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