3.1: Sources of finance

the need for funds

the need for funds

• short-term needs

• long-term needs

• start-up capital

• expansion

short-term needs

• finance needed to fund day-to-day expenditure that includes the running costs of a business

• usually repaid within a year

long-term needs

• when the business takes more than a year to repay what is owed

• comes from the owner or is borrowed from financial institutions

• often used to buy resources that will be used repeatedly by the business for long periods of time

start-up capital

• needed when first setting up a business

• ‘one-off’ items and other start up costs

expansion

need to raise finance to help fund business expansion

examples of business expansion

• expand capacity to meet growing orders

• develop new products

• branch into overseas markets

• diversify

internal finance

comes from inside the business

why might businesses prefer using internal sources of finance

cheap and more readily available

internal sources of finance

• personal savings

• retained profit

• selling assets

personal savings

finance contribution from owners when setting up a business from personal savings

retained profit

profit retained by the business and not returned to the owners

benefits of retained profit

• cheap with no charges involved

• flexible source of finance as it can be built up and kept in a bank to earn interest

downside of retained profit

cannot be returned to owners

selling assets

established businesses can sell some unwanted assets to raise finance

external finance

finance obtained from outside the business

why a business may need short-term sources of external finance

• seasonal trade

• pay for raw materials and wages to meet a large order

• short of money waiting for a customer to pay

• emergency expenditure

short-term sources of external finance

• bank overdraft

• trade payables

• credit cards

bank overdraft

• the business can spend more money than it has in its account

• the bank sets an overdraft limit and interest is charged when the account is overdrawn

• the bank has the right to call in the money owed at any time

trade payables

• a cheap way of raising finance as businesses often buy resources and pay for them at a later dae

downsides of trade payables

• many suppliers encourage early payment by offering discounts

• cost of goods is often higher if firms buy on credit

• delaying payment may upset suppliers

credit cards

• convenient, flexible and avoid interest charges if accounts are settled within the credit period

• used to meet expenses when travelling and small businesses can use them to buy materials

downsides of credit cards

• interest rates are high if accounts are not settled within the credit period

long-term sources of external finance

• loan capital

• share capital

• venture capital

• crowdfunding

loan capital

• fixed agreement between a business and the bank

• amount borrowed and interest must be repaid in regular installments over a fixed period

sources of loan capital

• unsecured bank loans

• mortgages

• debenture

• hire purchase

unsecured bank loans

• banks lend money without the security of having a claim on your assets if you don't pay it back

• if a business collapses the bank might not get its money back

downsides of unsecured bank loans

• higher interest rates

• hard to get as it is risky for banks

mortgages

• long-term loan

• borrower must use land or property as security

• if the borrower fails to make the repayments the lender can repossess the property

• lower interest rates than unsecured loans

• may be taken out for up to 25 years

debenture

long-term security yielding a fixed rate of interest issued by a company and secured against assets

hire purchase

buying specific goods with a loan, often provided by a finance house

features of a hire purchase

• business makes a down payment

• remaining fee is paid in monthly installments

• goods bought do not legally belong to the buyer until all installments are paid

• if the buyer falls behind with the repayment the goods can be repossessed

• agreements can be short term or long term

downsides of a hire purchase

• more expensive than a bank loan

• lenders aren't strict when checking the risk posed by borrowers

share capital

• important source of external finance for limited companies

• raise money by selling more shares to raise capital avoids paying interest

• shareholders will expect to be paid dividends

advantage of share capital

interest payments are avoided

disadvantage of share capital

• cost of administration

• flotation process

venture capital

• venture capitalists are specialists in the provision of funds for small and medium-sized businesses

• may invest in businesses after the initial start-up

• prefer to take a stake in the company meaning they have some control and entitled to a share in the profit

• raise their funds from institutional investors

crowd funding

• where a large number of individuals invest in a business venture using an online platform and avoiding using a bank

• transactions are conducted online

• specialist websites allow those seeking finance to publish details of their business idea and how investors will profit from it