Advantages and Disadvantages of Finance Sources

Vocabulary flashcards outlining the pros and cons of different finance sources for businesses.

Internal sources of finance (definition)

Finance that comes from within the organization, from its own resources and assets without the help of a third-party provider

Internal sources of finance (list)

• Personal funds

• Retained profit

• Sale of assets

Personal funds

• Internal source of finance, where owners use their own savings or money from friends or family, usually to finance their start-up business.

• Available for: Sole traders, partnerships

Advantages of personal funds

• Avoids interest payments or repayments

• Avoids loss of control

• May help attract funds from other sources of finance

  • Banks or investors will consider if the business owner is taking the risk of putting their own money into the business so they can trust the owner with their loan or investment

Disadvantages of personal funds

• Funds available are likely to be limited.

• May result in personal assets (such as property) being put at risk.

• Short-term only

Retained profit

• Refers to the profit from previous years that have not been paid to shareholders as dividends

• Available for: All

• Short-term

Advantages of retained profits

• No interest charges or repayments

• No loss of control

• Can be used for any purpose within the business. By contrast, bank loans are approved for specific uses only.

• Short term & long term (flexible)

Disadvantages of retained profits

• The owners of the business (e.g. shareholders) may wish to receive the profits.

• The business may lose out on valuable alternative investments.

• Not suitable for funding start-ups

• Retained profit is rarely enough as a sole source of finance for most businesses in their pursuit of growth and evolution.

Sale of assets

• An internal source of finance that involves the firm selling existing items of value that it owns and no longer requires

• E.g. Land, buildings

• Available for: All

• Long-term

Advantages of sale of assets

• A large sum of money can be raised

• Makes the business more asset-light

• Avoids interest payments.

• Can prevent loss of control

• Long-term

Disadvantages of sale of assets

• Assets are no longer available to the business.

• May involve ongoing payments if sale and leaseback deal

• It can be very time consuming to find a suitable buyer for second-hand assets

• Assets may be highly depreciated, not fetching enough funds

• Not suitable for newly established businesses

External sources of finance (definition)

Finance that comes from outside the organization, usually with the help of a third-party provider

External sources of finance (list)

• Overdraft

• Trade credit

• Loan capital 

• Crowdfunding

• Microfinance providers

• Business angels

• Share capital

• Leasing

Overdraft

• A banking service that enables customers (personal and business customers) to withdraw more money from their account than exists in the account.

• Short-term

Advantages of an overdraft

• A flexible way of funding day-to-day financial requirements.

• Interest is only payable on the actual amount borrowed.

• Available for: all, but may not be available based on bank’s judgement  

• Easy to obtain so suitable for small businesses

• Provide the business with emergency funds, so helps liquidity and cash flow problems

Disadvantages of an overdraft

• Interest rates are high.

• Bank may ask for repayment at any time

• Short-term, not suitable for large amounts of growth

Trade credit

• Financial service that enables a business to purchase and obtain goods and services from suppliers but to pay for these at a later date. The payment is postponed usually to 30-60 days after the purchase.

• Short term

Advantages of trade credit

• No interest is charged

• Good alternative for overdrafts if the business is struggling with cash flow

Disadvantages of trade credit

• Short-term

• Availability depends on reputation (market power)

Loan capital

• Refers to borrowed funds from financial lenders over a medium to long period of time 

• Long term

Types of Loan capital

• Bank loan

  • A bank loan is an amount of money provided to a business for a stated purpose in return for regular repayments of the amount borrowed plus interest charges over a period of time. 

• Debenture

  • These are a special type of long-term loan to be repaid at some future date, normally within 15 years of the loan being agreed. The rate of interest paid on debentures is normally fixed.

• Mortgage

  • Mortgages are long-term loans granted by financial institutions solely for the purchase of land and buildings. The land or building in question is used as security or collateral for the loan. These loans can be for long periods of time – often up to 50 years.

Bank loan

A bank loan is an amount of money provided to a business for a stated purpose in return for regular repayments of the amount borrowed plus interest charges over a period of time

Advantages of a bank loan

• Can be negotiated to meet a business’s precise requirements.

• Managers can plan for repayments within budgets.

• Large businesses are often able to negotiate a lower rate of interest on their loans (financial economies of scale).

• Do not need to dilute their ownership or potentially lose control through issuing shares

Disadvantages of bank loans

• They are inflexible and businesses may pay interest on funds they are not using.

• Businesses may be required to offer collateral

Debenture

These are a special type of long-term loan to be repaid at some future date, normally within 15 years of the loan being agreed. The rate of interest paid on debentures is normally fixed

Mortgage

Mortgages are long-term loans granted by financial institutions solely for the purchase of land and buildings. The land or building in question is used as security or collateral for the loan. These loans can be for long periods of time – often up to 50 years

Advantages of mortgages and debentures

• These are ideal sources of finance for very long-term projects.

• They avoid the owners losing any control over the business.

Disadvantages of mortgages and debentures

• Managers will have to offer property as collateral for mortgages.

• Businesses can pay large amounts of interest on very long-term loans

Short-term finance

Short-term finance refers to sources of finance needed for the revenue expenditure of a business

Types of short-term finance

• Personal funds

• Sale of assets

• Overdrafts

• Trade credit

Long-term finance

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

Types of long-term finance

• Share capital 

• Loan capital, such as mortgages

• Leasing

• Business angels

• Microfinance providers

• Crowdfunding

Appropriateness of sources of finance for a given situation

Revenue expenditure

• Refers to business spending on its assets that are used by the business in a relatively short period of time

• Effect on profits:

  • If not controlled, can have an immediate and damaging effect on profits (current liabilities)

Capital expenditure

• Business spending on fixed assets that will last more than 12 months.

• Essential for a firm to generate long-term profits

The role of finance for businesses

• Businesses require money

  • To start up or expand

  • To pay for day-to-day expenses

  • To provide a reward for the owners taking a risk in starting the business

  • To pay taxes to governments and other authorities

• Finance provides a means to measure a business’s performance through different types of calculations on monetary values

• Finance can indicate whether a business is collapsing

Capital

The money invested into a business and is used to purchase a range of

Fixed costs

• Costs a business incurs that do not vary with levels of production in the short term

  • Rent,

  • interest on bank loans,

  • property tax

  • Management salaries

Variable costs

• Costs a business incurs that vary proportionally with the rate of production

  • Packaging

  • Raw materials

  • Wages of employees working on a specific production line

Direct costs

• Costs that can be attributed to a specific unit of production or product

  • Raw materials

  • Fuel

Indirect costs/overheads

• Costs that cannot be easily allocated to the production of a particular product

  •  marketing costs

  • administration costs

Revenue streams + examples

• The income a business generates from different business activities 

• Examples

  • Sale of goods & services

  • Transaction fee

  • Subscription fee

  • % from advertising of another company on a business website

  • Merchandise

  • Sponsorship

  • Donations

Cash

The money a business has, either “in hand” (at its premises) and/or “at bank” (i.e., in its bank account). It is the most liquid of a firm’s current assets and is easily accessible

Cash flow

The movement of an organization’s cash inflows (cash received from the sale of goods and services) and cash outflows (used to pay for the costs of running the business).

Cash flow forecast

A quantitative technique used to predict how cash is likely to flow into and out of the business for a particular period of time

Cash flow problem

These are liquidity issues that arise when an organization has insufficient funds to run its business, i.e., when net cash flow is negative

Cash inflow

Refers to the money coming into a business from earnings (sales revenue) and other sources of finance, such as crowdfunding

Cash outflow

Refers to the money going out of a business to pay for its costs, such as the purchase of raw materials or the payment of wages and salaries

The difference between profit and cash flow

A business’s profit is calculated considering all transactions for sales of goods and services as fully completed, while cash flow refers to the cash that a company will have on-hand at any given time

The relationship between investment, profit, and cash flow

• A business investment is when a business spends on fixed assets (capital expenditures)

• A large amount of capital is required for this investment

• The investment should lead to higher profits in the long run

• In the short term, there will be a large outflow of cash at the beginning of the investment, possibly causing cash flow problems. As the business begins accumulating revenue from this investment, cash inflows should generally increase, leading to improvement in overall cash flow.

Strategies for dealing with cash flow problems

• Improving cash inflows

  • Reduce trade credit to customers → 60 days to 30 days

    • ---Could leave many customers deterred from purchasing from the business

    • +++ Prepones cash inflow this improving net cashflow 

  • Sources of finance:

    • Sale of assets

    • (personal funds) only applicable for unlimited liability companies

  • Reduce stock through:

    • Discounts

    • Loss leader

    • Promotion

    • ---This could increase marketing costs!!!

    • +++Would help liquidity!!!

• Reducing cash outflows

  • Finding cheaper suppliers

    • ---May be time consuming 

    • ---May reduce quality

    • +++helpful in the long term

  • Short-term sources of finance such as:

    • Trade credit

      • Can pay suppliers later

    • Overdraft

      • Account can go negative until the investment has been done

Statement of profit or loss

A financial document showing a firm's financial performance over a period of time

Sales revenue

Shown on the profit and loss account, this refers to the money an organization earns from selling goods and services

Costs of sales (COS)

These are the direct costs of production, such as the cost of raw materials, component parts, and direct labour.

Gross profit

A form of profit that is calculated by deducting the direct variable costs that a business incurs from its sales revenue

Gross profit indicates

An indication of the business production efficiency

Expenses

• These are a firm’s indirect costs of production

  • e.g., rent, management salaries, marketing campaigns, accountancy fees, bank interest charges, travel expenses, utilities, repairs and maintenance, and general insurance.

Profit before interest & tax

• A profit that deducts expenses and cost of sales from the sales revenue AKA operating profit

Profit before interest & tax indicates

An indication of how efficient or profitable the businesses operation is. When compared to gross profit, shows the impact of indirect costs on the profitability

Profit before tax

Deducts the interest received by the business on its savings

Profit before tax indicates

Shows the impact of the business's financing decision when compared to the previous profit

Profit for period

• The net profit that a business gains after taking into account all income and all costs incurred including taxes & interest

• Called surplus for NPO

Dividends

The payments from a company's profit for period paid to the shareholders of the Company. The amount of dividends paid to an individual shareholder depends on the number of shares held by the individual

Balance Sheet / Statement of Financial Position

A statement which records what the company owns, owes, and its net worth at one moment in time

Assets

The possessions owned by a business, which have a monetary value, e.g., buildings, land, machinery, equipment, inventories, and cash

Noncurrent Assets

Also known as fixed assets, this refers to the long-term possessions of an organization with a monetary value but are not intended for sale within the next twelve months of the B.S date

Noncurrent Assets includes

• Property plant, and equipment

  • Land, factory vehicles, machinery

• Accumulated depreciation

Accumulated depreciation

The accrued value of the non-current assets, most of which fall in value over time due to depreciation due to usage as well as newer models & tech being available.

Current Assets

Short term possessions of monetary value belonging to an organization that will last up to 12 months

Current assets includes

• Cash:

  • Refers to the money the organization has either at its premises or in its bank account. It is the most liquid type of current asset.

• Debtors:

  • Refers to the individual or business customers that owe money to the organization as they have bought goods or services on trade credit.

• Stock:

  • Also known as inventories, these are the goods that a business has available for sale per time period

Debtors

Refers to the individual or business customers that owe money to the organization as they have bought goods or services on trade credit

Stock

Also known as inventories, these are the goods that a business has available for sale per time period

Liabilities

The debts of a business

Current liabilities

Short-term debts of a business which need to be repaid within twelve months

Current liabilities include

• Bank overdraft

  • A financial service which allows customers to temporarily take out more money than is available in their Bank account.

• Trade creditors

  • Suppliers who need to be repaid at a future date, typically within 30–60 days.

• Other short-term loans

Non-current liabilities

AKA long-term liability refers to debt owed by a business which will take longer than a year to repay from BS data

Non-current liabilities includes

Long-term Borrowings

Equity

Refers to the value of the owners’ stake in the business, i.e., what the business is worth at the time of reporting the balance sheet

Equity includes

• Share capital 

  • The value of equity in a business that is funded by its shareholders, either through an initial public offering (IPO) or via a share issue

• Retained profit

  • Also referred to as retained earnings, this refers to the value of a firm’s earnings after all costs are paid (including interest and tax) and shareholders have been compensated (dividends).

Gross Profit Margin (GPM)

A profitability ratio that shows a firm’s gross profit expressed as a percentage of its sales revenue

Net Profit Margin (NPM)

Measures a firm's overall profit before interest and tax as a percentage of its sales revenue

Return on Capital Employed (ROCE)

ROCE is a measure of how profitable a business is per dollar of long-term source of finance

Liquidity Ratios

Financial ratios that represent a firm's ability to pay its debts

Current Ratio

A short-term liquidity ratio which calculates the ability of a business to meet its debts within the next 12 months

Acid-test/Quick Ratio

A liquidity ratio that measures a firm's ability to meet its short-term debts, ignoring stock because some inventories are difficult to turn into cash in a short time frame