Unit 5.3 - Sources of Finance

Internal source of finance

A source of finance that exists within the business

external source of finance

An injection of funds into the business from individuals, other businesses or financial institutions

Types of internal source source of finance

retained profits

sale of assets

Types of external source of finance

bank loan, mortgage

venture capital

share capital

overdraft

debt factoring

Short-term source of finance

finance that is needed for a limited period of time (less than 1 year)

Long term source of finance

finance that is needed for an extended period of time (more than 1 year)

Types of short term finance

Retained profits (Can also be long term)

Overdrafts

Debt factoring

Sale of assets (can also be long term depending on amount)

Trade credit

Types of long term finance

Bank loans

Mortgages

Venture capital

Share capital

May also be: retained profit and sale of assets

Overdraft

Business is allowed to spend more than is in its current account up to an agreed limit

Benefits of overdraft

- Flexible form of finance as amount can vary as long as it is within the boundaries

- Usually easy to increase /decrease the amount with limited forms

- Good for short-term cash flow problems

- Can be low interest if business stays within limits of amount and time

- Only pay interest on amount borrowed not on interest added after

Drawbacks of overdraft

- Only suitable for small amounts and short term

- Overdrafts can have high interest rates if you go over the agreed limit or use for longer than you should (usually around 4-6% depending on base interest rate)

- Banks can demand immediate repayment

- May be harder to get one for Smaller enterprises

Debt factoring

Bills that are yet to be paid (receivables, invoices etc), the business sells for cash. Whoever the bill is sold to will then recover that money and take a fee

Business tends to get 80% of value upfront, then gets the rest minus about 5% taken by the debt factorer after debts have been recovered

Benefits of debt factoring

- Immediate cash is made available to the business.

- The risk of collecting the debt becomes the factor's and not the business's.

- If cash is made available may be able to avoid overdraft and interest payments

Drawbacks of debt factoring

- Can be costly - the 5% fee could eliminate the profit margins of the sales for some firms especially smaller ones

- May impact relationships with customers as they will know their debt has been factored:

They may seek different supplier as they think the business has cash flow issues

Bank loans

A sum of money obtained from a bank which must be repaid and on which interest is payable

Benefits of bank loans

- Can be negotiated to meet a business's precise requirements.

- Managers can plan for repayments within budgets.

- Can usually borrow large sums and for longer period of time

Drawbacks of bank loan

- Requires security (collateral)

- Interest paid on the full amount outstanding (including interest owned)

- Harder to arrange

- Startups and small businesses often excluded

- Higher risk = higher interest

- Can be fixed or variable

Mortgages

Long-term loan repaid over up to fifty years and used to purchase property

Benefits of mortgages

- Ideal source of finance for very long term projects.

- Avoid the owners losing any control over the business.

- Can borrow very large sums of money

Drawbacks of mortgages

- Property bought with mortgage will be collateral until the mortgage paid in full

- Interest paid on the full amount outstanding (including interest owned)

- Harder to arrange

- Higher risk = higher interest

- Can be fixed or variable

Retained profit

profits from the current trading year or previous years is kept in the business and can be used to reinvest

Benefits of retained profit

- No interest repayments

- Does not involve any potential loss of control

Drawbacks of retained profit

- Opportunity cost: could leave it in the bank and earn interest

- Shareholders may be unhappy as they will receive lower dividends

- Only available if the business is making a profit and the profit would have to be significant enough to purchase potentially expensive non-current assets

Share capital

Money raised through the sales of shares, therefore selling a % of share in the business

Benefits of share capital

- large sums of money can be raised.

- capital does not have to be repaid.

- there is no interest - dividend payments can be missed if profits are low.

- Some new shareholders may bring expertise (although usually passive investment unless they are purchasing controlling stake

Drawbacks of share capital

- Only available to companies (i.e Ltd and Plc)

- Ltd would have to seek permission from current shareholders

- Loss of control if too many shares are sold and existing owner lose their majority stake

- Will be expected to pay dividends so there is still a long term cost (but can pay less of non in time of low profit)

Venture capital

Funds provided to business usually thought to be high risk or in their infancy in the form of share and loan capital

Benefits of venture capital

- Bring in expertise, experience, contacts

- Avoids having to pay interest.

- Often used by small or risky businesses

Drawbacks of venture capital

- The investors will want some control over how the enterprise operates

- Likely want a share of profits (although this is often forgone as venture capitalist look to make gains through businesses value growing

- Won't provide excessive amounts usually not anymore than £500,000

Sale of assets

when a business sells off its unwanted or unused assets to raise funds

Benefits of sale of assets

- no interest charges or repayments

- may be turning an obsolete asset into finance

- immediate lump sum cash injection

- No losing of control

Drawbacks of sale of assets

- Will lose access to the asset, what if it is needed later on

- May use sale and lease back but would now have to pay for the use of the asset

- Asset may have depreciated in value overtime - is it worth keeping until it sees out its useful life rather then sell it for small amount

Crowdfunding

raising money for a project or venture by obtaining many small amounts of money from many people

Benefits of crowdfunding

- Relatively cheap.

- Increasingly relevant as UK banks reduce short term lending.

- Interest free

Drawbacks of crowdfunding

- must follow rules/fees of crowdfunding platform

- may have to return funding if goals not met

- may harm reputation

- Unfamiliar source for many managers.

- May not be suitable to raise large amounts

Influences on a businesses choice of source of finance

- Ownership structure

- Cost of the source of finance

- Opportunity cost

- Flexibility

- Need to retain control of business

- Purpose for which finance is needed i.e cash flow problem or large investment

- Short term vs Long term

- Current financial position

- Managers attitudes