3.1 Sources of Finance

Question 1

Role of finance for businesses

Answer 1

Sources of finance

• Basically where do we get money/capital/finance from?

In terms of people:

• Paying for bills, groceries, etc
• Buying fixed assets such as cars and houses
• Where do we get capital from?
  
  • Income
  • Loans
  • Lease/rent

Types of expenditure

• Capital expenditure
  
  • Purchase of fixed assets that will last more than 1 year
  • E.g. buildings, machinery
• Revenue expenditure
  
  • Spending on costs and assets lasting less than 1 year
  • E.g. wages, rent, utilities, salaries, raw materials

Question 2

Internal and External sources of finance

Answer 2

Internal

• Finance generated from within the business
• Personal funds, sale of assets, retained profit

External

• Finance generated from outside the business
• Loan capital, trade credit, business angel, overdraft etc.

Question 3

Personal funds

Answer 3

Owner put their own savings into the company (Internal)

Question 4

Retained profit

Answer 4

A company makes a profit, which they put back into the business rather than paying to shareholders as a dividend

(Internal)

Question 5

Sale of assets

Answer 5

Selling physical and non-physical items that belong to the business

(Internal)

Question 6

Share capital

Answer 6

Selling a part of the business to an investor

Question 7

Loan capital

Answer 7

Borrowing money, usually from a bank, for a period of time. Interest is paid on the loan.

Question 8

Overdrafts

Answer 8

When the bank allows your account to go negative for a short period of time (-$50)

Interest is likely to be very high

Question 9

Trade credit

Answer 9

When a business delays paying its bills for goods and services after a period of time (rather than immediately). Usually 30 to 90 days.

Question 10

Business angels

Answer 10

A wealthy individual who invests in the business

Question 11

Venture capital

Answer 11

Organizations that are willing to invest in small businesses and start-ups with potential

Question 12

Grants

Answer 12

Payments from the Government to a business for a specific purpose, usually for public benefit

Question 13

Subsidies

Answer 13

Payments from the Government to a business to reduce their unit costs and encourage production

Question 14

Debt factoring

Answer 14

When a business is owed money but sells the debt to a third party in return for immediate cash

Question 15

Leasing

Answer 15

Obtaining the right to use an asset for a fixed period of time in return with regular payment

Question 16

Short, medium and long-term finance

Answer 16

Short = less than 1 year

Medium = 1-5 years

Long = greater than 5 years

Question 17

Overdrafts vs Loans

Answer 17

Loans

• Borrowing money, usually from a bank, for a period of time
• Interest is paid on the loan

Overdraft

• When the bank allows your account to go negative for a short period of time
• E.g. my account balance is 50 Euros
• I take out 100 and my balance is now -50
• Interest is likely to be very high

Question 18

Purchase vs Lease

Answer 18

Pros of Purchase:

• No need to make regular payments - better for cash flow in the longer term
• Less expensive in the long term
• Own the asset so helps the Balance Sheet - e.g. could use the asset to obtain a loan (use it as collateral)

Pros of leasing:

• Better for cashflow now (short term) - no need to pay full cost immediately
• Do not pay for repair/breakdown costs
• Can replace for newer model when contract finishes

Question 19

Debt vs Equity finance

Answer 19

Equity finance: Raise money by selling shares in your business, either to your existing shareholders or to a new investor.

Debt finance: borrowing money to be paid back at a future date with interest

Question 20

What factors influence what type of source of finance a company should use?

Answer 20

Time period

• Short term lack of cash - overdraft
• Long term investment - loan or shares

Amount required

• Share capital can raise millions
• Harder to raise a large amount in a short period of time

Cost

• Look at interest rates
• IPO can cost millions in legal/consulting fees etc

Legal structure

• Sole trader and partnership cannot issue shares

Size of existing borrowing

• High debt limits future borrowing

Identify which source of finance might be suitable for the following situations

• Business A wants to automate production by purchasing a new machine for $100,000
  
  • Loan capital
  • Leasing
  • Share capital (less possible)
• Business B is owed $2m by Walmart for goods they bought, but they are saying they cannot pay soon
  
  • Debt factoring
  • Extend trade credit with their suppliers
• Business C wants to expand the clothing business by opening 10 stores in Asia
  
  • Share capital
  • Venture capital
• Business D has run out of cash, none of the banks will lend them any money, they will go bankrupt tomorrow
  
  • Sale of assets
  • Overdraft