3.2 Sources of finance Flashcards
Internal sources of finance
- Personal funds
- Retained profit
- Sale of assets
Personal funds
source of finance for sole traders that comes mostly from their own personal savings
Advantages of personal funds
- sole traders know exactly how much money is available to run the business
- provides more control over finances
- not required to pay back
Disadvantages of personal funds
- risk to the sole trader in investing life savings
- might not be sufficient to maintain a business
Retained profit
profit that remains after a business has paid out dividends to its shareholders
Advantages of retained profit
- cheap, doesnt incur interest charges
- permanent source of finance
- flexible in how it can be used
- control over it without interference
Disadvantages of retained profit
- start-ups will not have any
- if it is too low it might not be sufficient
- if its too high it means that too little was paid to shareholders which affects the business’ image
Sale of assets
when a business sales off its unwanted or unused assets to raise funds
Disadvantages of sale of assets
- only available for established businesses, new businesses may lack assets to sell
- time-consuming to find a buyer, especially if its an obsolete asset
Advantages of sale of assets
- good way of raising capital with not used assets
- no interests incurred
External sources of finance
- Share capital
- Loan capital
- Overdrafts
- Trade credit
- Crowdfunding
- Leasing
- Microfinance providers
- Business angels
Share capital
money reaised from the sale of shares of a limited company
Advantages of share capital
- permanent source of capital
- no interest payments
Disadvantages of share capital
- shareholders expect to be paid dividends when the business makes profit
- for public limited companies, the ownership of the company may be diluted or change hands from the original shareholders to new ones via the stock exchange
Loan capital
money sourced from financial institutions such as banks, with interest charged on the loan to be repaid
Advantages of loan capital
- accessible and quick to arrange
- repayment is spread out over a predetermined period of time, reducing the burden
- large organizations can negotiate for lower interest charges
- owners still have full control of the business if no shares are issued to dilute their ownership
Disadvantages of loan capital
- capital will have to be redeemed even if the business is making a loss
- collateral (security) might be required before any funds are lent
- failure to repay the loan may lead to the seizure of a firms asset
- if variable interest rates increase, firms are faced with a high debt repayment burden
Overdrafts
when a lending institution allows a firm to withdraw more money than it currently has in its account
Advantages of overdrafts
- provides an opportunity for firms to spend more money than they have in their account
- helps in settling short term debts
- flexible
- charging interest only on the amount overdrawn can make it a cheaper option than loan capital
Disadvantages of overdrafts
- banks can request for the overdraft to be paid back at very short notice
- due to the variable nature of an overdraft, the bank can at times charge high interest rates
Trade credit
an agreement between businesses that allows the buyer of goods or services to pay the seller at a later date
Advantages of trade credit
- by delaying payments to suppliers, business are left in a better cash flow position than if they paid cash immediately
- interest-free
Disadvantages of trade credit
- debtors lose out on the possibility of getting discounts
- delaying payment leads to poor relations
- latter could refuse to engage in future transactions with the firm
Crowdfunding
when a business venture or project is funded by a large number of people each contributing a small amount of money
Advantages of crowdfunding
- provides access to thousands of investors who can see, interact and share
- valuable form of marketing, media attraction
- opportunity for feedback and expert guidance
- full control when raising funds
- it can decide how to structure the campaign
- good alternative for businesses struggling to get bank loans or traditional funding
Disadvantages of crowdfunding
- strong competition from other businesses seeking crowdfunding
- subject to rejection
- fees need to be paid to crowdfunding platforms (percentage of contributions)
- potential risk of failure
Leasing
a source of finance that allows a firm to use an asset without having to purchase it with cash
Advantages of leasing
- doesnt need a high initial capital to purchase the asset
- lessor takes on the responsibility of repair and maintenance of the asset
- useful when an asset is only required for short periods of time
Disadvantages of leasing
- can be more expensive than the purchase due to accumulated total costs
- leased asset cannot act as collateral for a business seeking a lloaon as an additional source of finance
Microfinance providers
institutions that provide banking services to low-income or unemployed individuals or groups who would otherwise have no other access to financial services
Advantages of microfinance
- most microfinance institutions dont seek any collateral
- provide or disburse loans quickly and with less formalities
- extensive portfolio of loans (working capital, housing, etc)
- promote self sufficiency and entrepreneurship
Disadvantages of microfinance
- can adopt harsh recovery methods if the customer does not have legal representation
- offer smaller loan amounts of financial capital than other financial institutions
- interest rates are high, they find it difficult to offer lower rates
Business angels
highly affluent individuals who provide financial capital to small start-ups or entrepreneurs in return for ownership equity in their businesses
Advantages of business angels
- more open to negotiation than other institutions or lenders to small/start up businesses
- no repayment required
- offer valuable knowledge, focusing on helping the business succeed
Disadvantages of business angels
- may assume a large degree of control or ownership in the business
- may expect a substantial return on their investment within the first few years, sometimes 10 times the original investment
Short-term finance
money needed for the day-to-day running of a business and therefore provides the required working capital, examples include bank overdrafts, short-term loans and trade credit
Long-term finance
funding obtained for the purpose of purchasing long-term fixed assets or other expansion requirements of a business, used for its overall improvement. examples include long-term bank loans and share capital
Factors influencing the choice of a source
- purpose or use of funds
- cost
- status and size
- amount required
- flexibility
- state of the external environment
- gearing
