3. Sources of Finance Flashcards
Internal sources of finance
Money obtained within the business, usually an stablished one.
Could be: personal funds, retained profit or sale of assets.
Examples internal sources of finance
Personal funds, retained profit or sale of assets.
Personal funds
Main source of finance for sole traders and partnerships, where the money comes from their own savings.
Advantages of Personal Funds
Control can be kept
Shows commitment to the business in case more funds are needed, such as bank loan.
Easily available and cheap with no interest rates to pay
Disadvantages of Personal Funds
Great risk (could be investing their life savings)
If it is the only source of funding it might not be enough to start or maintain the business.
Retained profit
the value of the profits that the business keeps after paying corporate taxes and dividends to shareholders. They are normally used to reinvest in the business or for purchasing more assets the organization might need.
Advantages Retained profit
It is cheap, no interest rates need to be paid.
Permanent source of finance and does not have to be repaid.
Flexible, the business can decide how to use it.
Owners have control of the Retain profits, without the interference of another financial institution.
Disadvantages Retained profit
Start-up business will not have any Retain profits.
If Retain profits are too low, there won’t be enough for a possible expansion of Owners can over use the Retain profits and not have any left for emergencies or growth opportunities.
A very high level of Retain profits means that not enough is either reinvested in the company or not enough is given to the shareholders.
Sale of assets
When a business sells some of their unwanted assets, remaining land or buildings.
Advantages sale of assets
Good way of generating cash from unwanted or extra assets
No interest has to be paid
Disadvantages sale of assets
It might be only available for established businesses and not start-up ones.
Might be time consuming to look form potential buyers
External sources of finance
External sources of finance come from outside the business.
Examples external sources of finance
Share Capital, Loan Capital, Overdrafts, Trade Credits, Crowdfunding, Subsidies, Leasing, Microfinance providers, and Business Angels.
Share capital
Main source of finance for most limited companies.
Company sells its shares to raise money (the buyers of the shares are called Shareholders). The company also decides the authorised shared capital, which is the maximum amount of shares they can sell.
Advantages share capital
Permanent source of capital as it will not need to be repaid by the business (redeemed)
No interest payments needed
Disadvantages share capital
Shareholders will expect to be paid dividends when the business makes profit.
The ownership of the company may change or be diluted due to a probable large amount of shares sold.
Loan capital
Money sourced from financial institutions such as Banks. Interest charges are imposed on the loan and this could be either fixed or variable.
Fixed interest rate
Does not change and remain fixed the entire time of the loan
Variable interest rate
Changes constantly based on market conditions.
Examples of Loan Capital: Mortage
Secured loan for the purchase of a property (if the borrower fails to pay the mortgage the lender can reposes the property)
Examples of Loan Capital: Business Development Loan
Highly flexible loans that businesses use to start or expand their business or to purchase new equipment.
Examples of Loan Capital: Debentures
Long term loans issued by a business or Government to raise funds (they do not need a collateral since they are based on creditworthiness and reputation of the issuer.
Debenture holders receive interest payment even if the business makes a loss (before the shareholders receive dividends). Debenture holders, however do not have ownership in the business or right to vote.
Advantages Loan Capital
Accessible and can be arranged quickly
Repayments spread over a period of time (medium to long-run)
The owners have full control of the business since no shares are sold.
Large organizations can negotiate lower interest rates depending on the amount they borrow.
Disadvantages Loan Capital
The businesses have to pay the loan (capital needs to be redeemed) even if the company is making losses.
Failure to pay the loan might lead to repossession of company’s assets
In cases if variable interest rate, the company might lose if the interest rate increased due to market conditions.
Overdrafts
Allows a business to withdraw more money than it has in its account, meaning temporarily overdraw. Overdrafts are mainly used when business have cash problems and normally face higher interest rate.
The amount to be overdrawn is agreed in advanced and the interest is charged ONLY on the amount overdrawn. However, if the overdraft exceeds the limit there will be additional costs.
Advantages of overdrafts
Gives the business the opportunity to spend more than they have for emergencies (i.e. paying suppliers)
Flexibility for business that may face cash flow problems
Since interest rate is ONLY on the overdraft amount, it might be cheaper than a regular loan.
Banks can cover cheques that might bounce with this facility
Disadvantages of overdrafts
Banks can ask for overdrafts to be paid back in a very short time with no prior notice.
The bank might change the conditions (i.e. interest rate, time)
Trade credit
Agreement between businesses that allows the buyer of goods and services to acquire them in the present and pay for them latter (buy now and pay later).
The credit period offered ranges from 30 to 90 days and no immediate cash is required.
What are organizations that offer trade credit called?
Creditors
What are the consumers of the credit called?
Debtors
Range of credit period offered
30 to 90 days and no immediate cash is required
Advantages trade credit
Business are in a better cash-flow position since they do not have to pay money upfront
No interest rate has to be paid
A trial use of the product might be possible
Disadvantages trade credit
Buyers might lose out of possible discounts of buying upfront
Delaying payment to creditors might not only lead to poor relationship with suppliers but also refusal to work with them in the future.
The business could buy more than they can pay for
Crowdfunding
External source of finance that involves raising small amounts of money from a large number of people to fund a particular business project or venture. This is typically done using online platforms. Could be equity crowdfundingor donation-based crowdfunding
Advantages Crowdfunding
As each individual lends a relatively small amount of money to the fundraiser, this limits the risks and impacts in case the business project fails to succeed.
It avoids the need for business to deal with commercial banks, which is often a time-consuming and a bureaucratic process.
Disadvantages Crowdfunding
There are legal challenges and considerations, such as transparent disclosure of legal documents, holding annual general meetings with investors, and publication of annual reports. This adds to the costs of the business.
Investors have the option to ask for additional information from the fundraiser, so this can delay decision making and incur additional costs for the business.
part 2 Advantages of Crowdfunding
Many people can invest in the business, so this can help to raise lots of much-needed finance for small to medium-sized enterprises.
Unlike business angels, individuals of the crowd do not take any controlling interest in the organization.
Crowdfunding is usually less costly than being listed on a public stock exchange.
part 2 Disadvantages of Crowdfunding
Theft of intellectual property is commonplace. Entrepreneurs are vulnerable to others stealing their business ideas, largely due to the absence of intellectual property protection. This is because of the lack of knowledge to defend these rights.
There are a lot of cases of crowdfunding scams. The loose regulatory requirements for crowdfunding in many parts of the world exposes investors to fraud.
Leasing
Source of finance that allows a business to use an asset without having to purchase it. A contract is agreed between a leasing company (the lessor) and the customer (the lessee) to hire the asset and pay in instalments (i.e. machinery, cars, buildings)
Leasing can be cheaper than buying the assets; so it helps the business in case they do not have initial cash to but assets upfront. However, sometimes the option of finance lease is available; where after a certain period of time (normally 3 years) the lessee can buy the asset.
Advantages of leasing
The Business does not need to have a high initial capital to start up the business (they could just hire it at the beginning)
The lessor takes the responsibility of maintenance and repair of the asset
It is useful when particular times are required for short periods
Disadvantages of leasing
It can turn out to be more expensive in the long-run (accumulated total costs)
A leased asset cannot act as collateral in case the businesses needs another source of finance (i.e. loan)
Angel investors
Extremely wealthy individuals that choose to invest own money in business showing growth potential . Will provide funds to business that:
Can’t have access to other types of funding but have potential to grow
Are too small to attract the attention of Venture capitalists
They can provide a one-off payment or continually support the start-up business. However, since the business is high-risk the Business angel will be extremely involved in the start-up business and hence the owner looses control (i.e. Sir Alan Sugar).
Advantages angel investors
They give better terms and conditions to start-up businesses than other institutions
They also believe in the “person” they are investing in
They use all their expertise to help the start-up business be successful
Disadvantages angel investors
They will assume a very high level of control of the business
The owner might want to buy the portion bought by the Business angel but he might not want to sell
Microfinance providers
For-profit social enterprises that offer financial and banking services to unemployed or very low income people.
These members of society would not ordinarily be able to secure
bank loans.
Aim of microfinance providers
Help entrepreneurs, especially women, struggling to finance their business start-ups to gain access to loans of a small amount.
Gives these people the opportunity to become self-sufficient and empower them to run their businesses.
As with the majority of loans, interest is charged on the amount borrowed, although these are typically lower than what commercial banks would charge.
Advantages microfinance providers
Can create benefits for the wider community, such as improved healthcare, education, and employment opportunities.
Microfinance providers behave in a socially responsible way by helping the poorest and most vulnerable adults in society.
Can help to build and foster a culture of entrepreneurial ship and economic independence.
PART 2 Advantages microfinance providers
can help many people to get out of poverty by making them become financially independent.
Around half of the world’s people live on less than $2 a day, so microfinance can help to provide poverty relief.
helps empower entrepreneurs of small businesses, especially women and the underprivileged working and living in low-income countries.
Disadvantages microfinance providers
Some people regard the practice of microfinance providers as being unethical as they earn profits from low-income individuals and households.
Only provides finance on a small scale, so is unlikely to be sufficient to make a real difference to society as a whole.
Loans incur interest charges, so can be rather expensive for small business owners who find it difficult to earn enough revenue to keep up with their loan repayments.
PART 2 Disadvantages microfinance providers
Increases the debts of entrepreneurs who may subsequently struggle in their business venture.
Due to relatively low profitability, microfinance providers may struggle to attract and/or retain employees and managers.
Short term finance
Money required for the day-to-day running of a business. In case of external source of finance , this means anything that has to be repaid to creditors within a year (12 months or less). Examples include Overdrafts and Trade credit.
Purpose to use funds
Need to be decided before embarking of the source of Finance. Whether the business needs to purchase an asset or it needs the funds for day-to-day activities the business will then need to decide the appropriate source of finance
Cost
Businesses need to take all the costs of a source of finance into account. Such costs could be: interest payments, administrative costs, costs associated with the “sale of shares” (pay dividends). Also, the Opportunity cost the firm might incur in.
Status and size
large organizations will have more access to finance than small organizations (like sole traders). That makes the decision on the source of finance more difficult.
Amount required
a long term loan might be needed for a large amount and an overdraft for a smaller one. Again, the business needs to know the amount required before embarking on a source of finance.
Flexibility
refers to how easy a business can change from one source to another.
State of the external environment
refers to factors that the business has no control of. For example, increase in interest rates or inflation (when things are more expensive people will demand less of the product). The business has to adapt to the situation and hence adapt the source of finance available.
Gearing
refers to the long-term external borrowing of a firm as a percentage of its capital. Firms with high gearing are relatively high risk as they have existing debts and are more vulnerable to any increase in interest rate.
high geared
proportion of capital the firms has is higher than its shared capital.
low geared
proportion of loan capital is smaller than its shared one
