Sources of finance Business Unit 1

Why do firms need finance?

– To expand– To buy new equipment– To start up a new business– To pay workers– To buy premises– To survive– To buy stock– To cover a fall in demand (recession)

Sources of Finance

Sources of Finance can be either:

Internal External

Internal can be cheaper, but spending this money on the

business means the money can’t be spent on other projects like

investing

Comes from outside the business. This

usually costs more as interest may be

charged

Types of Finance

• Internal – Personal savings– Retained profit–Working capital (money in the

till)

– Sale of assets–Debt Factoring

Types of Finance

• External – Shares capital –Debentures (secured loan)

–Mortgage (secured loan)

–Other loans–Overdraft facilities–Hire purchase / leasing– Trade credit– Venture Capital – Grants

How much finance can a business get?

• It depends on risk assessment based on:

– The type of business

– Stage of development

– State of the economy

Choosing the right type of finance is based on

How long the money is needed for

• The duration of the loan should reflect the time they expect to need the purchase for– You would not take a

5 year loan for a van that you expect to last 3 years

The legal structure of the business

• A sole trader can’t sell shares

• The liability of the owners must also be taken into account

Liability

Unlimited Liability – The owners of the

business are personally liable for any debts which the business may have (Can be risky)

Limited Liability– The liability of the

owners (the shareholders) to pay off debts is limited to the amount of money which they have invested in the business (Safer)

Time Periods for Finance

Finance is generally considered to be either:

Short-term Short/Medium Long-term

1 year 2 to 5 years Over 5 years

Borrowing Money

Time

frame

Possible

usage

Short term 1 year Working capital, raw materials

Short (medium)

term

1 – 5 years Capital expenditure (vehicles,

refurbishments etc)

Long term Over 5 years

Major capital expenditure

(buildings, lands etc)

Types of finance• Long term finance

– Normally for large projects like expanding, research or producing a new product.

– Often less interest to pay back on this type of finance

• Short term finance

– Often used to fill gaps in the cash flow of a business, like paying rent.

– Often flexible and comes at a higher rate of interest

Long Term Finance (5 – 25 years)

• Share capital (PLC & LTD only)

• Shares are sold by the business to raise capital. In a PLC this is done on the London Stock Exchange, LTD you must know the seller, the profit share they get is called a dividend

• Venture Capital (PLC & LTD only)

• Someone will buy shares in the business to help them grow faster and sell them at a profit (Dragons Den)

Long Term Finance (5 – 25 years)

• Debentures (PLC & LTD only)

• Is a secured loan. Interest is paid to each holder, this is paid before any money is paid to share holders

• Mortgages• Is secured a contract that means the loan is secured on property and that the party buying it will not own the property till its fully paid

Long Term Finance (5 – 25 years)

• Loans (this can be a short term source too)

• Normally given out by the bank, will have to repay over a set number of years with interest, paid at the same time every month

• Retained Profit• Profit the business has made and is reinvesting in the business, this is often used to buy stock, and pay wages on a weekly basis

Long Term Finance (5 – 25 years)

• Grants• This is money given to the firm by the government, this money does not have to be repaid

Short Term Finance (up to 5 years)

• Leasing equipment • Will allow you to rent out equipment

over time instead of buying it, useful if you only need equipment for a short time, but you never own it

• Hire Purchase• Like leasing but you pay every month

for the product / equipment, instead of paying in one go, it means you don’t have to spend a large amount at once, and you keep it after

Short Term Finance (up to 5 years)

• Bank overdrafts • is a negative balance that the bank

allows you to use in emergencies, this is repaid when money goes in to your account, high interest but flexible

• Trade credit• is an amount of time that firms give

you to repay them for items they have sold you (normally 30 days)

Short Term Finance (up to 5 years)

• Factoring• A factoring firm will buy a firms debts

and assume the risk on non-payment. The factor collects the debts directly from the businesses customers. (But pays less for the debt than owed)

Question Time

• All students must have one question !!

• Write 3 down in case somebody else asks it.What’s Business

Did you bring your text book?

And Homework!!

Owner’s fundsExplanation Benefits Drawbacks

Money put into the business by the owner

No need to pay interest on the money

Could have been invested elsewhere, earning a higher profit

Owner may not have enough funds to meet the needs of the business

Retained ProfitExplanation Benefits Drawbacks

Money kept in the business by the owners

Known as retained profit on the balance sheet

No need to pay interest on the money

Could have been invested elsewhere, earning a higher profit

The business may not have enough retained profit to meet its needs

Shareholders may become unhappy if this means lower dividend payments

Selling AssetsExplanation Benefits Drawbacks

Items owned by the business are sold and the money made used to finance the business

The business is using money it already has – so no need to take on loans or pay any interest or charges

The business has to have something worth selling for this to be an option

The business may sell something they later need

OverdraftExplanation Benefits Drawbacks

The bank allows the business to draw more money from their bank account than they actually have in it

Very quick to arrange

A good short term solution to a cash flow problem

Only suitable for smaller amounts and has to be repaid within a short amount of time

Interest or charges are paid

Trade CreditExplanation Benefits Drawbacks

Items are bought from suppliers on a ‘buy now pay later’ basis

Gives the business more cash to use in the immediate future

Can only be used to buy certain goods

Bills usually have to be settled within 30,60 or 90 days, usually 30!

Debt FactoringExplanation Benefits Drawbacks

The company sells a debt it is owed to a debt factoring company who pay the business a smaller sum than they were owed

Allows the business to get money for debts that might otherwise never have been paid

Saves the business time chasing customers etc for money owed

Time consuming to arrange

The business receives less money than it was originally owed – this may affect profitability

LeasingExplanation Benefits Drawbacks

Used to help obtain new equipment eg cars

The business rents the item from its owner

Cost of the asset is spread over its life

No need to find a lump-sum of money to purchase it

May be more expensive than buying the asset – the owner will want to profit from the deal

The business does not own the asset so it does not appear on the balance sheet

Debentures Explanation Benefits Drawbacks

Long term borrowing similar to selling shares, but with the promise of repaying the amount lent at a fixed period in time, usually for a set amount of interest

A very structured method which allows the business to know exactly how much interest will be paid and when the debt has to be paid back

Usually ‘secured’ onto assets of the business such as property, therefore if the interest on the debt, or the debt itself isn’t repaid, the debenture holder will claim the item/property

No longer a popular method of finance for businesses

Bank loanExplanation Benefits Drawbacks

An amount of money is borrowed from the bank, then repaid (with interest) over a set period of time

Easy and quick to set up

Large amounts of money can be borrowed

Structured repayment term

Interest payable If repayments

cannot be kept up, the business risks getting a poor credit rating or being made bankrupt

Issuing SharesExplanation Benefits Drawbacks

A share in the business is sold to an individual or another business. This money then used to purchase new assets

No need to repay the money invested

Cheaper than a loan.

Some businesses can raise large sums of money this way

Need to pay the shareholders a share of future profits

Ownership also means some influence over how the business is run – the original owners may lose control of the business

Risky for the shareholder - the investment may be lost if the business fails

Mortgage Explanation Benefits Drawbacks

Long term loan provided by a bank in order to buy property

Only method available to buy property

Structured repayments over a long term (25 years)

Large sums of interest charged

Can take a long time to repay debt

Government GrantExplanation Benefits Drawbacks

Money given to the business by the government.

Used to help finance new projects – especially those that create new jobs

No need to repay the grant

Limited funds are available

May be restrictions on what the money can be used for

Hire Purchase Explanation Benefits Drawbacks

An item is bought on finance, repayments are made each month until the final payment when the item becomes the property of the firm

Flexible method – can hand back the item if no longer required and payment will stop

High interest often charged

Item doesn’t belong to the business until the end of the term

Venture CapitalExplanation Benefits Drawbacks

Venture capitalists invest in small, risky business e.g. new business start-ups

Can raise money from them even when banks have refused to lend to the business

Risky for the venture capitalist

The VC may want to have some control over how the business operates