4.2 Sources of Finance (where can companies get money?).

Objectives

• Why do companies need money?• What are the sources of finance?• The importance of working capital.

Why do companies need money?

• Lets assume that the school is going to build a swimming pool.

• Make a list of all the things that will have to be paid for.

• Page 476. Write down the definitions of capital expenditure and revenue expenditure.

• Classify your expenditures as either ‘revenue’ or ‘capital’.

Where can the school get the money from?

• Make a list of all the methods by which the school can get money to pay for the new swimming pool.

Sources of Finance

Internal

Working capital Retained profitsSale of assets

External

External short-term

Credit card*OverdraftFactoring*Trade credit

External medium-

term

Leasing*Hire

purchase*Medium-

term loan*

External long-term

Sale of sharesVenture capitalNew PartnersLong -term loansMortgagesBonds / DebenturesGrants

Sources of Finance

Internal

Working capital Retained profitsSale of assets

What is working capital and why is it important?

• Cash is vitally important to businesses. Without cash; employees cannot be paid and stock cannot be purchased. Therefore, businesses cannot operate.

• Working Capital is cash and things that can easily be converted into cash: inventory and accounts receiveable (money owed by customers). It also includes things where cash is owed: accounts payable (money owed to suppliers) and overdrafts.

Working Capital Cycle

Cash

Purchase Inventory

Production

Sell on credit

Cash is converted into inventory then accounts receiveable and finally back to cash.

At anyone time the company has significant amounts of cash invested in the working capital cycle.

By speeding up the cycle the company can reduce the amount of cash invested in it.

Working Capital Example• You are a wholesaler.• You purchase inventory using cash. It takes 10 days to

arrive.• You put it in your warehouse, where it takes on average

20 days to sell.• You offer your customers 30 days credit.– How long is your working capital cycle?– You buy and sell 10 units of inventory per day. Each unit of

inventory costs $100 to purchase. How much money do you have invested in the working capital cycle?

– What happens to the length of the working capital cycle and the amount of money invested in it if we reduce credit terms to 20 days?

Sources of Finance

Internal

Working capital Retained profits

Sale of assets

External

External

short-term

Credit card*OverdraftFactoring*

Trade credit

External

medium-

term

Leasing*Hire purchase*Medium-term

loan*

External

long-term

Sale of sharesVentur

e capitalNew

Partners

Long -term loansMortgages

Bonds /

Debentures

Grants

• Accounts receivable = debtors. People or companies that you have sold to on credit and they will pay you in 30 days.

• Accounts payable = creditors. Companies that have supplied goods to you on credit and you will pay them in 30 days.

Working Capital

• What elements of working capital will the following businesses have?– Pizza restaurant– Tottus– Barber– Bookshop

How much working capital?• Supermarket:– Cash= 20,000, Inventory = 50,000, Accounts

Payable 65,000• Restaurant:– Cash= 2,000, Food = 5,000, Money owed to

suppliers = 3,000• Cinema:– Cash= 4,000, Popcorn etc= 2,000, Accounts

Payable =3,000, Money owed by customer = 2,000

How much working capital?

• Wholesaler:– Cash=1,000, Inventory= 20,000, Accounts Payable =

15,000, Accounts Receivable = 30,000– The wholesaler has been granted an increase, from its

supplier, in the trade credit it receives from 30 to 60 days.

– What has happened to the amount of money invested in working capital?

• Activity 26.2 Page 478.

Internal sources of finance

• Page 478 make notes on:– Profits retained– Sale of assets

• Page 480 Activity 26.3

Internal sources of finance – an evaluation

Sources of Finance

External

External short-term

Credit card*OverdraftFactoring*

Trade Credit

External medium-

term

Leasing*Hire purchase*Medium-term

loan*

External long-term

Sale of shares

Venture capital

New PartnersLong -term

loansMortgages

Bonds / Debentures

Grants

• Short-term = 1 week to 2 years• Medium-term = 2 to 5 years• Long-term = 5 to 30 years

Sources of Finance

External

External short-term

Credit card*OverdraftFactoring*

Trade Credit

External short-term sources of finance - Overdraft

• This is not a loan!!!!• Most of you will have a bank account and will

receive interest on the money that you have in the bank. (The interest rate you receive will be low).

• An overdraft allows you to have a negative bank balance for which you pay interest to the bank. (The interest rate you pay will be very high).

External short-term sources of finance - Others

• Credit card– you can pay off the credit card 30 days after purchasing the good

or service.– Interest rates can be high is debt not paid off.

• Trade credit– Other companies may agree for you to pay 30 days or more after

you receive the good.– No interest. Suppliers will stop supplying if debt not paid on time.

• Factoring– Sell your accounts receiveable to a ‘factoring company’. Your

debtors (people that owe you money now owe the factoring company).

Sources of Finance

External

External medium-term

Leasing*Hire purchase*

Medium-term loan*

External medium-termsources of finance

• Leasing – rent• Hire purchase – where you rent the item but

also pay extra each month to eventually buy it.• Medium-term bank loan – repayable in less

than 5 years – the bank will charge interest on the loan

Sources of Finance

External

External long-term

Sale of sharesVenture capitalNew Partners

Long -term loansMortgages

Bonds / DebenturesGrants

Long-term finance

• DEBT or EQUITY• This is probably the most important decision

when considering the financing of a company, as the company will have to live with this for years or decades to come.

• DEBT = borrowing money• EQUITY = selling a part of the company

Debt Finance

• Loans – from the bank for which a medium rate (10%) of interest has to be paid.

• Mortgages – these are a type of loan that are ‘secured’ on property, ie. If you do not pay the interest the bank can take your house. These have a low rate of interest (5%) as there is little risk involved.

• Bonds (sometimes called debenture) – the company can sell IOUs to private individuals and promise to pay them interest (10%). A bit like a loan.

Equity finance

• Sale of shares – can be privately or on the stock exchange (even small companies can get a listing on the Alternative Investment Market (AIM)).– There are costs involved in selling through the stock

exchange.– You may lose control of the company.– The company must make more profits to keep the

existing and new shareholders happy.• Take on a new partner.• Venture capital – Dragon’s Den

Equity finance

• Why do shareholders buy shares?• They receive dividends and gain as the share

price rises.• They actually want a return from their

investment. What percentage?

DEBT or EQUITY

• Page 482– Make notes on Debt or equity capital – an

evaluation.

• Page 481 activity 26.4

• Page 483 activity 26.5

Sources of Finance

What factors influence the choice of source of finance?