3.1 Sources of finance

Introduction

Start-up capital: capital needed by an entrepreneur to set a up a business.

Working capital: capital needed to pay for raw materials, day-to-day running costs and credit offered to customers. * In accounting terms: * $Working capital$ = Current assets - Current liabilities

Sources of finance

Internal finance: raised from the business’s own assets or from profits left in the business (ploughed-back or retained profits).

External finance: raised from sources outside the business.

$Internal sources of finance$ * Personal finds (for sole traders) * Profits retained in the business * Retained profit: profit left after all deductions, including dividends, have been made; this is “ploughed back” into the company as a source of finance. * Sale of assets

$External sources of finance$ * Short-term finance * Bank overdrafts (= bank agrees to a business borrowing up to an agreed limit as and when required). * Trade credit * Debt factoring: selling of claims over debtors to a debt factor in exchange for immediate liquidity; only a proportion of the value of the debts will be received as cash. * Medium-term finance * Hire purchase: asset is sold to a company which agrees to make fixed repayments over an agreed time period; the asset belongs to the company. * Leasing: obtaining the use of equipment or vehicles and paying a rental or leasing charge over a fixed period. This avoids the need for the business to raise long-term capital to buy the asset; ownership remains with the leasing company. * Long-term finance * Long-term loans from banks: loans that do not have to be repaid for at least one year. * Debentures (also known as loan stock or corporate bonds): bonds issued by companies to raise debt finance, often with a fixed rate of interest. * Other sources of long-term finance * Grants * Venture capital: risk capital invested in business start ups or expanding small businesses, which have good profit potential, but do not find it easy to gain finance from other sources. * Business angels: individual investors who put in their own money in a variety of businesses and are seeking a better return than they would obtain from conventional investments. * Subsidies: financial benefits given by the government to a business to reduce costs and encourage increased production.

Choosing appropriate sources of external finance

Sale of shares (long-term) * Advantages: * Permanent capital * No interest charges * Disadvantages: * Some loss of control by original owners * Dividends will be expected by shareholders * Most appropriate for long-term expansion of the business and for taking over another business * Last appropriate for buying inventories (stocks) and for temporary increase in working capital needs

Sale of debentures (long-term) * Advantage: * Fixed interest paid * Disadvantages: * Must be repaid at end of term * Interest payable has to be competitive * Most appropriate for long-term uses such as expansion or purchase of equipment expected to last several years * Last appropriate for short-term financing needs, e.g. paying for unforeseen maintenance

Leasing (medium-term) * Advantage: * Gives business full use of an asset without need to finance purchase * Disadvantages: * Asset is never owned/purchased * Expensive * Most appropriate for vehicles, equipment and computers * Last appropriate for major expansion or takeover project

Debt factoring (short-term) * Advantage: * Releases liquidity from accounts receivable (debtors) * Disadvantage: * The full value of accounts receivable will not be recouped by the business * Most appropriate for short-term liquidity needs such as financing increase in sales on credit * Last appropriate for major expansion or takeover project and for purchase of equipment

Bank overdraft (short-term) * Advantage: * Flexible amount can vary with daily needs * Disadvantages: * High interest * Bank can call in overdraft if they are concerned about liquidity of the business * Most appropriate when the amount of finance needed varies on a regular basis, e.g. daily expenses might exceed daily cash revenue * Last appropriate for major expansion or takeover project and for purchase of equipment (too expensive)

Subsidies (time period fixed by government) * Advantages: * No interest * No repayment * Disadvantage: * Can be withdrawn at short notice, e.g. change of government * Most appropriate to make production of a product viable that would otherwise be unprofitable * Last appropriate for financing long-term commitment of the business - because the subsidy could be withdrawn

Venture capital (long-term) * Advantage: * Provides finance when other sources might not be available due to risk * Disadvantages: * Some loss of ownership * Share of profits payable to venture capitalists * Most appropriate to finance a relatively risky business start-up or expansion of a recently formed business * Last appropriate for a profitable family business in which the family owners want to retain full control

Ten-year bank loan (long-term) * Advantage: * Fixed interest (usually) * Disadvantage: * Interest payments must be made on time or “security assets” might be sold * Most appropriate for finance expansion that is expected to lead to higher revenue to allow for the loan to be repaid n the time limit agreed with the bank, e.g. new factory * Last appropriate for purchasing an increase in inventories to meet expected demand over a festival period

Trade credit (short-term) * Advantage: * Finances purchase of inventories with no interest costs * Disadvantage: * May be loss of discounts for rapid payment of invoices * Most appropriate to finance an increase in inventory held or sales especially when the sales are on credit and cash will not be received quickly * Last appropriate for purchasing land on which to build an extension to the factory or offices of the business

Making the financing decision - factors to consider

Use and time period for which finance is required
Cost
Amount required
Legal structure and desire to retain control
Size of existing borrowing
Flexibility