Sources of Finance

The Role of the Finance Department

-Book keeping procedures: keeping records of purchases and sales

-Creating published accounts: financial statements that must be published each year

-Providing managers with financial information

-Raise capital: the department will look after how a firm raises finance

-Management of wages: calculate wages and collect income tax and NI for HMRC

The Finance Department is important to an organisation as the business has to know how viable it is and balance revenue with costs in order to make a profit.

Why Do Businesses Need Finance?

-Expansion

-Buy / Replace machinery/ equipment4

-Buy / lease premises

-Internal Growth

-Wages and salaries

-Marketing

-Paying bills

-Buy raw materials

Reasons for Finance

Finance is needed for…

•Business Set-up = initial funds

•Day-to-day trading = working capital

•Growth & development = investment capital

Sources of Finance

-Internal: generated from within the business such as retained profit, working capital or sale of assets

-External: from outside the business such as banks loans, the issue of new shares, over drafts or venture capital.

Sources of Finance

 External

Share capital,  Family and friends,  Bank Loan, Commercial Mortgage, Overdraft, Leasing, Sale and Leaseback, Hire purchase, Trade Credit, Government Grants, Factoring and Business Angels/Venture Capitalists.

Internal

Sale of Assets, Working Capital, Retained Profit and Owners capital.

Evaluate different sources of finance available to entrepreneurs and SMEs 

-Apart from capital provided by the entrepreneur and friends and family, sources of finance are likely to be severely limited 

-Sole traders and SME’s are likely to struggle to find external sources of finance until they establish an effective trading record

Factors affecting Source of Finance

-The type of business – Sole traders and partnerships cannot issue shares.  Consider start up vs established businesses

-The amount of control desired – Becoming a partnership or company can weaken control.

-Security – A lack of security (collateral) may mean that banks are unwilling to grant a loan.

-Existing levels of debt – If it is high, banks will think twice about lending.

Factors affecting Source of Finance

-Length of time – How long will it take to generate the funds to pay back investment.  Short term vs long term loans

-Current methods of finance being used – Inappropriate financial management will discourage the bank from lending

-Purpose – what is the finance required for?

-Cost – interest rates

-Flexibility

Internal Source of Finance

Retained profit

The profits retained (kept) after dividends have been paid to shareholders.

Advantages:

·It is cheap and readily available and it does not incur interest/repayments

Disadvantages:

·Opportunity cost, e.g. pay dividends to please shareholders

Internal Source of Finance

Working capital

The money that is used to run the business day to day.

This can be increased by reducing their trade credit period offered to customers and collecting debts more quickly.

Advantages:

·Short term source of finance - can help the business manage their cash flow better

Disadvantages:

·Can dent reputation, if demand cannot be met if stock is not available, or customers go elsewhere if their trade credit is reduced.

Internal Source of Finance

Sale of assets

This is when the business is able to sell premises, machinery, or other assets.

Advantages:

·It will bring in a lump sum immediately Disadvantages:

·The business has lost the use of the assets

·Smaller businesses are unlikely to have unwanted assets and, if growth is an objective, they are much more likely to want to acquire assets as opposed to losing them.

Internal Source of Finance

Owners capital

This is the money that the person setting up the business may have saved or gained from other sources e.g. retirement/ redundancy or inheritance.

Advantages:

•This source of funds does not need to be repaid and there will be no interest incurred.

Disadvantages:

•Usually small - unlikely that this source of finds will be adequate to finance the entire business or start up and for the owner it carries a high level of risk as if the business fails the owner will have lost all their own capital

Borrowing from friends and relatives

Where the business owners borrow money from their family or friends, it tends to be informal.

Advantages:

·Low rates of interest or no interest.

·Easy to negotiate/set up.

·Immediately available

Disadvantages:

·Tends to be informal and this can be a problem – people may fall out

·They may need urgent repayment if circumstances change.

Loans

-Borrowing a fixed sum from a bank for an agreed period of time (usually medium term eg 3-5 years)

-Loan provided over fixed period

-Rate of interest either fixed or variable

-Timing and amount of repayments are set – monthly repayments made up of interest and capital

-Security sometimes required

-Good for financing investment in production capacity (eg buildings equipment)

-Generally at a lower rate of interest than a bank overdraft

-Don’t provide much flexibility

-Hard to get for small start ups / high risk ventures

Overdraft

-Overspending on a current account up to an agreed amount for a negotiated period of time

-Short term source of finance, widely used by start ups and small businesses

-An overdraft is really a loan facility – the bank lets the business / individual ‘owe it money’ when the bank balance goes below zero, in return for charging a high rate of interest (only pay interest when account is overdrawn)

-A flexible sources of finance - used only when needed

-Good for helping business handle seasonal fluctuations in cash or for short term cash problems. 

Banks Overdraft 

Advantages: 

- Relatively easy to arrange

- Flexibe ; use as cash flow requires

-Interest; only paid on the amount borrowed under the facility

-Not secured on assests of business

Disadvantages:

-Can be withdrawn at short notice

-Interest charge varies with changes in interest rate 

- Higher interest rate than a bank loan 

Bank Loan

Advantages:

-Greater certainty of funding, provided terms of loan complied with

-Lower interest rate than a bank overdraft

-Appropriate method of financing fixed assets

Disadvantages:

-Requires security ( collateral)

-Interest paid on full amount outstanding

-Harder to arrange

Trade Credit

A business buys from its suppliers and pays at a later date in effect short term interest-free credit. 

Advantages: 

·Useful short term source of finance to help manage cash flow ·

Usually interest free if the business pays the suppliers within the agreed credit terms.

Disadvantages:

·Suppliers may stop supplying if the business owes too much

·May become a credit risk

·Will not benefit from cash discounts related to prompt payment

Factoring

For larger firms it is possible to let a debt factoring company buy problem debts.

The debt factoring business chases the original debtor for as close to the full amount as possible. Anything above what was paid to buy the debt is a profit for the debt factoring company.

Advantages:

·The business receives a lesser amount than the original debt but it receives it promptly, it can now spend this cash.

·The factoring firm will take responsibility for recovering the money owed to the business improving cash flow.

Disadvantages

·The business will not receive the full amount which it was  originally owed.

·Not suitable for a start up business.

Leasing

A business effectively rents an asset, for a monthly fee. It does not and will not own it, examples include, vans, machinery. 

Advantages:

·A form of renting used for machinery – no large sums of money needed to buy it. 

·Likely to get replacement machine if it breaks down.

·Useful if machinery is only needed occasionally.

Disadvantages:

·More expensive over machine lifetime than buying outright.

·Will never own the machinery – unless given option to purchase.

Hire Purchase

Similar to leasing but at the end of the hire period the asset belongs to the company that hires it.

Advantages:

·Can have equipment immediately

·May be easier to obtain credit from hire purchase companies than banks for some. 

Disadvantages: 

·Do not become owner until last payment made.

·If the business  falls behind with payments then asset can be repossessed.

·Usually higher rates of interest than banks. 

Commercial Mortgage

A business gets a long-term loan in order to purchase a property.

Advantages:

·Commercial mortgages might run for 10-15 years have predictable costs; helps budgeting and cash flow.

Disadvantages:

·Failure to make repayments may lead to the property being repossessed.

Sale and leaseback

The business sells assets (e.g. buildings, machinery) to a finance company and then lease (rent) the asset back.

Advantages:

·An asset can be turned into capital for reinvestment in the business

·Capital produced can be reinvested into growingthe business.

·Sale and leaseback also carries potential tax benefits as the leasing costs are offset as an operating expense.

Disadvantages:

·The business no longer owns the asset

·They may not receive market-rate for the asset

Share Capital

Limited companies can sell shares to raise finance

Definition: Share Capital is money given to a company by shareholders in return for a share certificate. This gives them part ownership of the company and entitles them to a share of the profits

Share Capital

Selling a share of the company to investors who seek a return on their investment, via increasing share price and dividends.

Advantages:

·The business doesn’t have to pay interest

·Can sell more shares as and when funds are needed in the business

Disadvantages:

·Selling shares can dilute the control of the business owners

·In extreme circumstances leave the original owners vunerable to takeover threats.

Business Angels / Venture Capitalists

Business angels are wealthy, entrepreneurial individuals who provide capital in return for a proportion of the company equity.

They take a high personal risk in the expectation of owning part of a growing and successful business.

Business Angels / Venture Capitalists

Selling shares to a business or individual that specialises in investing in small to medium sized firms that are expected to grow quickly.

Advantages:

·The business will not have to pay interest

·The business can also benefit from the expertise of the venture capitalist

Disadvantages:

·The venture capitalist  will want a say in how the busines is run and a share in the profits of the business.

·Venture capitalists only invest in businesses expected to grow quickly.

Government Grants

Local and central government may offer finance to business start-up schemes.

The qualifying criteria do tend to be quite narrow and businesses setting up in regions of high unemployment tend to be favoured.

Advantages:

·Money does not need to be repayed

·Interest free

Disadvantages:

·Administration requirements – forms to complete to meet what can be strict criteria.

·Tend to come with certain conditions which must be met.

·The amounts available tend to be relatively small and are for a limited period of time.

Long or Short Term

Short-term finance is needed to cover the day to day running of the business. It will be paid back in a short period of time, so less risky for lenders. Eg overdraft

Long-term finance tends to be spent on large projects that will pay back over a longer period of time. More risky so lenders tend to ask for some form of insurance or security if the company is unable to repay the loan. Eg mortgage, share capital

Long or Short Term

Short term                        Medium term                  Long term

Up to 1 year                 2–5 years                       •More than 5 years

• Factoring                  •Short-term loan          • Government grant                 

•Leasing                      •Share capital               •Overdraft    

                                         •Trade credit                •Hire purchase

Sources of Finance in relation to a firms size

More suitable for an entrepreneur of SME

•Government grant

•Venture capitalists

•Leasing

More suitable for a larger business

•Share capital

•Factoring

•Sale of assets

Security

Security – Something that acts as assurance to a lender that will get its money back if a business is unable to pay back money it has borrowed. Also known as collateral.

If the business fails to repay the loan, the bank – as holder of the deeds – is legally entitled to sell the factory or office in order to recover any amount outstanding on the loan.