4.10: Sources of Financing and Financial Institutions

Question 1

Identify the 2 types of financial institutions

Answer 1

• banks
• finance companies

Question 2

Describe a bank as a type of financial institution that a business could use to access finance

Answer 2

• provides basic banking services and products to the general public, both individual consumers and small to mid-sized businesses
• offers a variety of deposit, investment and loan accounts to businesses
• includechecking and savings accounts, loans and mortgages, basic investment services, as well as other services such as safe deposit boxes

Question 3

Describe finance companies as a type of financial institution that a business could use to access finance

Answer 3

• provide loans for businesses and consumers
• a finance company gains its funding from banks and other financial institutions at a set interest rate and uses these funds to extend credit to customers
• a finance company will earn profit by charging its customers a higher interest rate than what they are paying, and may charge loan fees and other administrative charges
• the difference between a bank and a finance company is that finance companies don’t accept DEPOSITS

Question 4

Identify the source of internal funding

Answer 4

• retained profits

Question 5

Explain retained profits as a source of internal funding

Answer 5

( how )
- is a long-term source of finance
- the net income left over after expenses, tax and obligations is known asretained earnings/profit
- the most basic source of funds for any company and the primary method that brings in money to the firm
( why )
- using retained earnings means companies don’t owe anyone anything
- is an inexpensive form offinancing
- ability to pay off debts increases

Question 6

Identify the 7 sources of external funding

Answer 6

• debentures
• share capital
• trade credit
• venture capital
• secured loans
• financial institutions
• government

Question 7

Explain debentures as a source of external funding

Answer 7

( how )
- a type of low-risk debt instrument
- provides a secure long-term source of finance
- financing from the general public, which offers a fixed term and fixed interest rate to the public
- the business must pay interest payments to holders
( why )
- debenture holders do not have a voting right, so a business could raise funds without losing any control of the company
- more secure than shares as if a business is unable to pay holders, the debt is covered by the firm’s assets

Question 8

Explain share capital as a source of external funding

Answer 8

( how )
- the funds raised by a limited company from selling shares to the public
- the funds raised can generate a large sum of finance for a company and as a result is a main source for limited companies
( why )
- shareholders have voting rights
- should a company raise funds by selling more shares, the company would increase the number of shareholders to whom profits / dividends are distributed to

Question 9

Explain trade credit as a source of external funding

Answer 9

( how )
- allows a business to ‘buy now and pay later’
- a sale is made but the seller / creditor does not receive the cash until a later date
- refers to an amount owed to suppliers for goods and services supplied on credit that has not yet been paid for
( why )
- could mean ‘free finance’ as the suppliers may not charge interest on the amount outstanding
- a flexible form of finance as businesses can decide when to pay and is widely available in most industries
- relieves cash outflows for the debtors, which can help to improve their cash flow management

Question 10

Explain venture capital as a source of external funding

Answer 10

( how )
- a high-risk investment in small to medium-sized businesses that have a strong growth potential, normally at the start of a business idea
- the amount borrowed can be paid back over a number of years depending on the terms of the agreement
( why )
- the venture capitalist is entitled to a return that is much higher than just charging interest on a loan

Question 11

Explain secured loans as a source of external funding

Answer 11

( how )
- this type of finance is obtained from commercial lenders such as a bank that can be for short-term or long-term
- interest charges can be fixed or variable depending on the agreement for the loan
- the amount borrowed is paid back over a nominated period of time
( why )
- if the borrower defaults on the loan, the lender can repossess the debtor’s assets
- used to purchase equipment, other assets or even to boost working capital

Question 12

Explain financial institutions as a source of external funding

Answer 12

( how )
- two main financial institutions are banks and finance companies
- financial institutions provide financial transactions such as investments, loans and deposits.
( why )
- businesses typically buy assets and borrow money to finance expansion / investments
- the cost of borrowing funds is the set interest rate

Question 13

Explain the government as a source of external funding

Answer 13

( how )
- can offer financial support to businesses or industries by providing government grants such as EMDGs or tax incentives
- businesses need to meet certain criteria to be eligible
( why )
- interest rates are usually lower than short-term debt
- the one-off payment to businesses is beneficial as they do not need to be repaid