Business Studies- Sources of Finance Flashcards
Sources of Finance
Are most needed when first setting up a business. This is because a lot of resources are needed for trading can begin. These resources are one-off items. For example, a new restaurant would need to buy cookers, refrigerators, utensils, furniture, glassware, cutlery, crockery and other equipment. Once these one-off cost are met, they may not be repeated for many years. Other start-up costs might include research, converting premises, legal fees, website design and marketing.
Once a business starts trading it will earn revenue. This money can be used to meet the day-to-day running costs of the business such as wages, materials, components and utility bills. However, sometimes the revenue from sales may not cover all expenditure. This is when a business will need to borrow money. The money needed to fund day-to-day expenditure is called working capital.
Once a business is established the owners may also want to expand. This often requires large amounts of money. Most businesses have to find extra funding to expand. This is because internal sources of finance, such as profit, are not adequate.
Businesses often get unexpected bills. A tax demand perhaps. If the business does not have enough money it will need to get some very quickly. Businesses have to manage their cash flow carefully. If businesses run out of cash, they will not be able to continue trading. Consequently, businesses are often forced to raise money quickly when the cash runs out.
Sources of finance maybe internal or external. External sources are those which come from outside the business. Examples would be the sale of shares, bank loans, overdraft or trade credit. Internal sources come from inside the business and can only be used when the business is established. This is because new businesses, are usually short of finance. There are three main internal sources of finance.
Retained profit is profit that has not been returned to the owners. It is retained by the business. It is the most important source of finance for business because it is cheap. There are no charges such as interest, dividends or administration. However, if profit is used by the business, it cannot be returned to the owners. Some owners might object to this.
It may be possible to use some working capital to provide extra finance for the business. This can be done by reducing the trade credit period, say from 90 to 60 days. This means that customers have to pay for their goods sooner. By reducing the amount of stocks held means money is released and can be used to boost cash reserves. It is also possible to delay payments to suppliers so that the business holds onto its cash for longer.
An established business may be able to sell some unwanted assets to raise finance. For example, machinery, land and buildings that are no longer required could be sold off. Large companies can sell off parts of their organisation to raise finance.
Short-term sources of finance
Businesses often need to borrow money for a short period. This is called short-term finance and is money borrowed for one year or less. Short-term finance is often used to boost working capital.
Some businesses have seasonal trade. A farmer, for example, may need to borrow money for a few months until revenue comes in from selling the hardest.
Short-term finance is also likely to be needed to make an emergency expenditure. For example, if the machine breaks down unexpectedly, the repair costs might have to be met by short term loan.
Bank overdrafts are a common source of finance for most businesses. A bank overdraft means a business can spend more money than it has in his account. In other words, they go overdrawn. The overdraft limit will be set by the bank and interest is only charged when the account is overdrawn. Bank overdrafts are simple and flexible. However the bank has the right to call in the money owed at any time.
A bank loan is a fixed agreement between a business and the bank. The amount borrowed, and interest, must be repaid in regular instalments over a fixed period. Bank loans can be short term or long term sources of finance. The main advantage of a bank loan is that the business will know exactly what it has to pay every month.
Businesses often use higher purchase to buy tools, equipment, vehicles and machinery. The main problem with higher purchase is that it is usually more expensive than a bank loan. This is because lenders are not as strict when checking the credit worthiness of borrowers.
A lease is a contract which allows businesses to use resources such as property, machinery or equipment in return for regular payments. It is like renting or hiring really. For example, the farmer might lease a combine harvester for six weeks during harvest period. The farmer will probably pay a daily or weekly rate for the term of the lease. Leasing maybe short-term or long-term.
Trade credit: businesses often buy resources and pay for them at a later date, usually within 30 to 90 days. This is called trade credit and is a cheap way of raising finance. It means a business holds onto its cash for longer.
Credit cards are popular because they are convenient, flexible and avoid interest charges if accounts are settled within the credit period. They can be used by executives to meet expenses when travelling on company business. Small businesses use credit cards to buy materials from suppliers. However, rates on credit cards are very high if accounts are not settled within the credit period, usually 56 days.
Finance is money borrowed from more than one year. External long-term plans can be in the form of capital or loans. Capital is the money put in by the owners and loans are borrowed money. The main sources of long-term finance are outlined below.
Owners capital: small businesses often set up by using money belonging to the owner. This is a cheap source of finance because there is no interest to pay. However the owners capital is rarely enough to start a business. Also, once this money is put into the business it is not likely to be taken out.
Share capital: for limited companies share capital is an important source of external finance. The sale of shares can raise very large amounts of money. When limited companies are formed, shares are issued to raise start-up capital. The main advantage of selling shares to raise capital is that interest payments are avoided. However, shareholders will expect to be paid dividends in the business is successful.
Loan capital: loan capital is money that is borrowed usually from banks and other financial institutions. It may come from a number of sources.
Debenture holders are creditors of the company, not owners. The bench holders are entitled to a fixed rate of return, but have no voting rights. They must also be repaid on a set date.
Mortgages are long-term loans and the borrower must use land or property as security. This means that if the borrower fails to make the repayments, the lender can repossess the property.
Venture capital provides funds for companies that have some potential, but are considered too risky by other investors.
Many countries governments give financial help to businesses. Government prefer to give money to businesses that setup in regions where there is heavy unemployment. Small businesses are also favoured, as are start-ups. The government may give you a business grant which does not have to be repaid. Alternatively it may lend businesses money at low rates of interest.
