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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