3.1 & 3.2
Section 3.1:
Capital expenditure: money spent to acquire fixed assets in a business.
Fixed assets are items such as machinery, land, equipment, and vehicles.
Fixed assets are needed to generate income for the business over the long-run.
Due to their high initial costs, most fixed assets can be used as collateral (repayment for particular source of finance) for a business.
Hence, fixed assets are long-term investments intended for the business to succeed and grow.
Revenue expenditure: Money used in day to day running of the business.
Such payments and expenses include rent, wages, raw material, fuel, and insurance. Hence, funds for revenue expenditure need to be available immediately to keep the business operational and there provide instant benefits, unlike capital expenditure which has a long-term focus.
Businesses need to be cautious not to have constantly high revenue expenditure, as it makes it difficult for them to build sufficient capital required for long term investments. In addition, it makes it difficult for them to get out of a sudden crisis situation.
Section 3.2:
Internal sources of finance:
Personal funds: a source of finance for free traders that mostly comes from their personal savings (mostly for sole traders).
By investing personal savings, sole traders maximize their control over a business.
The sole trader shows a personal commitment towards the business by investing in this way. Which is also a good sign for financial institutions and investors should the sole trader approach them for additional finance.
Advantages:
The sole trader knows exactly how much money is available to run the business.
It provides the sole trader with a much higher degree of control over the finances than the other finance options, since they do not have to pay the funds back or rely on outside investors or lenders who could decide to withdraw their support at any moment.
Disadvantages:
It poses a larger risk on the sole trader, because they could be investing their life savings, hence putting a strain on their family or personal life.
If savings are not sufficient it may be difficult to start or maintain the business especially if personal funds are the only source of funding.
Retained profit: profit that remains after a business (a profit making entity) gives dividends to shareholders.
May be reinvested in the business for growth purposes.
Advantages:
It is cheap, since it does not incur interest charges (like banks do).
It is a permanent source of finance, as it does not have to be repaid.
It is flexible as it can be used in a way as the business deems it fit.
The owners have control over their retained profit, without the interference of financial institutions such as banks.
Disadvantages:
Start-up businesses will not have any retained profit as they are new ventures.
If retained profit is low, it may not be sufficient for the business to grow or expand.
A high retained profit may mean that the business did not pay any dividends to their shareholders, which may be less attractive to stock buyers than a profitable business which pays their shareholders dividends.
Sales of assets: when a business sells its unwanted or unused assets to raise funds.
Assets that are no longer required by the business include obsolete machinery or redundant buildings.
To raise cash the business may sell any excess land or equipment they may not be using.
Advantages:
No interest or borrowing costs incurred.
This is a good way for raising cash from capital that is tied up in the assets which are not being used.
Disadvantages:
This option is only available to established businesses, since new businesses may lack assets to sell.
It can be time consuming to find a buyer for the assets especially if the asset is obsolete machinery.
In some cases, a business can adopt a sale and leaseback approach, which involves selling an asset that the business still needs to use.
Internal sources of finance:
Advantages: control for the business, flexibility (they don’t have to pay it back), no interest.
Disadvantages: option is not always there (for new businesses specifically), risky
External sources of finance:
Share capital (equity capital): Money raised from the sales of shares of a limited company.
Buyers of the shares are known as shareholders and may be entitled to dividends when profits are made.
Authorized share capital is the maximum amount of shareholders of a company is intended to raise.
Advantages:
It is a permanent source of capital, since it will not need to be repaid by the business. If the shareholder wants their money back, then they have to find another buyer for their shares.
There are no interest payments, thus relieving the business from additional expenses.
Disadvantages:
The businesses are expected to pay the shareholders when they make a profit.
For public limited companies, the ownership of the company can be diluted or change hands from the original shareholders to new ones via stock exchange.
Loan capital (debt capital): money sourced by taking a loan from financial institutions such as banks with interest charged on the loan to be repaid.
Usually the loan is spread out evenly until the full loan amount (plus interest) is paid.
A fixed interest rate does not fluctuate and remains fixed for the entire term of the loan period.
A variable interest rate changes periodically based on the prevailing market conditions.
Advantages:
Loan capital is accessible and can be arranged quickly for a firm’s specific purpose.
Its repayment is spread out over a predetermined period of time, hence reducing the burden to the business having to pay a lump sum. (smoother for cashflow).
Large organizations can negotiate for lower interest rate charges depending on the amount they have to borrow.
The owners still have complete and full control of the business if no shares are issued to dilute their ownership.
Disadvantages:
The capital is redeemed even though the business is making a loss.
In some cases, collateral (security) wll be required before the funds are lent.
Failure to pay the loan may lead to seizure of the firm's assets.
If variable interest rates increase, a firm that has a variable loan may be faced with a high debt repayment burden.
Overdraft: when a lending institution lends a firm more money than it has in its current account.
In most cases the overdrawn amount is an agreed amount which has a limited place on it. Exceeding the limit set may attract additional costs.
Interest is charged only on the amount overdrawn.
Advantages:
It provides an opportunity for firms to spend more money than they have in their account (even in situations where there is no money in the account), which greatly helps in settling short-term debts such as paying supplies and paying wages for their staff.
Charging interest only on the overdrawn amount can be a cheaper option than loan capital.
It is a flexible form of finance, as its demand will depend on the needs of a business at a particular point in time.
Disadvantages:
Banks can ask for the overdraft to be paid back at a very short notice (which can be a burden for the business). (lack of control, flexibility).
Due to the variable nature of an overdraft, banks can charge high interest rates at times.
Trade credit: an agreement between businesses which allows the buyer of the good or service to pay the seller at a different date.
No immediate cash transaction occurs at the time of trading.
The credit period offered by most creditors or suppliers is between 30 to 90 days.
Advantages:
By delaying payments to suppliers, businesses are left in a better cash flow position than if they paid the cash immediately. (Cash inflows, less cash outflows).
It is an interest-free means of raising funds for the length of the credit period.
Disadvantages:
Debtors (trade credit receivers) miss out on the possibility of getting discounts had they purchase by paying in cash.
Delaying payment to creditors or suppliers after the agreed period may lead to poor relations between debtors and suppliers.
Crowdfunding: when a business venture or project is funded by a large amount of people each contributing a small amount of money.
Crowdfunding makes use of a vast network of people who can be accessed primarily through crowdfunding websites or social media.
Its success relies upon the ability to appeal to a sufficiently large group of potential contributors in order to reach the financial target.
Advantages:
Provides access to thousands of investors who can see, share and interact with fundraisers.
Valuable form of marketing through online platform, media attention.
Good alternative option for businesses that struggled to get bank loans/ traditional funding.
Disadvantages:
Strong competition.
Fees need to be paid.
Potential risk of failure.
Leasing: A source of finance that allows a firm to use an asset without having to purchase it with cash. (discuss long-run, short run depending on context).
Advantages:
Does not need high initial capital (helps with cash flow).
Lessor takes on responsibility for repair and maintenance.
Useful when businesses want assets for a short period of time.
Disadvantages:
Can be more expensive with accumulation of costs.
Cannot act as collateral.
Microfinance providers: Institutions that provide banking services to low income or unemployed people who have no other access to financial sources.
Advantages:
Do not seek collateral.
Provide and disburse loans quickly with less formalities.
Extensive portfolio of loans.
Disadvantages:
Harsh recovery methods.
Smaller loan amounts.
High interest rates.
Business angels: Highly affluent individuals who provide financial capital to small startups in return for ownership equity in their businesses.
Advantages:
More open to negotiations.
No repayment or interest.
Offer valuable knowledge and help.
Disadvantages:
May assume a larger degree of ownership → diluting original ownership (less control).
Expect a substantial return on their investment.
Short term finance: Money needed for day to day running of a business and therefore provides the required working capital. Expected to be paid back within 12 months or less.
Long term finance: Obtained for purchasing long term fixed assets or other expansion requirements of a business. Used for overall improvement, more than one year to be repaid.
Factors influencing the choice of a source of finance:
Purpose or use of funds.
Cost, opportunity cost.
Status and size.
Amount required.
Flexibility.
State of external environment.
Gearing: The relationship of loan capital to share capital, if the proportion of loan capital to share capital is large → high geared, if proportion is small → low geared.
External finance:
disadvantages: less control, interest (usually), time limits, less flexibility, collateral required.
Advantages: helps cash flow in the business.