3.1: Sources of finance

State the two needs for finance in a business organisation and the type of expenditure for each.

Growth/Expansion (capital expenditure) and to cover day-to-day costs of business activity (revenue expenditure).

Capital expenditure. Include three examples.

Money spent to acquire fixed assets (that will last for longer than a year and be used repeatedly). CEs are long-term investments which will assist in growing the organisation and its long-term income.

Examples: Machinery, land, buildings

State the characteristics of capital expenditure

• High cost

• (and so) so CE is often used as collateral.

Collateral. Include an example.

Financial security pledged for repayment of a source of finance.

Example: Bank loans

Revenue expenditure. Include three examples.

Money used to cover the day-to-day operational costs of an business. REs are short-term investments which are covered immediately to keep the business operational. It does not contribute to the growth or expansion of a business.

Examples include: Rent, wages, insurance.

Explain the danger of consistently higher REs than CEs

Businesses will struggle to build sufficient finance for

Internal finance

Money obtained from within the business (usually from well-established businesses).

State the three internal sources of finance

• Personal funds

• Retained profits

• Sale of assets

State personal funds. State the benefits and disadvantages.

Money an individual has available for personal use. Mainly used by sole traders.

Benefits:

• Flexibility in expenditure.

• Undiluted ownership.

• In case of the need for financial aid from financial institutions or investors, the use of personal savings will show commitment, giving the sole trader a positive perception.

• Easily accessible.

• Doesn’t have to be repaid.

• No interest.

Disadvantage:

• If personal funds aren’t large enough, the business will struggle to cover its REs, yet alone CE.

• Personal risk which may result in financial insecurity.

Define retained profits (ploughed-back profit). State benefits and disadvantages.

The profit that remains after a business has paid corporation tax. It is retained for reinvestment back into the business rather than contributing to dividends.

Benefits:

• Flexibility in expenditure

• Undiluted ownership

• A permanent source of finance

Disadvantage:

• For shareholders (the "cost of capital" of retained profits is the opportunity cost for shareholders of leaving profits in the business (i.e. the return they could have obtained elsewhere). causing internal conflict.

• Retained profit may be too low for capital expenditure

• Not often applicable to start-ups.

Define sale of assets. State benefits and disadvantages.

When (obsolete/redundant) assets are sold off to individuals/organisations by a business, to raise funds.

Benefits:

• Efficient way of raising money from excess capital (therefore improving the business’s balance sheet).

• Immediate cash inflow.

• Capital gains from the sale in the form of money.

Disadvantages:

• Time-consuming to find buyers

• Capital gain tax (CGT) may have to be paid if an asset sells for more than it was purchased for (known as capital gain).

• Opportunity cost if a business sells an income-generating asset.

• Risk of undervaluation.

• Could result in employee redundancy.

External finance

Money obtained from sources outside a business (from financial institutions).

State the ten external sources of finance

• Share capital

• Loan capital

• Overdrafts

• Trade credit

• Grants

• Subsidies

• Debt factoring

• Leasing

• Venture capital

• Business angels

Define share capital/equity capital. State benefits and disadvantages.

Money raised from the sale of shares of a limited company. Buyers of these shares are known as shareholders who are entitled to dividends when profits are made (typically from retained profits).

Benefits:

• Permanent source of finance which does not need to be repaid.

• no interest

Disadvantages:

• Dividends of share holders will need to be paid from profits.

• Diluted ownership

• Risk of potential hostile acquisition if the quantity of shares aren’t monitored. This is why authorised share quantity is more important than authorised share capital.

Define Loan capital (debt capital). State benefits and disadvantages.

Money sourced from financial institutions, with interest charged on the loan (principle plus interest) to be repaid/installed.

Benefits:

• Principle plus interest loan is installed/repaid over a predetermined period. So, not in a lump sum.

• Interest rates can be negotiated by large organisations.

• Undiluted Ownership

• Fixed interest rates are predictable.

Disadvantages:

• lack of flexibility in expenditure

• Loss of capital through collateral.

• Variable interest rates are unpredictable- risk of high debt repayment burden.

Define overdrafts . State benefits and disadvantages.

When a lending institution allows to withdraw more money than it currently has available in its account. This amount of money is agreed upon and so has a limit placed on it. Interest is charged only on the overdrawn money.

Benefits:

• Especially beneficial for short-term debts

• Flexible

• Banks can cover a business’s checks without them bouncing.

Disadvantage:

• Repayment of overdrafts are made on short notice.

• Higher interest rates because they are short-term.

Define Grants. State benefits and disadvantages.

Funds provided by granting organisations (eg. government) that do not need to be repaid.

Benefits:

• Doesn’t need repayment

• full ownership

Disadvantage:

• Grant makers are very selective

• reduced flexibility in expenditure

Define Trade credit. State benefits and disadvantages.

an agreement between businesses that allow buyer of goods and services to pay the seller at a later date. No immediate transaction at the time of trading.

Benefits:

• Delayed payments to suppliers is better for cash flow.

• Interest-free

Disadvantage:

• poor relationships between suppliers and debtors may develop if debts aren’t paid with due time.

• No discounts, compared to direct transactions.

Define subsidies. State benefits and disadvantages.

Financial assistance granted by governmental, non-governmental organisations (NGOs) or an individual to support social enterprises (businesses that in the public’s interest). Subsidies are usually given to businesses such as agricultural ones, to help these businesses survive in competitive environments, while still being able to sell their products at low market prices.

Benefits:

• subsidies help increase the demand for a businesses product as the business will be able to charge lower prices for their product, making them more attractive.

Disadvantages:

• They do not need to be repaid

• Governmental subsidies are distorted by political interreference.

Define debt factoring. State benefits and disadvantages.

A financial arrangement where the debt factor (a third party) is responsible for collecting debts owed to a business and giving the business a percentage of the debt money back.

Benefits:

• immediate source of money as the third party will pay (a percentage) of the money before the debtor has even paid.

• less responsibility

Disadvantage:

• the business will have a percentage of the money owned subtracted by the debt factor. So no full repayment. (this is why it is best for short-term cash inflow).

• Debt factors, if hostile, could ruin customer-seller relationships.

Define leasing. State benefits and disadvantages.

A source of finance that allows a firm to use an asset without having to purchase it.

Benefits:

• At the end of a finance-lease agreement, if the business chooses to purchase the asset, no high capital outlay is required because the business will just pay the residual value for the asset.

• In general, no high capital expenditure/outlay is required because of the lease installments (over a short-term period)

Disadvantages:

• In the long-term leasing is more expensive than purchasing the asset.

• leased assets cannot be used as collateral.

Define venture capital. State benefits and Disadvantages

The financial capital provided by investors/venture capitalists high-risk, high-potential start-up organisations.

Benefits:

• provide financial aid to businesses considered too high-risk by other financial institutions.

Disadvantage:

• The venture capitalists become shareholder, so diluted ownership.

• Time-consuming business plan is required to mitigate the risk of investment.

• Venture capitalists have high profit targets, which if not met, result in higher equity of shares of the investor.

Define business angels. State benefits/disadvantages.

Highly wealthy people who provide financial capital to small start-ups or entrepreneurs in return for ownership equity in a business.

Benefits:

• Favourable financial terms because they invest more in the person than the viability of the business.

• Mentorship

Disadvantages:

• Very diluted ownership

Short-term finance (+ examples)

the money needed to cover operational (day-to-day) costs/working capital. Therefore, needs to be covered immediately. (One year)

• Overdrafts

• Trade credit

• Debt factoring

Medium-term finance

For the purpose of buying shorter-term assets (in comparison to long-term). (1 to 5 years)

• Bank loans

• leasing

Long-term finance

For the purpose of purchasing long-term assets or growth/expansion.

• bank loans

• share capital

State the 6 factors influencing the choice of source of finance

• Purpose of funds

• Cost (opportunity cost)

• Amount required

• Flexibility

• Gearing

• Size and status of the organisation

• State of external environment

Gearing

The ration between loan capital and share capital. If a company has a high gearing this means that the company has a larger proportion of loan capital than share capital.