D1 - Sources of finance

What are sources of finance? 

• Sources of finance are the options available to a business when seeking to raise funds to support future business actions

• For a start up business this might be raising sufficient capital to establish the business

• For an established business this might be to fund growth or implement a new strategy e.g. relocation

What are the 2 types of sources of finance?

• Internal - the funds used from within the business e.g. retained profit

• External - funds raised from outside of the business. This involves taking on debt, issuing equity, or applying for financial support.

How many internal and external sources of finance are there? 

Internal - 3 

External - 13

What are the 3 internal sources of finance?

• Retained profit

• Net current assets

• Sale of assets

What are the 13 external sources of finance? 

• Owners capital

• Loans

• Crowdfunding

• Mortgage

• Venture capital

• Debt factoring

• Hire purchase

• Leasing

• Trade credit

• Grants

• Donations

• Peer to peer lending

• Invoice discounting

What is Retained profit + advantages and disadvantages? (Internal)

• Profit kept within the business from profit for the year to help finance future activities.

• Profit will either be retained, in which case it becomes part of total equity, or distributed as dividends

• Retained profit can be used as a short term source e.g. to fund day to day activities or accumulated over time and used as a long term source.

• A company with a corporate objective of growth is likely to want to maximise profit without alienating shareholders.

• A sole trader or partnership may be willing to sacrifice short-term gains to fund long-term growth and may therefore wan to maximise retained profit.

Advantages

• Do not have to repay which will help cash flow

• No interest charges which helps to reduce costs

• Does not dilute the business ownership

Disadvantages

• Only an option if sufficient retained profit exists within the business

• May cause shareholder dissatisfaction if this is at the expense of dividends

• Reduces the security blanket of keeping retained profits for unforeseen situations or to take advantage of new opportunities

What is Net current assets + advantages and disadvantages? (internal)

• Net current assets - The difference between current assets and current liabilities that can be used to fund day to day activities e.g. replenish inventory

Calculated as:

• Current assets - current liabilities

• Current assets are items of value owned by a business that will be used and change in value within a year:

• i.e. inventory, trade receivables, and cash and cash equivalents

• Current liabilities are items owned by a business that are to be repaid within a year

• i.e. trade payables and overdrafts

Advantages

• No interest repayments

• No loss of ownership 

Disadvantages

• May lower profitability if customers are lost due to short credit terms

• May lower profitability as may lose discounts from suppliers if long credit terms are required/if you pay early. 

What is sale of assets + advantages and disadvantages? (Internal)

• A method of raising short-term finance by disposing of a business asset in return for cash.

• This will help to improve short-term cash flow problems but may impact on long term profitability

• Assets are items of value owned by a business.

• Sale of assets refers to the sale of long term, fixed assets, non-current assets

• Fixed assets/non-current assets will stay in the business for more than a year e.g. machinery and vehicles

• These assets can be sold in order to get an immediate injection of cash into a business and thereby provide finance

Advantages

• No interest charges or repayments

• May be turning an obsolete asset into finance

• Immediate lump sum cash injection

Disadvantages

• May be expensive in the long-run if need to lease the asset back

• Loss of use of the asset and future value

• Is only a one off option i.e. once sold cannot be resold

• Potential loss of business value - selling key assets may diminish the overall value of the business

What is Owners capital + advantages and disadvantages? (external)

• When an entrepreneur invests their own money into a business e.g. from personal savings

• This shows a degree of confidence as the entrepreneur is willing to risk their own savings and will therefore be motivated to ensure the venture is a success

• Owner’s capital shows the proportion of the businesses’ assets that are owned by the business owner rather than creditors.

Owners capital can be from:

• Personals savings e.g. an entrepreneur setting up as a sole trader or partnership

• Share capital when a business sells their shares in return for part ownership in the business

Advantages

• Do not have to repay which will help cash flow

• No interest charges which helps to reduce costs

• Owners maintain control giving them greater autonomy in decision making

• Risking own savings can be motivational

• Do not have to go through any lengthy application procedures

Disadvantages

• May only be limited amounts available

• Threat to personal finances and family which could result in stress

• Opportunity cost of the investment

What are loans + advantages and disadvantages? (external) 

• A set amount of money provided for a specific purpose, to be repaid with interest over a set period of time

• May be secured against an asset and if there is a default on repayments the asset can be taken.

• Financial institutions can vary interest rates depending upon the amount of risk placed on the loan.

• Generally considered to be more suitable for longer-term products

Advantages

• Quick and easy to secure

• Fixed interest rates allows businesses to budget

• Improved cash flow as the cost is spread out over a longer period of time

• No loss of ownership as this is a form of debt finance and not equity finance

Disadvantages 

• Interest must be paid regardless of financial performance. 

• A business that is highly geared i.e. has high proportion of capital raised through debt, may be seen as high risk. 

• Often more expensive than other forms of finance. 

• Can be charged a penalty for early payment - as they may miss out on interest if you did the whole time. 

What is crowdfunding + advantages and disadvantages?

• Raising finance from a large number of people each investing different, often small, amounts of money.

• The business uses the internet to explain how much money is required, how it will be used and the exit strategy stating predicted return on the investment.

• The investor is only tied to their promised contribution if the total amount is raised.

Advantages

• Saves time and money instead of having to apply to banks for loans or arrange meetings with potential investors.

• Can help establish a customer base.

• Gives you control over how to reward your investors. 

Disadvantages 

• The investor is only tied into their promised contribution if the total amount is raised.

• Some crowdfunding websites will only release the funds if you reach 100% of your target.

• If you require a larger sum e.g. £100,000+ then you may need to go down more traditional routes such as a bank loan 

What is a mortgage + advantages and disadvantages?

• Borrowing a large amount of money to purchase an asset which is to be repaid with interest over a set period of time, often 25 years.

• Interest can be fixed or variable

• Legally the asset e.g. a building belongs to the lender until the debt has been repaid 

Advantages

• Makes it possible to buy an expensive asset, such as a factory, which would not be feasible otherwise.

• Spreads the cost of an asset over a long period of time 

Disadvantages 

• Payments can be subject to change e.g. if interest rates change making it difficult to budget.

• Risk of repossession if default on payments

• Total interest repayments over the length of the mortgage can be substantial 

What is Venture capital + advantages and disadvantages?

• Investment from an established business person or business into another business in return for a percentage equity in the new business.

• Venture capitalists will normally look for high rate of return in a specific time period.

• The business or entrepreneur may also benefit from expertise and mentoring from the venture capitalist.

• Often considered as a high risk investment but potentially rewarding investment

• Also known as private equity finance

• Often associated with high risk start-ups

Advantages

• Potential for large sums of money from investment.

• Expertise to help the business.

• Makes it easier to attract other sources of finance.

• Provides the required capital for expansion

Disadvantages

• A long and complex process based on due diligence.

• Expert financial projections are likely to be required.

• Initially expensive for the business e.g. legal and accounting fees.

• Partial loss of ownership.

• Risk of conflict or perceived interference

What is Debt factoring + advantages and disadvantages?

• The process of selling the debts owed to a business to a financial institution.

• The business will receive funds immediately but at a reduced rate e.g. may only receive 80% of the total value of the debt.

• After the debt has been paid the business will receive further payment but the financial institution will keep a percentage of the repayment as a fee. 

Advantages

• Receives a large amount of the debt immediately.

• Good source of short-term finance to address cash flow problems.

• Debts are chased by experts saving managers time

• Reduces the risk of bad debts

Disadvantages 

• Reduces the profitability of the business as a result of the fee paid to the financial institution.

• May damage the reputation of the business as they are seen to be in need of short-term finance. 

What is Hire purchase + advantages and disadvantages?

• A financial agreement that allows a business to enjoy the use of an asset whilst paying for it in regular instalments.

• The asset remains the property of the seller up until the point where all instalments have been made at which point it becomes the property of the buyer.

Advantages

• Avoids one off lump sum payments.

• Regular instalments make budgeting easy.

• Helps with managing cash flow.

• You can start using the asset immediately even though you haven’t fully paid for it.

• Ownership transfers to you.

• Spreads cost of expensive items over a longer period of time, more manageable for business to afford high value assets.

Disadvantages

• Interest will normally be charged on top of the cost of the asset, reducing profitability.

• The business does not own the asset until all instalments have been made and therefore cannot make alteration or changes to it.

• If you default on repayments, the asset can be repossessed - can negatively impact credit scores.

• Hire purchase agreements can last several years (typically 3 to 5) which may not be ideal for all purchases.

What is Leasing + advantages and disadvantages?

• A contract that allows the renting of assets from another party

• The business pays a set amount in instalments to lease the asset for a pre-determined period of time.

• The asset remains the property of the leasing company and at the end of the time period the asset is returned to the lease company and the business stops making the payments.

Advantages

• Allows a business to benefit from the use of an asset without owning it or buying it outright.

• Regular instalments make budgeting easy.

• Avoids the need to finance the outright purchase of the asset.

• The lease company is responsible for any repairs and maintenance.

• At the end of the lease the business may start a new lease agreement for the latest model, therefore keeping equipment up to date.

Disadvantages

• Costly in the long run, adversely affecting profitability.

• The business never actually owns the asset.

What is trade credit + advantages and disadvantages?

• Trade credit is an arrangement by a supplier to provide goods and services on account.

• The supplier is paid at a pre-agreed time after the goods or services have been received.

• In effect the supplier is providing the business with finance for the period of the trade credit e.g. 30 days.

Advantages

• The buyer does not have to make immediate cash payment.

• The supplier is providing the business with finance for the credit period e.g. 30 days.

• Most trade credit arrangements don’t involve interest charges - cost effective for short-term financing.

Disadvantages

• Trade credit will impact on cash flow for both the buyer and seller.

• The business may lose out on discounts offered for immediate or quick payments, increasing costs.

What are Grants + advantages and disadvantages?

• Grants are fixed amounts of capital provided to businesses by the government or other organisations to fund specific projects.

• These do not have to be repaid assuming the terms of the grant are met.

Often conditions are attached to the grants for example:

• Locate in an area of high deprivation

• Provide employment

• Reduce negative environmental impacts

• Support a good cause

Advantages

• Grants do not require repayment - attractive option for businesses seeking financial support without the burden of debt.

• Grants often provide larger amounts of funding compared to individual donations - allowing businesses to undertake significant projects or initiatives.

Disadvantages

• Grants may be difficult to obtain and linked to a lengthy application process.

• The number of grants available is often limited.

What are Donations + advantages and disadvantages? 

• Finance freely provided by an individual or organisation to support the activities of another organisation. 

• Normally only available to non-profit organisations such as charities and social enterprises.

Advantages

• No interest charges. 

• No need to repay or reward the individual or organisation. 

• Tax deductions - donations can provide immediate deductions which can be a significant benefit for donors.

Disadvantages 

• Relies on the generosity of others as there is no need to repay or reward the individual or organisation.

• sums available may be limited and are not guaranteed.

• May be severely cut at times of economic difficulties.

• Have to ensure the cost of receiving the donations does not outweigh the amount received in donations. 

What is Peer to peer lending (P2P) + advantages and disadvantages?

• The practice of an individual lending to other individuals (peers) with whom there is no relationship or contact.

• Borrowers are given a credit rating.

• Normally an unsecured personal loan although on some occasions collateral may be offered.

• Cuts out the use of traditional intermediaries’ e.g. banks.

• Lending is done online.

• Lenders decide who they want to lend to, then compete to win the lending opportunity in a reverse auction i.e. the lender willing to offer the lowest interest rate wins.

• The lenders motive is profit.

Advantages

• P2P lending often provides lower interest rates compared to traditional banks.

• Faster approval and funding - application process for P2P loans is typically streamlined, allowing for quicker decisions and funding. Can often receive funds within days - beneficial for urgent financial needs.

Disadvantages

• P2P lending platforms often have limits on the amount of money that can be borrowed - may not meet the needs of all borrowers, restricting access to larger loans that some businesses may require.

• P2P loans may come with shorter repayment terms compared to traditional loans - can put additional financial pressure on borrowers, can lead to higher monthly payments and increased risk of default.

• Possibility of borrowers defaulting on their loans - can lead to financial losses for lenders especially if they invest in high risk borrowers.

• Unlike traditional bank deposits, P2P investments are not insured meaning investors may not have the same level of protection in case the borrower defaults.

What is Invoice discounting + advantages and disadvantages?

• The act of negotiating a discount i.e. a reduction in prices on invoices from suppliers.

• This in effect, reduces costs, hence freeing up finance for other purposes.

• This may be achieved as a result of early payment or bulk buying.

• Although finance is received, helping cash flow in the short term, this may have a negative effect on profitability in the longer term.

Advantages

• Reduces costs, hence freeing up finance for other purposes.

• Finance is received, helping cash flow in the short term

Disadvantages

• Although finance is received, helping cash flow in the short term, this may have a negative effect on profitability in the longer term.

What may sources of finance be and why?

• Sources of finance may be short term or long term.

• This will depend on the reason for needing finance e.g. to solve a short term cash flow problem or fund the purchase of non-current assets.