Task 7: types of financial institutions (BME)

Business funding

Require funding (finance) to start, operate and grow

Used for purchasing assets, covering expenses, expanding, developing new products

Business funding considerations

Control - how much

Cost - associated expenses

Speed - how quick to negotiate and access

Best for - most suitable uses

Internal funding

Sourced from within business

e.g., retained profits, sale of assets, owner’s capital

Retained profits

Profits kept within the business rather than paid out as dividends to owners/shareholders

Cash reserve is build up by allocating profit to be saved and kept by the company

Considered a long term source of finance because the come from business’s own earnings, don’t need to be repaid and can be reinvested

Stable and ongoing source of funding

Retained profits pros

No interest or repayment costs

Increases financial independence and control (limit reliance on financial institutions)

Can be used for long term investment

Improves stability and creditworthiness

Retained profits cons

Only available if business is profitable

Slower and require accumulation when compared to external options

May be differences between profits on paper and cash flow due to credit sales

Must be careful and ensure funding for ongoing operations

External funding

Sourced from outside of business

e.g., financial institutions, share capital, gov

Sources of external funding

Debentures

Share capital

Trade credit

Venture capital

Secured loans

Financial institutions

Gov

Debentures

Long term loan issued by a company to investors (debenture holders)

Company will issue a prospectus detailing their financial performance, future plans and the details of the debentures (e.g., interest rate, loan length)

Investors receive fixed interest payments over life of the loan

Debenture holders don’t own part of the business and have no voting rights

Debentures pros

Provides large, predictable source of finance

Control of the business is retained (no extra stakeholders)

Fixed interest payments make costs easy to plan

Businesses issuing debentures have more control over details than other loan types

Debentures cons

Increases business debt levels (liability)

Interest must be paid at agreed intervals even if profits fall

Debentures appropriate for

Large, established companies needing long term finance for major projects while keeping ownership

Share capital

Finance raised by selling shares in a company

Share represents a unit of ownership in org

Shareholders become part owners and are entitled to a portion of profits (dividends) and may gain voting rights

Companies aren’t obliged to pay dividends and choose to retain profits in the business to focus on capital growth and investment

Private company (pty ltd)

Shares are owned by a small group (often family or partners) and are not traded on the stock exchange

Max 50 non-employee shareholders

Public company (ltd)

Shares can be bought freely and sold on the stock exchange, making it easier to raise large amounts of finance from many investors

Share capital pros

Can generate very large sums of finance

No repayment obligation like loans

Strengthens the balance sheet by not increasing debt

Share capital cons

Loss of some control and ownership - due to intro of more shareholders with voting rights

If public, additional scrutiny as share price pressure may influence business management decisions

Share capital appropriate for

Large companies (public) seeking long term growth finance

Smaller companies (private) seeking funds without going public

Trade credit

Short term financing method where suppliers allow business to purchase g/s and pay later (often 30 - 90 days)

In some circumstances, longer period may be negotiated and/or instalment payment terms

Trade credit pros

Improves short term cash flow

Often interest free if paid on time

Trade credit cons

Missed payments may harm supplier relationships

Short term only - not suited to major investments

Trade credit appropriate for

Businesses with good supplier relationships needing short term flexibility

Venture capital (VC)

External funding provided by wealthy individuals or venture capital firms investing in high risk, high growth businesses

Venture capitalises may provide finance as a loan or in exchange for equity and partial ownership

Often accompanied by management expertise and industry connections

VC pros

Provides finance for innovative, risky ventures that banks reject

Adds expertise, strategic guidance and valuable networks

Long term funding supports rapid expansion

VC cons

Loss of some ownership and control

VCs demand high returns, often through dividends or eventual sale of business equity

Potential for conflict between founders and investors

VC appropriate for

Start ups and growth business with strong potential that are seeking long term finance by have limited access to traditional finance

Secured loans

Loans obtained from financial institutions secured against assets

In return for loaned funds, the lending institution receives interest payments

Amount business can borrow, interest rate and term of loan depend on value and type of security provided by business seeking the loan

If repayments can’t be made, lender can seize and sell assets to recover funds

Secured loan considerations by lender

Purpose of loan - likely to result in earnings

Amount of loan - based on security/business financials

Other assets and income - can reduce loan risk

Duration of loan - determines repayment terms

Secured loans pros

Larger loans often available compared to unsecured lending

Interest rates may be lower (compared to unsecure loans) due to reduced lender risk

Negotiable repayment periods (short/long term)

Secured loans cons

Business risks losing critical assets if unable to repay

Increases debt and interest costs (expenses)

Approval process may be lengthy due to asset validation

Secured loans appropriate for

Established businesses with valuable assets that can be utilised as security as well as predictable income/profit

Financial institutions

Orgs that provide finance and credit to businesses

e.g., banks, finance companies

Banks

Provide a wide range of funding products (secured/unsecured, term, mortgage loans, overdrafts) that businesses may access (dependent on eligibility)

Lending criteria generally stricter than other financial institutions

Loan terms are negotiated and dependent on the business’s financial health

Term loan

Borrowed money repaid in instalments over an agreed period which can be secured or unsecured

Mortgage loans

Long term loans secured against property, used to purchase or develop land and buildings

Overdrafts

Short term facility that lets businesses spend more than is in their account, up to agreed limit, with interest charged on overdrawn amount

Finance companies

Specialise in smaller loans (small to medium business) that target high risk borrowers and charge higher interest rates and fees with strict repayment terms

Banks pros

Flexible sums availble

Lower interest rates than other provides

Trusted instituions

Banks cons

Stricter lending requirements

Slow to approve

Finance companies pros

Willing to take on businesses with less established/healthy financials

Faster approvals

Useful for businesses without strong credit history

Finance companies cons

Higher interest rates and fees

Banks appropriate for

Established businesses with stable finance seeking a range of long/short term loans (can be secured or unsecured)

Finance companies appropriate for

Higher risk small to medium sized businesses who may be/have been rejected by banks

Government

Supports businesses through grants, subsidies and low interest loans, usually targeted at specific industries

Grants

One off payments that don’t need to be repaid

Often tied to projects that provide innovation, employment or community benefit

Low interest loans

Provided at cheaper rates than commercial banks

Makes long term investments more affordable

Gov pros

Grants reduce financial burden and require no repayment

Low interest loans allow large projects to go ahead with reduced financing costs

Encourages innovation and investment in sectors important to the economy

Gov cons

Competitive application process with strict eligibility rules

Often one off or project specific - not ongoing

Can involve complex compliance and reporting obligations

Gov appropriate for

Businesses in gov supported sectors (e.g., tech, renewable energy, agriculture)

Companies pursuing innovative projects that align with gov priorities

Ratio analysis

Tool that compares financial figures to evaluate business performance

Helps owners, managers and investors assess profitability, liquidity and stability

Shows how well a business uses resources, controls costs and generates returns

Profitability ratios

Gross profit: gross profit/net sales

Profit: profit/net sales

Expense: operating expenses/net sales

Return on equity: net profit/equity at end

Liquidity ratios

Current: current assets/current liabilities

Stability ratios

Debt to equity: total liabilities/total equity

Profitability

Measures ability to generate profit and provide a return on investment for owners/shareholders

Liquidity

Measures ability to meet short term debts

Stability

Measures long term ability to meet obligations

Equity

Owner’s/shareholder’s claim on the business’s assets after all liabilities are paid

Expenses

Costs incurred in running the business’s ops

e.g., wages, rent, utilities, marketing

Gross profit ratio

Shows the ratio of sales revenue remaining after covering the cost of goods sold (COGS)

Indicates how efficiently a business controls production/purchasing costs

Indicates efficiency in buying, producing or managing stock relative to sales

40% = retains 40c for every $1 of sales after covering COGS

Gross profit ratio interpretation

High > 40-60% - strong markup and efficient control of COGS (often luxury or niche goods)

Medium 20-39% - reasonable control of costs (in relatively competitive industries)

Low < 20% - thin margins, possibly due to high COGS or aggressive pricing/comp (supermarkets, competitive industries)

Profit ratio

Measures how much net profit a business keeps from its sales after all expenses are deducted

Shows overall efficiency in turning sales revenue into final profit

20% = keeps 20c in profit for every $1 of sales

Profit ratio interpretation

High > 15-25% - very profitable, strong sales revenue, cost control and efficiency

Medium 5-14% - acceptable profitability, may need closer monitoring of expenses

Low < 5% - weak profitability, expenses too high or pricing strategies ineffective

Expense ratio

Measures the proportion of sales revenue consumed by operating expenses

Shows how efficiently the business manages its costs relative to sales

Want to be low

30% = spends 30c on operating costs for every $1 made in sales

Expense ratio interpretation

Low < 20% - strong efficiency, minimal expenses compared to sales

Medium 20-35% - reasonable but could be improved

High > 35% - excessive expenses, may be limiting profitability

Return on equity ratio

Measures how effectively a business uses owners’ equity to generate profit

Indicates the return shareholders/owners are receiving on their investment in the business

8% = generates 8c in profit for every $1 of equity

Return on equity ratio interpretation

High > 20% - strong return, equity is being used very effectively

Medium 10-19% - reasonable return, competitive with other investments

Low <10% - weak return, may discourage current or potential investors

Current ratio

Compares current assets with current liabilities

Businesses should aim to have a current ratio greater than 100%, indicating they have enough current assets to cover short term debts

150% = $1.50 in current assets for every $1 of current liabilites

Current ratio interpretation

Solvent > 100% - enough current assets to cover short term debts

Acceptable solvency ~ 100% - likely able to cover debts, but little buffer

Poor/insolvent < 100% - can’t short term debts, liquidity risks

Current assets

Resources a business owns that can be converted into cash within 12 months

Current liabilities

Debts or obligations a business must pay within 12 months

Debt to equity ratio

Measures the business’s gearing

Indicates the balance between creditor financing (debt) and owner/shareholder financing (debt)

150% = $1.50 debt for every $1 of equity

Gearing

How much finance comes from debt vs equity

Lower gearing (< 100%) indicates the business is funded primarily by equity as opposed to debt which is safer

Debt to equity ratio interpretation

Low gearing < 100% - more equity than debt, safer but may limit growth

Moderate gearing 100-200% - balanced use of debt and equity, moderate risk with the potential for debt to accelerate growth if used effectively

High gearing > 200% - more debt than equity, high risk and high loan repayment obligations