3.1 Sources of Finance

Question 1

Why firms need money

Answer 1

New firms need finance to buy the assets (machines/premises) to run the business. This is called start up capital
New firms need finance to pay the day to day expenses. To finance poor cash flow
All firms need to finance the working capital
To expand
To cover liquidity shortages

Question 2

Small firms

Answer 2

Grants: government money (gift mostly to small businesses)

Trade credit:

Question 3

Large firms

Answer 3

Overdrafts: agreements with bank to spend more than the money it has in the account
Hire purchase: purchase of an asset by paying a fixed amount over an agreed period of time
Leasing: obtain the use of a non-current asset by paying over an agreed period of time
Bank loans: long term (up to 10 years) payments over a period of time (principal capital + interest). May or may not have collaterals.
Mortgage: long-term loan (15-30 years) to buy property (real estate: land/buildings) paid back with interest
Debentures: bonds issued by business (limited companies) to raise finance
Issuing shares: limited companies only - no repayment - cost = cost of issuing shares, capital diluted (owners lost control)
Sale of fixed assets: selling old/unused property of machinery
Retained profits: profits not redistributed to shareholder. Money left after spending on all other expenses - no cost - however less dividends -> share prices may fall -> less attractive for investors
Use of working capital: capital needed to pay the day to day expenses and short term debts -> cash balance - reducing inventory levels - reduce trade receivables

Question 4

Internal sources of finance

Answer 4

Capital raised from the business:
Retained profits (LT)
Sale of fixed assets (LT)
Use of working capital (ST)
Owner’s savings

Question 5

External sources of finance

Answer 5

Capital raised outside of the business:
Overdrafts (ST)
Hire purchase (MT)
Leasing (MT)
Issuing shares (LT)
Banks
Debt factoring (ST)
Mortgage (LT)
Debentures (LT)
Trade credit (ST)

Question 6

Factors affecting sources of finance

Answer 6

1. Size and Legal Organisation
   Debentures: issue shares only available for limited companies
   Small have difficulties to borrow from banks: if they get a loan they will have to pay a higher interest rate
2. Amount Required
   Large: debentures, share issues, mortgage
   Small: hire purchase, leasing, bond loans
   Very small: overdrafts, working capital, owners money, trade credit
3. Length of Time
   Longtime - long term sources & short time period - short term source -> the business has to plan very carefully how long it will need finance for
4. Indebtedness
   Measured by gearing ratio
   High: bank loans are risky, debentures are also riskier

Question 7

Debt vs Equity

Answer 7

Debt
Benefits
Ownership is not affected
Lenders do not have a say in the decisions of the business

Limitations
Cost -> interests
Must be paid back even if the business fails (high risk/high reward)

Equity
Benefits
There is no cost (except IPO) 
Not paid back
If the business fails -> no dividends

Limitations
Lose control and ownership
Have to share profits with new partners/shareholders