750,000.
Venturecapitaliststendtohavemadetheirmoneybysettingupandsellingtheirownbusiness–inotherwordstheyhaveprovenentrepreneurialexpertise.Theadvantagesanddisadvantageofthissourceoffinanceare:
þ Venturecapitalistsoftenmaketheirownskills,experienceandcontactsavailabletothefirm.þ Theyhaveaccesstolargeamountsoffunds.ý Theventurecapitalcompanyorinvestorwillusuallywantashareofthebusinessandofthe
profits,whichcanresultinsomelossofcontroloverthefirmfortheentrepreneur,whichhe/shemaynotwanttogiveup.
Obtainingventurecapitalisquitedifferentfromraisingdebtoraloanfromalender,suchasabank.Lendershavealegalrighttointerestonaloanandrepaymentofthecapital,irrespectiveofthesuccessorfailureofthebusiness.Bycontrast,venturecapitalisofteninvestedinexchangeforastakeinthecompanywherethereturnwillbedependentonthegrowthandprofitabilityofthebusiness.
Noteverybusinessissuitableforinvestmentbyaventurecapitalist.Suchinvestorsprefertoinvestinsmallentrepreneurialbusinesseswhichareaiming(andhavethepotential)forsalesandprofitgrowth.Asaroughguideunlessabusinesscanoffertheprospectofsignificantturnovergrowthwithinfiveyears,itisunlikelytobeofinteresttoaventurecapitalfirm.
Sharecapital
Smallornewbusinessesthataresetupasaprivatelimitedcompanycanraisefinancebysellingsharesinthecompany.Therearemanyadvantagestoabusinessofraisingfinancethroughshareissues:
þ Largesumsofmoneycanberaised.þ Capitaldoesnothavetoberepaid.þ Thereisnointerest–dividendpaymentscanbemissedifprofitsarelow.
Therearehoweversomedisadvantagesincluding:
ý Possiblelossofcontroliftheoriginalownerssellmorethan50%ofthetotalshares.ý Needtosatisfyshareholdersexpectationsofdividendsandsharepricegrowth.
Retainedprofit
Thisisaveryimportantsourceoffinanceforanexistingsmallbusiness,butisclearlynotsuitableforanewbusiness,astheyareyettobuildupreservesofprofit!
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Theideaissimple.Whenabusinesshasworkedoutitsprofits,theownersorshareholderscandecidewhethertotaketheprofitsforthemselvesorreinvesttheprofitsbackintointhebusiness.
Retainedprofitshaveseveralmajoradvantages:
þ Theyarecheap,asnointeresthastobepaidonthem.þ Theyareveryflexible–thebusinessownershavecompletecontroloverhowtheyare
reinvestedandwhatproportioniskept,ratherthanpaidasdividends.þ Theydonotdiluteorreducetheownershipoftheorganisation,soforcompaniesthereisno
increasedriskofatakeover.
Thereare,however,alsosomedisadvantages:
ý Ifabusinessneedssometemporaryfinancebecauseitisfacingdifficulties,thenitisunlikelytohaveanyprofitsthatitcanuse.
ý Growthmaybeslowifitisdependentonretainedprofits,asprofitsmaynotbehighenoughtofinancethegrowthquickly.
Crowdfunding
Crowdfundingisarecentwayofsmallbusinessesorprojectsraisingmoneyfromoutsideinvestors,oftenthroughtheinternetoracrowdfundingplatformsuchaswww.kickstarter.comorwww.crowdfunder.co.uk
Aproposalispublicisedandtheaimisthatalargenumberofsmallinvestorswillbeattractedfromallovertheworld.Theinvestorswillgenerallybeinsympathywiththeaimsoftheprojectorthecauseforwhichthefundsarebeingraised.
Therearesomeadvantagestoabusinessofusingcrowdfundingtosecurefinance:
þ Itprovidescheapinvestmentwhenothersourcesofexternalfinancemaynotbeavailable.þ Iftheprojectisinterestingornewsworthyitmightattractgoodpublicity,whichwillhelpthe
businessinbecomingsuccessful.þ Thebusinessmaycreateawebblogorusesocialmediatokeepinvestorsinformed,whichmight
provideongoingfinance.þ Investorsmayhaveexperienceorskillsthattheycanofferthebusiness.
Therewillhoweverbedrawbacks:
ý Investorswillneedtobeofferedareturn;thismightbefreeuseofthegoodorserviceproduced,orashareintheprofits.Someschemeswillalsoprovideshares,whichthereforedilutesthecontroloftheoriginalownersofthebusiness.
ý Thereisariskthattherewillbealimittotheamountofmoneyinvestorsarewillingtouseinthisway.