2.1 Flashcards
paper 2
what is internal finance
Internal finance comes from the owner’s capital, retained profit, or the sale of assets
internal sources of finance
what is retained profit
The profit that has been generated in previous years and not distributed to owners is reinvested back into the business
The opportunity cost of investing the money back into the business is that shareholders do not receive extra profit for their investment
internal sources of finance
what is the Sale of assets
Selling business assets which are no longer required (e.g. machinery, land, buildings) generates a source of finance
A sale and leaseback arrangement may be made if a business wants to continue to use an asset but needs cash
The Benefits & Drawbacks of Using Internal Finance
advantages
Internal finance is often free
It does not involve third parties who may want to influence business decisions
Internal finance can usually be organised very quickly and without significant paperwork
Businesses that may fail credit checks (necessary for a bank loan) can access internal finance sources more easily
The Benefits & Drawbacks of Using Internal Finance
drawbacks
There is a significant opportunity cost involved in the use of internal finance
Internal finance may not be sufficient to meet the needs of the business
Using an internal finance method is rarely as tax-efficient as many external methods
what is external finance
External finance is sourced from outside of the business
sources of finance: family
advantages
Usually a very cheap source of funds
May have ‘no strings attached and can be provided to the business on very flexible terms
sources of finance: family
disadvantages
Relationships may be damaged if the finance is not repaid
external sources of finance
Banks
Banks provide several different kinds of loans to businesses e.g. a small business loan
The Advantages & Disadvantages of Bank Loans
Advantages
May offer both short term finance and long term finance if a business qualifies
Banks are often keen to provide free advice and guidance to businesses that use their services
Small sums may be borrowed from unsecured
The Advantages & Disadvantages of Bank Loans
Disadvantages
A business plan is usually required to access bank finance
Banks can be cautious about lending to new, untested businesses
Interest is payable
Businesses must be customers of the bank to access some loans
For larger amounts,** businesses may need to provide security to be granted a loan**
external sources of funding defenition
Peer-to-peer funding
Individuals with available savings pool it with others in a peer investment scheme such as Funding Circle
The Advantages & Disadvantages of Peer to Peer Funding
Advantages
Loans can usually be made available to businesses very quickly
Usually has ‘no strings attached (e.g. a share of the business
The Advantages & Disadvantages of Peer to Peer Funding
Disadvantages
Borrowers are charged a small fee to access finance in this way and have to pay interest in the same way as a bank loan
The individuals who made the money available in the first place receive some of this interest as compensation
sources of external finance defenition
Business angels
Some individuals specialise in making investments in start-up or expanding businesses e.g. Dragons Den investors
The Advantages & Disadvantages of Business Angels
Advantages
Business angels tend to be more willing to take a risk than banks
Angels often offer advice and guidance to the businesses in which they invest
Investment is usually for a determined period of time so owners regain shares in the future
The Advantages & Disadvantages of Business Angels
Disadvantages
Finding the ‘right’ business angel (e.g. with appropriate experience, expertise or interest) can be challenging
Networking is vital when entrepreneurs seek this kind of investment
As business angels own a stake in the business, they may be involved in decision-making and will receive a share of business profits
external methods of finance
crowdunfing
Crowdfunding allows businesses to access finance provided by a large number of small investors on online platforms such as Kickstarter
The Advantages & Disadvantages of Crowdfunding
Advantages
Creates an organic customer base and the platform provides a form of free marketing
A good credit rating is not required so new businesses that lack a trading record can attract funding
The Advantages & Disadvantages of Crowdfunding
Disadvantages
Businesses need to provide a persuasive business plan to convince individuals to invest in their product as they will be competing with many other projects online
The potential for negative publicity if the project is not successful in attracting enough crowdfunding capital
external sources of finance
Other businesses
It may be possible for a business to access finance via a joint venture with another business, such as a key customer or supplier
The Advantages & Disadvantages of Finance from Other Businesses
Advantages
May provide access to business processes and market knowledge alongside finance
Can access large amounts of finance
The Advantages & Disadvantages of Finance from Other Businesses
Disadvantages
Profits need to be shared between businesses
Decisions will usually need to be agreed by all of the businesses involved
Methods of Finance: loan
Explanation
A sum of money is borrowed and repaid (with interest) over a determined period of time
Bank loans are usually unsecured and are typically repaid over two to ten years
Methods of Finance: loan
Benefits
Interest rates are fixed for the term of the loan
Repayments are made in equal instalments, helping budgeting
Methods of Finance: Loan
Drawbacks
Interest rates depend on the businesses credit rating
Non-current liabilities are increased in the balance sheet
Methods of Finance, Loans(mortages)
explanation
Mortgages are long-term secured loans
They are typically used by a business to purchase buildings, land or large items of capital equipment
Methods of Finance, Loans(mortages)
advantages
Businesses can purchase expensive equipment or property without the need for large amounts of capital
Methods of Finance, Loans(mortages)
drawbacks
Missed payments may lead to property being repossessed
Repayments are variable, and linked to the current interest rate, making budgeting difficult
Methods of Finance, Loans(debentures)
explanation
Debentures are ** long-term agreements between a business and a lender to repay** a specified amount (with a fixed rate of interest) by a certain date
Debenture holders are creditors rather than owners of a business and do not hold voting rights
Methods of Finance, Loans(debentures)
drawbacks
Control over decision-making is retained within the business
Interest is fixed, aiding budgeting
Methods of Finance, Loans(debentures)
drawbacks
Interest is often higher than for other types of loan
Failure to repay debentures may deter investors in the future
Methods of Finance (Overdraft)
explanation
- An arrangement for business current account holders to spend more money than it has in their account
- A limit is agreed and interest is charged only when a business ‘goes overdrawn’
Methods of Finance (Overdraft)
Advantages
- A short-term source of finance that offers significant flexibility and aids cash flow
Methods of Finance (Overdraft)
drawbacks
Risk of Withdrawal: Banks can withdraw the overdraft at any time, with little notice if the bank is concerned about a business’s ability to repay what it owes. This unpredictability can leave a business or individual in a difficult financial position if the overdraft is suddenly no longer available.
Methods of Finance (Share Capital)
Explanation
- Share capital is finance raised from the sale of shares in a limited company
- Shareholders are the owners of shares and they are entitled to a share of the company’s profit when dividends are declared
Methods of Finance (Share Capital)
advantages
Large amounts of capital can be raised, especially by public limited companies
Interest is not payable on finance raised in this way
Methods of Finance (Share Capital)
drawbacks
Shareholders usually have a vote at a company’s Annual General Meeting (AGM) where they can have a say in the composition of the Board of Directors
Methods of Finance (venture capital)
explanation
Funds provided by specialist investors in small to medium-sized businesses that have significant potential for growth
Methods of Finance (venture capital)
advantages
Businesses that may have been refused finance from other sources may be able to attract investment from less risk-averse venture capitalists
Methods of Finance (venture capital)
drawbacks
Venture capitalists usually require a stake in the business in return for finance and often expect to exert some control over the business
Methods of Finance (leasing)
explanation
renting out an asset such as a piece of machinery or a vehicle used by the business in return for regular payments
Methods of Finance (leasing)
advantages
Regular Income Stream: Leasing provides a steady stream of income, which can improve cash flow and provide financial stability over the lease term.
Methods of Finance (leasing)
drawbacks
Loss of Asset Control: When you lease out an asset, you give up control over how it is used. The lessee may not take care of the asset as well as you would, leading to potential damage or increased wear and tear.
Methods of finance (Grants)
explanation
Governments and industry trusts may offer grants to businesses that meet specific criteria
Methods of finance (Grants)
advantage
Grants do not need to be repaid
Methods of finance (Grants)
drawback
The business must use the finance for its intended purpose
what is unlimited liability
Sole proprietors and partnership owners are fully responsible for all debts owed by the business
Owners are also legally responsible for any unlawful acts committed by those connected to the business
what are the implications of unlimited liability
There is no legal distinction between owners with unlimited liability and the business
As a result, these business owners may have to use their own personal assets to pay debts or legal fees
what is limited liability
Owners (shareholders) of private limited companies and public limited companies can only lose the original amount they invested in the business if it fails
Shareholders are not responsible for business debts
In most cases, the shareholders cannot be held responsible for unlawful acts committed by those connected with the business
what are the implications of limited liability
Companies are incorporated and owners are considered a separate legal entity to the business
This means that if a company fails, the owners would lose their investment (shares) but would not have to use their assets to meet additional debts or legal fees
what is the aim of producing a business plan?
to reduce the risk associated with starting a new business
what is a business plan?
a document produced by the owner at start-up, which provides forecasts of items such as sales, costs and cash flow
Producing a business plan forces the owner to think about every aspect of the business before they start which should reduce the risk of failure
i shows potential lenders or investors that the business has done their research
Producing a business plan allows lenders (e.g. banks) and other investors to analyse the plan and make an informed decision about providing a loan
what is a cash flow forecast
a prediction of the anticipated cash inflows and cash outflows, typically for a six to twelve month period
what is a net cash flow?
calculated by subtracting total outflows from total inflows
what is a opening balance?
the previous month’s closing balance carried forward
what is a closing balance?
net cash flow to + opening balance
The Uses & Limitations of Cash Flow Forecasts
Advantages of Cash-flow Forecasts
Cash flow forecasts can support an application for a loan and are an integral part of the business plan
They can help identify where the business may experience cash shortfalls or cash surpluses so that plans can be made to manage these periods
Cash flow forecasts aid planning and help a business avoid costly mistakes
The Uses & Limitations of Cash Flow Forecasts
Disadvantages of Cash Flow Forecasts
Forecasts are usually based on estimates and in reality inflows and outflows may differ significantly from the estimates
Cash flow forecasts require appropriate skills, insight, research and time to prepare and update adequately
External factors that can impact inflows and outflows may not be reflected in the cash flow forecast
