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Sources of finance
Where or how businesses obtain their funds
Internal sources of finance
Money / funds generated from within the organization
3 internal sources of finance
Personal funds
Retained profit
Sale of assets
Personal funds
Use of an entrepreneur's own savings
Main source of finance for sole traders
Personal funds
What are personal funds used for?
To finance business start-ups
Pros of personal funds
0 cost of finance (no need to repay)
Cons of personal funds
Amt available limited to size of savings owned by sole trader
Retained profits
The value of the surplus / profit that a business keeps to use within the business after paying:
Corporate taxes on its profits to the government
Dividend payments to its shareholders.
What is retained profit used for?
Capital expenditure
What can some retained profit be kept in + why?
A contingency fund
In case of emergencies, crises, unforeseeable expenditure in future
Pros of retained profit
Doesn’t incur interest charges
Cons of retained profit
Business makes a loss → SoF unavailable
Shareholders paid high dividends → not much RP left over to be reinvested into the business
Sale of assets
Selling existing items of value that the business owns, eg dormant + obsolete assets
Examples of assets a business will sell
Dormant (unused) assets
Obsolete (outdated) assets
Eg obsolete machinery, old computer equipment that was recently replaced
If a business has chosen to relocate, how could it raised finance (related to sale of assets)?
Sale of land + buildings
In extreme cases, eg major liquidity threat to its survival, what can a business sell to raise external finance?
Sell subsidiaries
Uses of sale of assets
Capital expenditure
Revenue expenditure (only in extreme cases when business is facing liquidity crises)
Pros of sale of assets
No interest charges (0 costof finance)
Cons of sale of assets
Undesirable assets (eg obsolete tech) / no demand for it → funds can’t be raised
External sources of finance
Money / funds from outside of the organization=
8 external sources of finance
Share capital
Loan capital
Overdrafts
Trade credit
Crowdfunding
Leasing
Microfinance providers
Business angels
Share capital
Money raised from selling shares in a limited liability company
For public limited companies what does share capital come from?
Inital public offering (IPO)
Main souce of finance for limited liability companies?
Share capital
Where is share capital recorded in?
Company’s balance sheet
Pros of share capital
Can raise huge amts of finance (esp for PLC)
Cons of share capital
Time consuming + expensive (many legalities + administrative procedures) to prepare + launch
Issue shares → ownership + control of company is diluted
No guarantee investors will be interested in buying shares
What can’t private limited companies do?
Private limited companies can’t sell their shares to the general public
What can public limited companies do that private limited companies can’t?
Issue their shares on a stock exchange
Main functions of a stock exchange (market)
Enable companies to raise capital
Provide a market for second-hand shares + government stocks
Initial public offering
A business converts its legal status to a publicly traded company by floating / selling its shares on a stock exchange for the first time.
Share issue
An existing publicly held company raises further finance by selling more of its shares on a stock exchange
Poor performance of a company leads to →
Fall in company’s value → share price falls
What happens when shareholders sell their shares?
These shares are traded on the secondary market of the stock exchange- no new shares issued by the company
COMPANY DOESN’T RECEIVE ANY MONEY
Loan (debt) capital
Medium - long term sources of interest-bearing finance obtained from commercial lenders, eg banks
Key features of loan capital regarding:
Interest charges
Time to pay back amt borrowed
Interest charges = fixed / variable
Depend on agreement betw borrower + lender
Amt borrowed paid back in instalments over predetermined period of time
3 examples of loan capital
Mortgages
Business development loans
Debentures
Mortgages
Secured loans for the purchase of property (real estate), eg land or buildings
In a mortgage, what happens if the borrower defaults on the loan (fails to repay)?
Lender can repossess (reclaim) the property
Business development loans
Highly flexible loans catered to meet the specific needs of the borrower to develop aspects of their business
What are business development loans used for?
Range of purposes
Start / expand their business
Purchase specialist equipment
Improve organisations cash flow position
Debentures
LT loans issued by a business
What do debenture holders (individuals, governments, other businesses) receive?
Fixed / variable interest payments even if the business makes a loss + b4 share holders are paid any dividends
Debenture holders vs shareholders
Debenture holders don’t have ownership + voting rights
Pros of debentures
Provide a LT SoF for businesses, w/o the business losing any control
Cons of debentures
Issuing debentures increases a firm’s gearing ratio → more vulnerable to risks if interest rates increase
Increased gearing ratio
Business has more borrowing as a % of its total capital employed
Pros of loan capital
Repayment in installments → gives business time to earn revenue so they can repay the loan
Cons of loan capital
High IR = high cost of borrowing
Collateral provided + business fails → lender takes possession of the asset
Overdrafts
Allow a business to spend in excess of the amount in its bank account, up to a pre-determined limit
Most flexible form of borrowing for most businesses in the ST
When are overdrafts commonly used by businesses?
When they have minor cash flow problems
Pros of overdrafts
Flexible finance for unexpected large cash outflows
Cost effective compared to bank loans
Cons of overdrafts
Repayable on demand from lender
High IR compared to other loan bearing SoF = high cost of borrowing
Why are overdrafts more cost effective than bank loans?
Overdrafts = ST SoF
IR changed on daily basis only if business overdraws its accounts
When are overdrafts suitable to use?
When there is aneed for a large cash outflows
For businesses that have sold products on trade credit + awaiting payment from customers
Trade credit
Allows a business to postpone payments / to 'buy now + pay later'
The credit provider doesn’t receive any cash from the buyer (even though a sale is made) until a later date (usually betw 30-60 days)
Creditors vs debtors
Creditors: organisations that offer TC (customers pay them)
Debtors: customers who need to pay creditors back. Owe creditors
When does a firm use TC + why?
To ease a firm’s cash flow problems → bc can postpone payments to suppliers
Credit cards
Similar to TC
But creditor is a financial institution, not a supplier
Important source of external finance for sole traders + partnerships
Credit cards
Pros of TC
Can ease a firm’s cash flow problems
Allows time for businesses to process RM into g/s + earn revenue to pay suppliers
Cons of TC
Payments on invoices are late → business charged overdue payment penalties
Crowdfunding
Raising finance for a business venture / project by getting small amounts of money from a large no. of people, usually thru online platforms.
What does crowdfunding rely on to raise money?
Online social media platforms
Charge for hosting these services
Network of friends, family, work colleagues
Is it possible to raise money thru donation crowdfunding?
Yes (depending on the cause)
Contributions for which the business doesn’t have to pay back
The more creative / innovative the person is…
The more likely they are able to use crowdfunding to source funds for new business ventures / projects / ideas
Why is crowdfunding not a typical source of finance in many countries?
Crowdfunding = heavily regulated
Why is crowdfunding heavily regulated?
To protect donors
To prevent fraudulent business activities
Pros of crowdfunding
Potential high reward in generating funding w low risk
Feedback from potential investors provides valuable market research
Cons of crowdfunding
Cost of finance- hosting fees must be paid to CF platform
Low success rate in getting sufficient funding due to competition for funds
Business start ups can use CF as a platform to pitch their idea + raise finance, but what can this result in?
Loss of ownership + control bc investors can demand the right to shares in the new company
Leasing
Form of hiring whereby a lessee (customer) pays rental income to hire assets from the lessor (leasing company) , the legal owner of the assets.
Lessee vs lessor
Lessee = customer
Lessor = leasing company
Why are some assets leased instead of bought?
Cheaper to lease assets esp in short-med term
Eg machinery, equipment, computers, motor vehicles
When is leasing suitable?
When business customers don’t have the initial capital to buy such assets
This releases cash for other purposes within the business
Who is responsible for the maintenance + repairs of the asset?
Lessor (leasing company)
Pros of leasing
Cheaper than purchasing asset, in ST (useful for businesses who don’t have capital to purchase expensive assets)
Maintenance + repair = responsibility of lessor
Spending on leased assets = business expense → helps reduce tax bill of lessee
Cons of leasing
In LR, cost of leasing = more than purchasing asset outright
Sale and leaseback
Business sells a particular fixed asset to raise finance + immediately leases the property back
Business transfers ownership of asset, but asset doesn’t physically leave the business
Hire purchase
Allows firm to pay creditor in instalments
Asset is legally property of creditor until all payments are made
HP vs leasing
In HP, the buyer eventually owns the asset on payment of the last installment
What is needed to secure a HP deal from lender?
Deposit (down payment)
What happens if the buyer defaults on the agreement (falls behind on repayments)?
Lender can repossess the asset
Since HP is a form of buying on credit, what does the lender charge interest on?
Amt borrowed
Microfinance
A type of financial service aimed at entrepreneurs of small businesses, especially females + those on low incomes.
What do microfinance providers help do?
Enable disadvantaged members of society gain access to essential financial services to help eradicate poverty
Why are microfinance provider businesses important?
W/o them, finance is only available to the low income entrepreneurs from unofficial money lenders at v high costs to the borrower
W/o them access to banking + insurance services = v limited for small businesses
Pros of microfinance providers
Accessibility
Job creation
Social wellbeing from increased access to healthcare
Cons of microfinance providers
Immorality- profit from poor
Limited sums finance due to high risk of default
Limited eligibility for borrowers (only those who can repay loans)
Business angels
Extremely wealthy individuals who risk their own money by investing in small to medium sized businesses w high growth potential
Who do business angels fund?
Firms unable to secure sufficient finance from commercial banks
Firms too small to attract the attention of shareholders / other investors
When using business angels, what happens to the owners control of the business + why?
Owner loses some control to BA
BA take proactive role in setting up / running business venture
If the owner wants to regain control + ownership from BA, what do they need to do?
Owner needs to eventually buy out the stake owned by the BA
Pros of BA
BA = abundance of experience + financial backing → help new business survive + succeed
Source of funding for firms unable to secure loans from banks / attract investors
Cons of BA
Some loss of control bc BA tend to take proactive role in the business
Business may eventually need to buy out the stakes owned by the BA
4 criteria BA consider before giving capital in an investment project
Return on investment- need +ve RoI
The business plan- high growth in future
People
Track record
Short term sources of finance
Available for a period of less than 1 year
Used to pay for daily operations of a business
Overdrafts, trade credit
Long term sources of finance
Those available for any period longer than 12 months from the accounting period
Used for the purchase of fixed assets / to finance the expansion of a business
Factors to consider when deciding on sources of finance. SPACED
Size + status of firm
Purpose of finance
Amount required
Cost of finance
External factors
Duration