Comprehensive Guide to Business Sources of Finance and Evaluative Techniques

Core Definitions for Financial Understanding

In the context of the business environment, several key financial terms serve as the foundation for understanding how organizations manage their capital and debt. Interest is defined as the additional charge for borrowing money, which is usually expressed as a percentage of the sum borrowed. An overdraft limit refers specifically to the largest size of negative balance allowed on a bank account by a financial institution. Security involves something that the business owns, such as buildings, motor vehicles, or investments, that will be taken by the bank if the business fails to keep up its loan repayments. Finally, dividends are the payments made to shareholders as a reward for investing in the company.

Classifying Internal Sources of Finance

Internal sources of finance are generated from within the business itself and generally do not involve external lenders or investors. Every source of finance has its own distinct advantages and disadvantages as detailed in Table $1.12$. The first internal source is Owners' savings. This can be used for either short-term or long-term timeframes and is available to legal forms of business ownership such as sole traders and partnerships. The primary advantages of using owners' savings include the fact that there is no need to repay the money and there is a low cost associated with it since no interest needs to be paid. However, the disadvantages are significant: owners may not have enough savings to meet the business's needs, and utilizing these funds may leave the owners with insufficient savings for their personal use.

Reserves, also known as retained profits, represent the second internal source. This is a long-term timeframe source of finance available to all businesses. Much like owners' savings, the advantages are that there is no need to repay the money and the cost is low because no interest is required. The drawbacks regarding reserves are that they are not available to new businesses in their first year of trading, as there has been no time to accumulate profit. Additionally, this source is not available to businesses that have made losses rather than profits.

External Short-Term Sources of Finance

External sources of finance involve obtaining funds from outside the organization. Short-term external finance options are often used to manage immediate cash flow needs. Trade credit is a short-term source available to all businesses. Its advantages include improving cash flow by allowing the business to buy now and pay later, and no interest is charged if the balance is paid within the agreed timescale. The disadvantages include the loss of any discounts available for cash or early payment, and interest will be charged if the payment is not made within the agreed timeframe.

Hire purchase is another short-term option for all businesses where payments are spread over a period of time. This allows a business to obtain equipment that could not be afforded otherwise. The disadvantages are that interest and additional charges make it an expensive option, and it can only be used to obtain equipment and machinery. Credit cards provide another short-term route for all businesses. If repaid within the payment period, the borrowing is free. They also offer payment protection, meaning money can be claimed back if there is a problem with a purchase. However, interest is charged if not repaid within the interest-free period, and high interest rates can lead to spiralling debt. Finally, an overdraft is a short-term source for all businesses that helps with short-term cash flow problems. Interest is only charged on the daily amount overdrawn rather than the full overdraft limit. The disadvantages include usually high interest rates and the fact that prolonged use makes it very expensive.

External Long-Term Sources of Finance

Long-term external finance is typically used for major investments or long-term growth. A loan is a long-term source available to all businesses. Advantages include repayments being spread over a period of time and fixed instalments that help with cash flow management. Disadvantages involve the length of the loan and the interest rate, which can make it expensive, and the lender may require security on the loan. A mortgage is specialized for property and is available to all businesses. It allows a business to obtain premises that could not be afforded otherwise, with repayments spread over a long period of time (often many years). Disadvantages are that it can only be used to purchase a property, and if repayments are not kept up, the property will be repossessed.

Venture capitalists provide long-term finance to all businesses. The advantages include receiving finance coupled with advice and expertise, and gaining business connections that can help the business grow. The disadvantages are that it is equity-funded, meaning the venture capitalist becomes an owner, leading to reduced control over decision-making for current owners. Share issues are a long-term source available to companies only. The advantages are that there is no need to repay the money and no interest to be paid. Disadvantages include the fact that shareholders need to be paid dividends out of profit, and issuing more shares may dilute the control of existing shareholders. Lastly, crowdfunding is a long-term source for all businesses. It provides finance coupled with the promotion of the business and is available to businesses struggling to secure funding by conventional methods. The drawbacks include the cost of providing appropriate rewards to investors and the fact that business intentions are made public, meaning they may be copied if not fully protected.

Exam Strategy and Evaluative Writing Skills

Success in business exams requiring the discussion of finance sources depends on a structured approach. An essential exam tip is to be able to discuss both benefits and drawbacks. To plan an answer, one should jot down two benefits and two drawbacks for a specific source of finance. The answer should begin by describing one possible benefit and then analyzing the impact of this benefit on the business. This process should be repeated for the second benefit, and then similarly applied to two drawbacks, ensuring the impact of each drawback is fully analyzed. The response must conclude with a decision that answers the set question. It is vital to re-read the question before the conclusion to tailor the answer to the specific wording, usually justifying whether benefits outweigh drawbacks for that specific business context.

A typical mistake in these assessments is failing to make a decision when a question requires one. Any question beginning with the words 'evaluate' or 'discuss' requires a definitive decision. For instance, if asked to evaluate two sources of finance, the student must go further than just analyzing benefits and drawbacks; they must write a conclusion that clearly argues which source is superior and why. The final answer must take into consideration the reason for the finance and specific details about the business seeking it, making the decision plain to the examiner and using context to justify the argument.