2.1 Raising Finance Flashcards
What is finance required for?
Capital expenditure: (spending on fixed assets such as equipment, buildings, IT equipment and vehicles
Revenue expenditure: (spending on raw materials or day-to-day expenses such as wages or utilities)
What is an internal source of finance?
Where the finance comes from inside the business
What is an enternal source of finance?
Where the finance comes from outside the business
Where do internal sources of finance come from?
- owner’s capital (personal savings)
- retained profit
- the sale of assets
What is owner’s capital?
Personal savings
Owners may introduce their savings or another lump sum e.g. money received from a redundancy payment (where a job role is no longer needed by a business and a worker is dismissed, usually with compensation)
Owners may invest more as the business grows or if there is a specific need, e.g. a short-term cash flow problem
What is retained profit, why is it good and what is the opportunity cost that comes about with it?
The profit that has been generated in previous years and not distributed to owners is reinvested back into the business.
Retained profits are good as they are a cheaper source of finance, as it does not involve borrowing and therefore there is no interest.
The opportunity cost of investing the money back into the business is that shareholders do not receive extra profit for their investment
What is sale of assets?
Selling business assets which are no longer required (resources owned by the business e.g. machinery, buildings, stock and cash)
What are the advantages of using internal finance?
Advantages:
Internal finance is often free (e.g. it does not involve the payment of interest or charges)
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
What are the disadvantages of using internal finance?
Disadvantages:
There is a significant opportunity cost involved in the use of internal finance, e.g. once retained profit has been used, it is not available for other purposes
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, e.g. loan repayments may be treated as a business cost and offset against tax
What are the sources of external finance?
- family and friends
- banks
- peer to peer lending
- business angels
- crowdfunding
- other businesses
What is obtaining finance from family and friends and what are the advantages and disadvantages?
Where small business owners approach close acquaintances to invest or lend money to a business
Advantages:
Usually a very cheap source of funds
May have ‘no strings attached (e.g. a share of the business) and can be provided to the business on very flexible terms
Disadvantages:
Relationships may be damaged if the finance is not repaid
What are the advantages and disadvantages of bank loans?
Banks provide several different kinds of loans to businesses, e.g. a small business loan
Advantages:
May offer both short term finance (e.g. overdrafts) and long term finance (e.g. loans or mortgages) 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
Disadvantages:
A business plan is usually required to access bank finance
Banks can be cautious about lending to new, untested businesses
Interest (and often an arrangement fee) is payable
Businesses must be customers of the bank (i.e. hold a banking account) to access some loans
For larger amounts, businesses may need to provide security to be granted a loan
What is peer to peer funding and what are the advantages and disadvantages?
Peer to peer funding is an alternative form of business finance which allows individuals or businesses to lend directly to other people or businesses, bypassing traditional banks
Advantages:
Loans can usually be made available to businesses very quickly
Usually has ‘no strings attached (e.g. a share of the business)
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
What is a business angel and what are the advantages and disadvantages?
business angels are wealthy, entrepreneurial individuals who provide capital in return for a proportion of your company’s shares
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
Disadvantages:
Finding the ‘right’ business angel (e.g. with appropriate experience, expertise or interest) can be challenging
So 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
What is crowdfunding and what are the advantages and disadvantages?
Crowdfunding is finance provided by a large number of small investors on online platforms such as kickstarter.
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
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
What are investors often attracted by?
Incentives such as samples or early access to products
It may be possible for a business to access finance via a joint venture with another business, such as a key customer or supplier, what is a joint venture?
A contractual agreement between 2 or more firms to combine their resources and expertise to achieve a particular goal
What are the advantages and disadvantages of finance from other businesses?
Advantages:
May provide access to business processes and market knowledge alongside finance
Can access large amounts of finance
Disadvantages:
Profits need to be shared between businesses
Decisions will usually need to be agreed by all businesses
What are the methods of external finance?
- loans
- share capital
- venture capital
- overdrafts
- leasing
- trade credit
- grants
What are loans and what are the benefits and drawbacks?
A loan is a sum of money that is borrowed and repaid (with interest) over a determined period of time
Bank loams are usually unsecured meaning no asset or collateral is required to gain access to the loan
Benefits:
Interest rates are fixed for the term of the loan
Repayments are made in equal instalments, helping budgeting
Businesses can purchase expensive equipment or property without the need for large amounts of capital
Control over decision-making is retained within the business
With debentures, interest is fixed, aiding budgeting
Drawbacks:
Interest rates depend on the businesses credit rating
Non-current liabilities are increased in the balance sheet
With a mortgage, missed payments may lead to property being repossessed
Failure to repay debentures may deter investors in the future
What is a debenture?
A long-term agreement between a business ad a lender to repay a specific amount (with a fixed rate of interest) by a certain date
Debenture holders are creditors (a business or individual to whom a business owes money) rather than owners of a business and do not hold voting rights
What is an overdraft and what are the benefits and drawbacks?
An overdraft is an arrangement where business current account holders can spend more money than is in their account
A limit is agreed and interested is charged ONLY when a business goes over the limit
Benefits:
A short-term source of finance that offers significant flexibility and aids cash flow
Drawbacks:
An overdraft may be ‘called in’ if the bank is concerned about a business’s ability to repay what it owes, meaning they have to pay it all back immediately.
What is share capital and what are the benefits and drawbacks?
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
Benefits:
No need to make regular payments
Lower risk of bankruptcy
Disadvantages:
Issuing shares mean the company founders are giving up some control. (Shareholders can become diluted)
What is venture capital and what are the benefits and drawbacks?
Venture capital is funds provided by specialist investors in small to medium-sized businesses that have significant potential for growth e.g. in the tech sector
Benefits:
Businesses that may have been refused finance from other sources may be able to attract investment from less risk-averse venture capitalists
Drawbacks:
Venture capitalists usually require a stake in the business in return for finance and often expect to exert some control over the business
What is leasing and what are the benefits and drawbacks?
Leasing is where an asset such as a piece of machinery or vehicle is used by a business in return for regular payments
E.g. office equipment such as a photocopier
Benefits:
The business does not own the asset during the period of the lease and so is not responsible for maintenance or repair costs
Drawbacks:
Leasing is usually more expensive in the long run than buying an asset
What is trade credit and what are the benefits and drawbacks?
Trade credit is an agreement made with suppliers to buy raw materials, components and stock which are paid for at a later date, typically 30 to 90 days later, this allows a business to improve their cash flow
Benefits:
Trade credit is usually interest free
Drawbacks:
Discounts for early payment will not be available
If businesses fail to repay in time it will damage their relationship with their suppliers
What are grants and what are the benefits and drawbacks?
Grants are money given to a business by the government, grants are usually offered to businesses that meet a specific criteria
E.g. grants may be available for businesses that create jobs or improve infrastructure in a region
Benefits:
Grants DO NOT need to be repaid
Drawbacks:
The business MUST use the finance for its intended purpose
What types of businesses have an unlimited liability?
Sole traders
Partnerships
What types of businesses have a limited liability?
Private limited companies
Public limited companies
Franchises
What are the characteristics of an 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 characteristics of a 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
Why are debentures, retained profit, share capital, venture capitalists and business angels not viable for a company with an unlimited liability?
Because they don’t want to risk their personal assets.
What are the factors affecting the choice of finance?
WHY IS FINANCE NEEDED?:
Capital expenditure on buildings and expensive equipment will usually require a longer-term method of finance, such as a mortgage or share issue
Revenue expenditure (e.g. purchasing raw materials or paying business rates) is more likely to be funded through a short-term method such as trade credit or overdraft
FOR HOW LONG AND HOW QUICKLY IS THE FINANCE NEEDED?:
For quick, short-term finance, businesses may use methods such as overdrafts, trade credit, short-term loans or leasing
If a business needs access to finance over the longer term, methods such as a share issue, debentures, mortgages or grants may be more suitable
WHO WILL LEND TO THE BUSINESS?:
Start-ups or struggling businesses may find their choice of finance limited and will often pay much more to access it than more established, stable businesses
Businesses that present more of a risk to lenders may choose to raise finance through venture capitalists, business angels or crowdfunding
Unlimited liability businesses, as well as businesses that own few assets, often struggle to raise finance as they’re seen as risky
HOW MUCH WILL IT COST, AND HOW EASY IS IT TO ACCESS THE FINANCE?:
Methods of finance that attract interest, e.g. loans, mortgages and overdrafts, are less affordable for businesses when interest rates are high
Interest-free methods of finance are usually more complex to access, e.g. share issues and grants
WHAT IS THE LEGAL STATUS OF THE BUSINESS?:
Unlimited liability businesses often struggle to raise finance
They may be small, own few business assets (e.g. to use as collateral) or have a limited trading record
Lenders (e.g. banks) prefer to lend to more established businesses that own assets
Investors prefer to invest in limited companies as they are often able to obtain a share in the 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
What is the main aim of producing a business plan?
To reduce the risk associated with starting a new business.
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,
It shows potential lenders or investors that the business has done their research
What is a cash flow forecast?
A prediction of the anticipated cash inflows and cash outflows, typically for a 6 or 12 month period
A detailed business plan should include a cash flow forecast that allows the business owners to identify its financial needs
How is net cash flow calculated?
By subtracting total outflows from total inflows
How is the opening balance calculated?
The closing balance of the previous month or period of time given
How is the closing balance calculated?
Adding the net cash flow to the opening balance
What are the advantages and disadvantages of cash flow forecasts?
Advantages:
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 (e.g. arranging an overdraft)
Cash flow forecasts aid planning and help a business avoid costly mistakes
Disadvantages:
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
