1.4.3 Types and Sources of Credit

Question 1

why do businesses need finance

Answer 1

• Start up costs: starting a new business involves numerous costs. Some of these will be large one off payments → premises and equipment
• Need finance for working capital to cover costs such as wages and raw materials until enough income comes in from sales
• Day to day: even if the business goes well it doesnt mean that it will always have enough cash on a day to day basis to pay its bills
• May add additional finance to provide sufficient working capital to cope with any cash flow problems
• Expansion: may come a time for when the business will want to expand → may involve extra finance to pay for it

Question 2

3 internal sources of finance

Answer 2

• Owners capital
• Retained profits
• Sale of assets

Question 3

owners equity

Answer 3

• Money owners have available to put into the business → friends and family may contribute too but may expect to receive interest on their loans
• Does not need to be repaid
• No interest
• Risky as they can lose all their savings and wealth if the business goes bankrupt
• Maybe not enough

Question 4

retained profit

Answer 4

• All the money that is left after all the deductions have been taken away from total sales revenue including tax, interest and any dividends paid to shareholders → can be reinvested into the business
• Does not need to be repaid as not borrowed
• Low risk
• No interest
• Can be limited when a business is just starting out
• Opportunity cost
• Shareholders not happy as they receive less dividends

Question 5

sales of assets

Answer 5

• Means selling things of value in order to raise money → business may lease the assets back again
• Doe not have to be repaid, no interest
• Good to get rid of underused assets
• Assets may have been useful in the future, they are not available for new businesses later
• One time profit
• Loss of resources

Question 6

what external sources of finance do banks provide

Answer 6

• overdrafts
• bank loans

Question 7

overdrafts

Answer 7

• Allow a business to spend more than it has in its account on an agreed limit. Interest is only paid on the amount borrowed for the time it is used
• Flexible and useful if there is a cash flow problem
• Buffer when there is a temp shortage to pay the bills
• Quick and easy to pay
• Good in the short term
• Too expensive for start up major spending
• Interest rates are usually higher than loans
• Not suitable in the long term or for large amounts

Question 8

bank loans

Answer 8

• Fixed amounts that are borrowed for a specific period at an agreed rate of interest
• Lower int rate than overdraft
• Fixed sum available: easy to plan for fixed payments
• Has to be paid monthly regardless of cash flow
• Interest has to be paid
• May need collateral in case of default on loan

Question 9

what external sources of finance do businesses provide

Answer 9

• trade credit
• leasing
• hire purchase

Question 10

trade credit

Answer 10

• Offered by suppliers, giving time to pay, commonly 30-60 days
• No interest
• Allow time for the business to process the raw materials and generate profit to pay bills
• Limited amounts, short term
• Delaying payment for too long means the supplier withdraws credit
• Works for big businesses with negotiating power not smaller ones

Question 11

leasing

Answer 11

• Long term rental agreement with a supplier, so they can use the equipment without having to buy it outright, frees up funds for other uses (vehicles, machiners, photocopiers)
• Much lower outlay on equipment
• Maintenance is often included (servicing)
• New models reg updated
• More expensive than buying outright in the long term
• Cannot own leased items
• Regular monthly payments

Question 12

hire purchase

Answer 12

• An asset is bought over a period of time with repayments made each month until the final payment and it becomes the firms property
• Spreads the cost of purchasing assets
• Own the asset in the end
• Can use immediately
• Intermediary involved
• Costs more over time

Question 13

what are external sources of finance investors may provide

Answer 13

• share capital
• venture capital
• online collaborative funding
• P2PL

Question 14

share capital

Answer 14

Investors may buy shares in the company

• Valuable
• Do not need to pay dividends unless you make a profit
• Risks shared by all the shareholders
• More people own the business
• Need to share profits or pay dividends
• Need to keep 51% minimum to own

Question 15

venture capital

Answer 15

• Funding provided by a specialist firm or individuals (dragon’s den) in return for a proportion of the company’s shares
• Immediate cash injection
• Does not need repayment
• Can get loans where the bank wont provide them
• The investors have control and know how to run hte businesses successfully, less risk
• Relatively high risk: business may not succeed
• Given in exchange for a share of the business

Question 16

online collaborative funding

Answer 16

Can bypass traditional financial intermediaries

• Access to investment funds from many sources
• Investors can give small amounts of money to a large number of businesses
• Access to share capital/unsecured loans without past credit rating
• Risky
• May take time to arrange
• May not actually raise enough funding

Question 17

peer to peer landing (P2PL)

Answer 17

• Arrange unsecured loans, from finance from different people lending to the business of their choice
• Faster than bank loaning as it is done online
• Lower fees than bank finance
• Investors advised to never put more than 5% of their assets into P2PL
• New businesses need atleast a year of accounts, hard

Question 18

crowd funding

Answer 18

• Raising money from a large group of people
• Equity crowdfunding: where the funders are investors who provide funds in return for shares in the business
• Debt crowdfunding: funders are investors who provide funds in return for their money back plus interest
• Reward crowdfunding: funders are enthusiasts for the project and provide the funds in return for tickets, merchandising or publicity

Question 19

crowdfunding in creative industries

Answer 19

• Source of finance
• A form of market research and a way to test a business idea
• Entrepreneur can learn that they have a market, and raise the finance from his customers
• Avoided debt or giving shares away to raise the money
• Gains free market research and free start up capital

Question 20

new business problems with external sources of finance

Answer 20

• Cost of finance reflects the risk involved
• Business that are big can get cheaper loans than small ones bc they are well established and less likely to fail
• New businesses may have to pay premium interest rates bc of their lack of experience making them risky → sometimes banks refuse loans altogether

Question 21

benefit of internal finance over external finance

Answer 21

• A large benefit of internal finance is that it will usually cost less than external finance because there will be little or no interest to pay
• When owners finance themselves, they lose only the interest that their money might have made in a savings account (opp cost) → interest rates paid to savers are always lower than the interest rate charged to borrowers
• Similarly retained profits are the savings of the company → they have an opportunity cost but the interest lost will be less than the interest on a loan from the bank

Question 22

importance of credit

Answer 22

• Without credit sources it would be hard to set up a business
• Vital for the economy’s efficiency that people with good ideas are given a good chance to develop them
• Most goods and services that we rely on have needed some finance to get production started
• All sources of finance take risk seriously and try to ensure that do they do not lose the money they invest
• Willingness to accept some risk is essential to the effective functioning of the economy

Question 23

problems of businesses when trying to seek funding for good ideas

Answer 23

• May take time and alot of energy and commitment
• Depends on the willingness of the entrepreneur to investigate the available opportunities and continue the search when they have been refused
• Short termism in the UK: evidence of people wanting to see quick, guaranteed returns on their investments instead of planning for the future
• Want to see signs of strong demand in the economy before risking expansion