3.2 Sources of finance

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102 Terms

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Sources of finance

Where or how businesses obtain their funds

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Internal sources of finance

Money / funds generated from within the organization

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3 internal sources of finance

  1. Personal funds

  2. Retained profit

  3. Sale of assets

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Personal funds

Use of an entrepreneur's own savings

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Main source of finance for sole traders

Personal funds

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What are personal funds used for?

To finance business start-ups

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Pros of personal funds

0 cost of finance (no need to repay)

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Cons of personal funds

Amt available limited to size of savings owned by sole trader

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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.

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What is retained profit used for?

Capital expenditure

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What can some retained profit be kept in + why?

A contingency fund

  • In case of emergencies, crises, unforeseeable expenditure in future

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Pros of retained profit

Doesn’t incur interest charges

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Cons of retained profit

  1. Business makes a loss → SoF unavailable

  2. Shareholders paid high dividends → not much RP left over to be reinvested into the business

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Sale of assets

Selling existing items of value that the business owns, eg dormant + obsolete assets

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Examples of assets a business will sell

  1. Dormant (unused) assets

  2. Obsolete (outdated) assets

Eg obsolete machinery, old computer equipment that was recently replaced

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If a business has chosen to relocate, how could it raised finance (related to sale of assets)?

Sale of land + buildings

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In extreme cases, eg major liquidity threat to its survival, what can a business sell to raise external finance?

Sell subsidiaries

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Uses of sale of assets

  • Capital expenditure

  • Revenue expenditure (only in extreme cases when business is facing liquidity crises)

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Pros of sale of assets

No interest charges (0 costof finance)

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Cons of sale of assets

Undesirable assets (eg obsolete tech) / no demand for it → funds can’t be raised

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External sources of finance

Money / funds from outside of the organization=

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8 external sources of finance

  1. Share capital

  2. Loan capital

  3. Overdrafts

  4. Trade credit

  5. Crowdfunding

  6. Leasing

  7. Microfinance providers

  8. Business angels

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Share capital

Money raised from selling shares in a limited liability company

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For public limited companies what does share capital come from?

Inital public offering (IPO)

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Main souce of finance for limited liability companies?

Share capital

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Where is share capital recorded in?

Company’s balance sheet

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Pros of share capital

Can raise huge amts of finance (esp for PLC)

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Cons of share capital

  1. Time consuming + expensive (many legalities + administrative procedures) to prepare + launch

  2. Issue shares → ownership + control of company is diluted

  3. No guarantee investors will be interested in buying shares

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What can’t private limited companies do?

Private limited companies can’t sell their shares to the general public

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What can public limited companies do that private limited companies can’t?

Issue their shares on a stock exchange

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Main functions of a stock exchange (market)

  1. Enable companies to raise capital

  2. Provide a market for second-hand shares + government stocks

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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.

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Share issue

An existing publicly held company raises further finance by selling more of its shares on a stock exchange

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Poor performance of a company leads to →

Fall in company’s value → share price falls

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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

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Loan (debt) capital

Medium - long term sources of interest-bearing finance obtained from commercial lenders, eg banks

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Key features of loan capital regarding:

  1. Interest charges

  2. Time to pay back amt borrowed

  1. Interest charges = fixed / variable

  • Depend on agreement betw borrower + lender

  1. Amt borrowed paid back in instalments over predetermined period of time

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3 examples of loan capital

  1. Mortgages

  2. Business development loans

  3. Debentures

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Mortgages

Secured loans for the purchase of property (real estate), eg land or buildings

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In a mortgage, what happens if the borrower defaults on the loan (fails to repay)?

Lender can repossess (reclaim) the property

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Business development loans

Highly flexible loans catered to meet the specific needs of the borrower to develop aspects of their business

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What are business development loans used for?

Range of purposes

  1. Start / expand their business

  2. Purchase specialist equipment

  3. Improve organisations cash flow position

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Debentures

LT loans issued by a business

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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

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Debenture holders vs shareholders

Debenture holders don’t have ownership + voting rights

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Pros of debentures

Provide a LT SoF for businesses, w/o the business losing any control

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Cons of debentures

Issuing debentures increases a firm’s gearing ratio → more vulnerable to risks if interest rates increase

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Increased gearing ratio

Business has more borrowing as a % of its total capital employed

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Pros of loan capital

Repayment in installments → gives business time to earn revenue so they can repay the loan

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Cons of loan capital

  1. High IR = high cost of borrowing

  2. Collateral provided + business fails → lender takes possession of the asset

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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

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When are overdrafts commonly used by businesses?

When they have minor cash flow problems

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Pros of overdrafts

  1. Flexible finance for unexpected large cash outflows

  2. Cost effective compared to bank loans

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Cons of overdrafts

  1. Repayable on demand from lender

  2. High IR compared to other loan bearing SoF = high cost of borrowing

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Why are overdrafts more cost effective than bank loans?

  • Overdrafts = ST SoF

  • IR changed on daily basis only if business overdraws its accounts

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When are overdrafts suitable to use?

  1. When there is aneed for a large cash outflows

  2. For businesses that have sold products on trade credit + awaiting payment from customers

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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)

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Creditors vs debtors

  • Creditors: organisations that offer TC (customers pay them)

  • Debtors: customers who need to pay creditors back. Owe creditors

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When does a firm use TC + why?

To ease a firm’s cash flow problems → bc can postpone payments to suppliers

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Credit cards

  • Similar to TC

  • But creditor is a financial institution, not a supplier

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Important source of external finance for sole traders + partnerships

Credit cards

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Pros of TC

  1. Can ease a firm’s cash flow problems

  2. Allows time for businesses to process RM into g/s + earn revenue to pay suppliers

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Cons of TC

  1. Payments on invoices are late → business charged overdue payment penalties

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Crowdfunding

Raising finance for a business venture / project by getting small amounts of money from a large no. of people, usually thru online platforms.

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What does crowdfunding rely on to raise money?

  1. Online social media platforms

    • Charge for hosting these services

  2. Network of friends, family, work colleagues

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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

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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

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Why is crowdfunding not a typical source of finance in many countries?

Crowdfunding = heavily regulated

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Why is crowdfunding heavily regulated?

  • To protect donors

  • To prevent fraudulent business activities

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Pros of crowdfunding

  1. Potential high reward in generating funding w low risk

  2. Feedback from potential investors provides valuable market research

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Cons of crowdfunding

  1. Cost of finance- hosting fees must be paid to CF platform

  2. Low success rate in getting sufficient funding due to competition for funds

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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

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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.

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Lessee vs lessor

  • Lessee = customer

  • Lessor = leasing company

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Why are some assets leased instead of bought?

Cheaper to lease assets esp in short-med term

  • Eg machinery, equipment, computers, motor vehicles

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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

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Who is responsible for the maintenance + repairs of the asset?

Lessor (leasing company)

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Pros of leasing

  1. Cheaper than purchasing asset, in ST (useful for businesses who don’t have capital to purchase expensive assets)

  2. Maintenance + repair = responsibility of lessor

  3. Spending on leased assets = business expense → helps reduce tax bill of lessee

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Cons of leasing

  1. In LR, cost of leasing = more than purchasing asset outright

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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

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Hire purchase

  • Allows firm to pay creditor in instalments

  • Asset is legally property of creditor until all payments are made

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HP vs leasing

In HP, the buyer eventually owns the asset on payment of the last installment

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What is needed to secure a HP deal from lender?

Deposit (down payment)

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What happens if the buyer defaults on the agreement (falls behind on repayments)?

Lender can repossess the asset

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Since HP is a form of buying on credit, what does the lender charge interest on?

Amt borrowed

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Microfinance

A type of financial service aimed at entrepreneurs of small businesses, especially females + those on low incomes.

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What do microfinance providers help do?

Enable disadvantaged members of society gain access to essential financial services to help eradicate poverty

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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

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Pros of microfinance providers

  1. Accessibility

  2. Job creation

  3. Social wellbeing from increased access to healthcare

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Cons of microfinance providers

  1. Immorality- profit from poor

  2. Limited sums finance due to high risk of default

  3. Limited eligibility for borrowers (only those who can repay loans)

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Business angels

Extremely wealthy individuals who risk their own money by investing in small to medium sized businesses w high growth potential

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Who do business angels fund?

  1. Firms unable to secure sufficient finance from commercial banks

  2. Firms too small to attract the attention of shareholders / other investors

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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

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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

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Pros of BA

  1. BA = abundance of experience + financial backing → help new business survive + succeed

  2. Source of funding for firms unable to secure loans from banks / attract investors

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Cons of BA

  1. Some loss of control bc BA tend to take proactive role in the business

  2. Business may eventually need to buy out the stakes owned by the BA

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4 criteria BA consider before giving capital in an investment project

  1. Return on investment- need +ve RoI

  2. The business plan- high growth in future

  3. People

  4. Track record

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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

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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

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Factors to consider when deciding on sources of finance. SPACED

  1. Size + status of firm

  2. Purpose of finance

  3. Amount required

  4. Cost of finance

  5. External factors

  6. Duration