Loans and Sources of Finance - AQA Business A Level Notes

Loans: Making Financial Decisions

Learning Objectives

  • Understand internal and external sources of finance.
  • Sources of finance include:
    • Debt factoring
    • Overdrafts
    • Retained profits
    • Share capital
    • Loans
    • Venture capital
  • Advantages and disadvantages of different sources of finance for short- and long-term uses.

The Role of Finance

  • No business can survive without finance.
  • Finance is the provision of money when needed.
  • The 3 main uses of business finance are:
    • Initial Funds: to start a business.
    • Working Capital: money for day-to-day running.
    • Investment Capital: to help grow the business.

Finance and New Business

  • New businesses often have limited finance.
  • They need to plan and manage the use of limited funds carefully.
  • Managers need to assess the level of risk associated with any decision and compare this against the potential rewards.

Short Term Sources of Finance

  • Firms decide on the time period for needing finance.
  • Short-term sources cover cash shortages and bill payments.
  • Short-term finance is typically repaid within 1 year.
Examples of Short-Term Finance
  • Retained Profit
  • Bank Overdraft
  • Debt Factoring

Long-Term Sources of Finance

  • Long-term sources fund capital investment (e.g., machinery, vehicles, buildings).
  • The repayment period is longer (e.g., 3 years or more).
  • Monthly interest charges tend to be lower due to the cumulative effect of repayments over a longer time.
Examples of Long-Term Finance
  • Share Capital
  • Retained Profit
  • Bank Loans
  • Venture Capital

Internal and External Sources of Finance

  • Sources of finance can be internal and external.

Internal Sources of Finance

  • Internal finance is money generated from within the business.
  • Internal sources include:
    • Retained profit
    • Personal sources of finance
    • Sale of assets
    • Sale and leaseback
Retained Profit
  • Money kept back within the business instead of being paid out to the owners.
  • Benefits:
    • Cheap – no interest charges.
    • Provides funds for future growth.
    • Offers a buffer against liquidity problems.
    • No loss of ownership or control.
    • No security required.
  • Drawbacks:
    • Only available to established firms.
    • Opportunity cost – once spent, it is gone.
    • Shareholders may prefer dividends.
    • Inefficient use of resources – hoarding cash instead of reinvesting.
    • Misuse of funds.
Sale of Assets
  • Selling off assets no longer considered useful to improve cash flow.
  • Benefits:
    • Cheap – no interest charges.
    • Provides an immediate one-off boost to cash flow.
  • Drawbacks:
    • Only available to established firms.
    • A business might need these assets again in the future.
Sale and Leaseback
  • A financial transaction where a company sells an asset and then leases it back.
  • The company becomes the lessee (tenant) of the asset it previously owned.
  • The company receives a lump sum of cash, which can be used to finance immediate needs such as debt repayment, working capital requirements, or investment in other areas of the business.
  • Over the duration of the lease, the company may end up paying more in lease payments than it would have incurred in ownership costs, resulting in higher overall expenses in the long run.
  • Since the company no longer owns the asset, it may lose control over its use, subjecting it to the terms and conditions of the lease agreement.
  • The company incurs lease obligations, including rental payments and potentially other costs such as maintenance, insurance, and taxes, which can affect its cash flow and financial flexibility.
  • Selling the asset may result in the loss of potential future benefits from ownership, including any appreciation in the asset's value.
Personal Sources of Finance
  • Funds from an individual's own resources or networks instead of external institutions.
  • These sources can include personal savings, investments, sale of personal assets, inheritance, or loans from family and friends.

Debt Factoring

  • When a factoring company buys the right to collect money from the credit sales of a business.
  • Advantages:
    • Improved cash flow in the short term.
    • Lower administration costs.
    • Reduced risk of bad debts.
    • Increased efficiency.
  • Disadvantages:
    • Loss of revenue (5-10% of revenue).
    • High cost.
    • Customer relations problems.

External Sources of Finance

  • Generated from outside of the business.
  • Drawbacks are the business owners are likely to lose an element of control and influence and they will probably have to repay debts with interest.

Overdrafts

  • Allows you to spend more money than is in your account.
  • Banks offer overdrafts to established businesses up to an agreed limit.
  • It is a short term source of finance and provides a source of working capital.
  • Benefits:
    • Improves working capital.
    • Helps cover any cash flow deficits to allow a firm to keep trading.
    • Security is not usually required.
  • Drawbacks:
    • Interest charged is very high.
    • Banks can withdraw them with just 30 days notice.

Venture Capital

  • Venture capitalists are professional investors who identify SMEs that offer the potential for profit.
  • Benefits:
    • Large amount of capital invested.
    • Access to the skills, resources and experience of the venture capitalist – more rapid growth.
    • Suitable to those businesses which cannot get finance elsewhere due to the risk involved.
  • Drawbacks:
    • Loss of control
    • Venture capitalists will demand shares and a seat on the board.
    • They will be actively involved in the daily running of the firm.

Bank Loans

  • Banks look for security (collateral) against a loan to reduce their risk.
  • Property is often used as security.
  • Bank loans consist of the original loan + interest charges.
  • Loans can be short, medium, or long-term.
  • If repayments cannot be made, the security is used instead.
  • The interest and repayments are fixed, which will help in budgeting the expenses. However. They can be variable.
  • The interest rate is lower than the overdraft. However, there is a limit on the amount of loan.
  • Loans can be more expensive than share capital because in case of loan the business has to pay interest even if there is no profit made But in case of share capital ,dividends need not be paid specially to Ordinary share capital if there is a loss.

Commercial Mortgages

  • Loans specifically designed for purchasing commercial properties.
  • The property itself is used as security against the value of the loan.
  • The mortgage can be as high as 60-70% of the property's value.
  • Repayment values are often fixed, and the length of the mortgage usually lasts between 10-15 years.
  • The fixed element of the mortgage helps a business to plan and budget more effectively.

Share Capital

  • The issue of shares is a long-term source of finance.
  • Changing to a company means the owners give away some control but get a cash injection.
  • Share capital is permanent and does not have to be repaid.
  • New shares can be sold later to existing shareholders to raise more capital through a rights issue.
  • Shareholders expect a say in how the company is run and expect dividends. However, it need not be paid if there is a loss or if the business wants to keep it for future investments specially in case of ordinary share holders.
  • There is limited liability , which means the if there is a loss the share holders Will only lose the amount of money they have invested, this encourages the shareholders To invest more.
  • It is easier to get loan from the bank , as share capital ( large amount of capital) can be used as a collateral.
  • However , sometimes the objective of the business can be in conflict with the new share holders.

Crowdfunding

  • Used for high-risk ventures that traditional sources reject.
  • Attracts many small investors, typically via the internet.
  • The business will require lots of separate contributions.
  • This lowers the risk for the investors , but it does mean that there are lots of people with a say in how the business should operate.

Peer-to-Peer Lending

  • Another form of loan capital carried out online.
  • A website matches savers to businesses seeking loans.
  • The process is quick, but guarantees are required.
  • Peer-to-peer lending is an external source of finance.

Choosing a Source of Finance

  • Legal structure: Private/public limited companies sell shares; sole traders/partnerships use personal finance.
  • Use of finance: Fixed assets use long-term finance; working capital uses overdrafts or debt factoring.
  • Amount required: Larger sums need loans or share capital.
  • Firm's profit levels: Profitable firms use internal money; unprofitable firms need loans but may not get them.
  • Level of risk: Risky enterprises struggle to attract loans; venture capital may be an option.
  • Views of the owners: Owners may reject shares/venture capital to retain control.

Objective Test

  • Which source of finance is classified as external?
    • a) Share Capital
    • b) Sale of Assets
    • c) Retained Profit
    • d) Working Capital
  • Which source of finance is typically used to help alleviate short-term cash flow problems?
    • a) Overdraft
    • b) Long-term Loan
    • c) Commercial Mortgage
    • d) Share Capital

Essay Practice

  • Evaluate whether a loan is the best source of finance for the success of a business. (20 marks)