Chapter 19 continued Flashcards
Notes on overdraft
- Most businesses have an overdraft agreement with their bank
- Allows them to withdraw a sum of money which is greater than the balance in their account
What is the benefits of overdrafts?
- Very flexible
- This is because businesses are able to change the amount of borrowing at short notice, depending on their needs
What is are the limitations of overdrafts?
- Cost is often higher than most other sources of borrowing
- Only used to meet short-term cash shortages
What is trade credit?
Trade credit is a business-to-business (B2B) agreement in which a customer can purchase goods without paying cash up front, and paying the supplier at a later scheduled date.
Notes on trade credit
- Most resources that businesses buy e.g. raw materials and components from their suppliers are bought on credit
- If a business can negotiate longer credit terms with suppliers it will increase short-term finance
- For example, if a business can buy £5000 of raw materials from its supplier on credit terms of 40 days instead of 30, they will have £5000 available for an extra 10 days
What is another method of using TC to provide short term finance?
- Delay the payment to the supplier
- E.g. instead of negotiating with the supplier to increase the credit period from 30 to 40 days, the customer simply takes longer to pay
Why is trade credit a source of finance?
Since the supplier is really lending the money for the cost of the goods for the length of the agreed credit period.
What are the limitations of delaying payment?
- Discounts offered by supplier for early/prompt payment will be lost
- Supplier may refuse further deliveries to the business until the outstanding payment has been made
- If delayed payment happens to much, supplier may demand payment before delivery!
Notes on debt factoring
- Most businesses sell their goods on credit (except those in the retail sector)
- These customers become a debtor (person who owns money) to the business
- They’re shown in the statement of financial position as trade receivables
- Longer the period of time a business gives its customers to pay, greater amount of finance it will need to find from other sources to meet day-to-day expenses/short-term debts
What is a solution to the problem above?
- Sell the debt to a debt-factoring company
- Company will buy the debt for a discounted amount
- Provides business with immediate cash
- Company gains a profit as it will receive full payment from the customer
Notes on a bank loan
- Most common source of external finance
- The amount borrowed is offered with either a fixed or a variable rate of interest
- If there’s a fixed interest rate, business can be certain as to how much interest it will have to pay
- Reduces the risk of increased costs if interests on borrowing rise in the future
- Variable rate - can fall or rise depending on economic factors
Why do small businesses find it harder to obtain bank loans?
- They’re seen as a greater risk by the banks
- If they do obtain a loan, then this is often at a higher rate of interest than might be charged to larger businesses (they’re seen to be at a much lower risk of not being able to repay the loan when due)
- Larger businesses often have collateral which they can use as security against any money borrowed
Explanation of collateral
Collateral guarantees a loan, so it needs to be an item of value. For example, it can be a piece of property, such as a car or a home, or even cash that the lender can seize if the borrower does not pay.
Notes on leasing (Card 1)
- Most often used for non-current assets, in particular motor vehicles and machinery
- In return for use of the asset, business pays leasing company a fixed amount over a set period of time
- Usually paid monthly or quarterly (once every quarter of a year)
Notes on leasing (Card 2)
- Asset’s not owned by the business
- At the end of the lease term it can give the asset back to the leasing company
- Company is responsible for the maintenance and repair of the asset
What is similar about leasing and a hire purchase?
Most often used to finance non-current assets like motor vehicles/machinery (like leasing)
- Both leasing and HP enable a business to have the use of an asset without the need for a large one-off cash investment
Benefits of HP (and leasing)
- Both leasing and HP enable a business to have the use of an asset without the need for a large one-off cash investment
- Cost is spread over time (usually one to five years)
- Can be financed out of working capital
Limitation of HP (and leasing)
Expensive as the interest charges are much higher than other finance options.
What is the main differences between leasing and a hire purchase?
The business will own the asset once all payments have been made and is responsible for any maintenance or repairs to the asset.
Is a mortgage similar to a bank loan?
Yes
What is a mortgage specifically used for?
The purchase of land or buildings
Is there interest in a mortgage?
- Interest is charged on the amount borrowed
- Must be paid each year
- By the end of the mortgage term the amount borrowed must be completely repaid
Notes on a debenture
- Type of bond that a business sells in order to raise very large sums of money
- In return for buying the bond or debenture, the full purchase price of the debenture must be repaid to the debenture holder
Is it usual for a business to provide security against the value of a debenture?
- Yes
- This is so that the debenture holder is guaranteed to get their money back even if the business is unable to repay it themselves
- E.g. business may provide debenture holder with the legal right to sell some of its land or buildings if it fails to repay the amount
Notes on a share issue
- Only available to limited companies (private and public) as they’re the only form of legal structure allowed to raise finance through a share issue
- Company can offer to sell shares up to a maximum number
- Called authorised share capital
- Amount of capital raised through a share issue becomes permanent capital + never has to be repaid unless business ceases to trade
What is debt financing?
Debt financing is the act of raising capital by borrowing money from a lender or a bank, to be repaid at a future date.
What are the benefits of debt financing?
- Doesn’t charge the ownership of the company
- Lenders have no say in the running of the company
What are the limitations of debt financing?
- Interest is charged on the amount borrowed, increasing business costs
- Interest is compulsory even if the business makes a loss
- Amount borrowed must be repaid
What are the benefits of equity financing?
- Never has to be repaid
- No ongoing cost
- If business makes a loss it doesn’t have to pay dividends to shareholders
What are the limitations of equity financing?
- The increase in shareholders ‘dilutes’ the ownership of the company
- Expensive to produce a prospectus to offer the shares for sale
What are government grants?
The governments of many countries support businesses in their country by providing grants/financial assistance to encourage new business start-ups or to assist business growth.
Why is micro-finance used?
- In some parts of the world it is difficult for people with a business idea to get access to any of the sources of finance previously mentioned
- Often they’re entrepreneurs from poor backgrounds so don’t have savings or relatives who can loan money for them to start their business
- Banks and lenders won’t lend them money (they’re considered to be too high-risk)
Notes on crowd-funding
- Entrepreneurs publish their idea for a project on the internet or through social media networks
- They invite anyone who’s interested to invest in their business idea
- Often finance is raised from a large number of people each investing a small amount of money
