Sources of Finance

What factors affect the suitability of the finance option chosen by a business?

1. How much funding is needed

2. How long the money is required

3. What the finance will be used for

4. The affordability of repayments

5. Whether or not personal or business assets are available as security

6. Whether or not the business owner is willing to give up a share of ownership, perhaps through taking on a partner or selling shares

Define internal sources of finance.

Money that is generated from within the business or from the business owners own capital.

List some internal sources of finance.

• Retained profit

• Working capital

• Sale of assets

• Owner’s savings

What is retained profit?

Profit that has been made by the business in previous years that is then reinvested back into the business.

What are the advantages of retained profit?

• Cheapest form of finance as you don’t have to pay interest on your own money

• Provides a liquidity buffer and potential funds for growth.

What is liquidity?

The ease at which a business can turn its assets into cash immediately in order to pay its current liabilities.

What are the disadvantages of retained profit?

• Money is tied up to the business so no interest is earned.

• Cannot be used for other purposes (opportunity costs).

What is working capital?

Working capital is the money needed to finance the day-to-day running of the business. It allows stock to be bought and wages and bills to be paid.

What are the advantages of working capital?

Businesses may receive money from customers more quickly as they are able to reduce their trade credit and collect debts more efficiently.

What are the disadvantages of working capital?

• This is likely to drive customers away and may have the opposite effect on making finance available.

• A sudden surge in demand could result in lost sales if the business is unable to meet delivery dates.

What is sale of assets?

Sale of assets is when a businesses sell items that they no longer need, for example, machinery or transport.

What are the advantages of sale of assets?

Established businesses are able to sell off assets that are no longer required, such as buildings and machinery.

What are the disadvantages of sale of assets?

Smaller businesses are unlikely to have such unwanted assets, and, if growth is an objective, they are more likely to want to acquire assets as opposed to losing them.

Define external sources of finance.

Money that is raised from sources outside of the business.

List some external sources of finance.

• Bank loan

• Overdraft

• Trade credit

• Debt factoring

• Hire purchase

• Commercial mortgages

• Sale and leaseback

• Share capital

• Business angels / Venture capitalists

• Government grants / Government assistance

What is a bank loan?

A loan is borrowing a fixed amount, for a fixed period of time, perhaps 3-5 years.

What are the advantages of a bank loan?

• If application for the loan is successful, the money becomes immediately available.

• Payments made up of interest and capital are made monthly, which can help with cash flow planning.

• Funds are made available for medium- to long-term borrowing of large sums of money, for example if a business needs to acquire building land.

• Offering security against a loan can make it much easier to get funding and reduces interest rates charged.

What are the disdvantages of a bank loan?

• Interest has to be paid on the loan; thus, businesses have to pay back more than what they borrowed.

• Very difficult to obtain for small businesses. It is likely that most new start-ups are unlikely to receive a loan unless security is offered.

• Some form of collateral may be required to secure the loan – if the business owner is not able to maintain payments, homes can be lost or business assets removed.

What is an overdraft?

An overdraft is the facility to withdraw more from an account than is in the bank account, resulting in a negative balance.

What are the advantages of an overdraft?

• Very useful for overcoming short term liquidity problems – useful for day-to-day transactions, easing cash flow needs and emergency requirements.

• Only pay interest when account is overdrawn, i.e. do not have to pay off regular sums.

What are the disadvantages of an overdraft?

• Interest charged can be very high indeed.

• The overdraft limit tends to be fairly low for small businesses.

• May be arrangement fee.

• Can be called in immediately – it is repayable on demand.

What is trade credit?

Businesses buy items such as fuel and raw material and pay for them at a later date.

What are the advantages of trade credit?

The 30-90 days offered by suppliers can be viewed as interest free way of raising finance.

What are the disadvantages of trade credit?

• Suppliers often offer discounts for cash or early payments, meaning the cost of goods is higher if full credit period is used.

• Late payment can also lead to a business gaining a bad reputation with suppliers.

What is debt factoring?

Debt factoring involves a business selling their outstanding sales invoices to a third party company (a factoring company) in return for cash.

What are the advantages of debt factoring?

• Amounts owed by customers (receivables) are turned into cash quickly.

• Business can focus on selling rather than collecting debts.

• The facility is practically limitless and therefore suits a fast-growing business.

• There is no security required – unlike a loan or overdraft.

What are the disadvantages of debt factoring?

Factoring services are only offered to businesses with a good trading record and reliable customers.

What is leasing?

Leasing is when a business gains use of a productive asset, without ever owning it.

What are advantages of leasing?

• The business acquires the use of resources without the need for a large sum of money.

• The maintainance and repair bills are met by the leasing company.

• Leases are generally easier to obtain than loans.

• Equipment can be updated regularly.

What are disadvantages of leasing?

• Over a long period of time, it can be very expensive and well in excess of the purchase price.

• The business never gets to own the items leased.

What is hire purchase?

Method of gaining the use of capital goods, whilst paying a monthly fee.

What are the advantages of hire purchase?

• Useful for purchasing machinery that can be obtained quickly.

• Finance houses may also be less selective than banks.

• At the end of the hire purchase period, the business will own the asset

What are the disadvantages of hire purchase?

• Interest rates are usually very high.

• The property is not owned by the business until the last payment has been made. Items can be legally repossessed if the business falls behind with repayments.

• Add servicing charges for paying in installments.

What is a commercial mortgage?

If a business owns property, a commercial mortgage may be available.

What are the advantages of commercial mortgages?

• Because security is being offered to the lender, the interest rates will be lower than an unsecured loan.

• Payments are made monthly for the term of the mortgage.

• Commercial mortgages might run for 10 or 15 years so generally have predictable costs – this can be helpful with budgeting and predicting cash flow.

What are the disadvantages of commercial mortgages?

Failure to make repayments may lead to the property being repossessed by the lender.

What is sale and leaseback?

This involves the business selling assets (buildings, machinery) to a finance company and then leasing the asset back

What are the advantages of sale and leaseback?

• This method of raising finance means the capital that is produced can be reinvested into growing the business.

• An asset owned by the business can be turned into capital for reinvestment in the business.

• Sale and leaseback also carries potential tax benefits as the leasing costs are offset as an operating expense.

What are the disadvantages of sale and leaseback?

Once the item has been sold, it is no longer an asset of the business thus it is a one time option.

What is share capital?

Involves the selling of shares in order to provide funds.

What are the advantages of share capital?

• Share capital is a form of permanent capital; this means it does not have to be repaid.

• Owners of shares have a say in how the business is run, but the amount of influence they have depends upon the percentage shareholding they own.

What are the disadvantages of share capital?

• Loss of control – the business owner or owners will have decisions influenced by new investors.

• New shareholder investors may be looking for an exit strategy within a few years. This means that they are expecting the business to grow rapidly and then they expect to be able to sell their shares, taking their capital gain

What are business angels / venture capitalists?

Professional investors who can invest large amounts of capital into small- and medium-sized businesses.

What are the advantages of business angels / venture capitalists?

• Possibly large sums of money can be attained quickly.

• Advice may also be given.

What are the disadvantages of business angels / venture capitalists?

Will not only take a shareholding but also expect to be fully involved in running the business.

What are government grants / assistance?

Both local and central government may offer finance to business startup schemes.

What are the advantages of government grants / assistance?

• Usually given to small businesses in regions where unemployment is high.

• Often, they are grants that do not have to be repaid.

What are the disadvantages of government grants / assistance?

• They tend to be small amounts that last only for a relatively short period of time.

• They are also few and far between – tend to come with certain conditions which must be met.

• Administration requirements – forms to complete that meet what can be strict criteria