nature, purpose and sources of finance

Question 1

what are internal sources of finance?

Answer 1

funds raised from assets owned by the business or profits that are ploughed back

Question 2

what are the types of internal sources of finance?

Answer 2

retained earnings, sale and leaseback of assets and reductions in working capital

Question 3

What is retained earnings?

Answer 3

the amount of net profit left over for the business after it has paid out the dividends to its shareholders + these profits are accumulated over the years and becomes a significant source of finance for future activities

Question 4

What are the limitations of retained earnings?

Answer 4

newly-formed companies have no access to this source of finance and established companies which have been suffering losses would not be able to tap on retained earnings

Question 5

What is sales and leaseback of assets?

Answer 5

established companies might own idle assets that they no longer need to use. these assets could be sold off to raise funds. in addition, some companies might choose to sell away assets that they still intend to use, but which they do not need to own. in such cases, these assets might be sold to a leasing specialist and leased back by the company. this will allow the company to raise funds, but it would incur costs of leasing and rental payment.

Question 6

what is reductions in working capital?

Answer 6

working capital refers to the funds required to pay for raw materials/inventory, daily operating expenses and credit offered to customers. a business can reduce working capital by reducing the amt of inventory they hold or not sell goods to customers on credit.

Question 7

what are the limitations of reductions in working capital?

Answer 7

there are risks involved, as reducing inventory levels and debts owed to the company may cause the business to have cash flow problems

Question 8

what is the evaluation for internal SOF?

Answer 8

they do not increase liabilities of the business and there is no risk that the original owners would lose control as no shares are sold. however, only depending on internal sof for expansions can slow down biz growth as the speed of development is limited by profits earned and the value of the assets.

Question 9

what are external sources of finance?

Answer 9

funds raised from outside the biz

Question 10

what are short to medium term external SOF?

Answer 10

bank overdraft, debt factoring, hire purchase and leasing

Question 11

what is bank overdraft?

Answer 11

a facility provided by the bank for businesses to borrow up to an agreed limit as and when required. it is the most flexible of all SOF. this means that the amt raised can vary daily, depending on the specific needs of the business. But it often carries high interest charges, and banks may force the biz to pay back the amt owed if it is concerned about the stability of the business

Question 12

what is debt factoring?

Answer 12

When a biz sells gds on credit, it creates trade receivables. the longer the time allowed to pay up, the more finance the biz has to find to continue operations. One option, if it is commercially unwise to insist on cash payments, is to sell these claims on trade receivables to a debt factor. this allows cash to be obtained immediately, but not for the full amt of the debt. this is bcs the debt factoring company’s profits are made by discounting the debts and not paying their full value. when full payment is received from the original customer, the debt factor makes a profit

Question 13

What is hire purchase?

Answer 13

A hire purchase is where an asset is sold to a company that agrees to make fixed repayments over an agreed time period. it is a form of credit for purchasing an asset over a period of time. it allows the biz to own the asset without the need to make a large initial cash payment to buy it. it is not a low-cost option but it improves ST cash flow of a biz as compared to an outright purchase of an asset for cash

Question 14

What is leasing?

Answer 14

allows a biz to use a NCA by paying a rental or leasing charge over a fixed period. The biz avoids the need to raise long-term funds to buy the asset. Leasing involves a contract with a leasing or finance company to acquire, but not necessarily to purchase, assets over the medium term. A periodic payment is made over the life of the agreement, but the biz does not have to purchase the asset at the end. This agreement allows the biz to avoid cash purchase of the asset. The risk of using unreliable or outdated equipment is reduced as the leasing company will repair and update the asset as part of the agreement.

Question 15

What are the long-term external SOF?

Answer 15

equity, long-term bank loan and bonds

Question 16

What is equity finance?

Answer 16

It means to raise funds through sale of shares. For private limited companies, new shares could be sold to existing shareholders, which does not change the control or ownership of the company. Owners of private limited companies can also list their companies publicly and sell shares to the wider public. This will allow the company to raise much more capital than from selling to existing shareholders, but it comes with the risk of loss of control or ownership to new shareholders.

Question 17

How can a public limited company avoid the risk of loss of ctrl/ownership?

Answer 17

A rights issue of shares can be issued done to raise further capital by selling additional shares to existing shareholders. this ensures that the ownership of the biz does not change, and this allows the company to raise funds without the need for public promotion/advertising. However, as the rights issue increases the ss of shares to the stock exchange, the ST effect is often to reduce the existing share price, which is unlikely to give existing shareholders too much confidence in the biz if the share price falls too sharply.

Question 18

What is long-term bank loan?

Answer 18

These are loans offered by the banks that do not have to be repaid for at least 1 year. The loan may be offered either a fixed or variable interest rate. Fixed rates provide more certainty, but they can be expensive if the loan is agreed at a time of high interest rates. Companies borrowing from banks will often have to provide security or collateral for the loan. This means the right to sell an asset is given to the bank if the company cannot repay the loan. Bizs with few assets might find it difficult to obtain loans, or can be asked to pay higher interest rates

Question 19

What is bonds?

Answer 19

Bonds are issued and sold by companies to investors as a form of debt finance. a fixed rate of interest would be paid to investors for the life of the bond. investors may resell the bonds to other investors if they do not wish to wait until maturity before getting their investment back. Bonds are usually not secured on a particular asset of a company.

Question 20

what are the advantages of debt finance?

Answer 20

1) As no shares are sold, the ownership of the company does not change or is not diluted by the issue of additional shares
2) Debts have to be repaid eventually, hence liabilities will not increase permanently
3) lenders such as banks, financial institutions and bondholders have no voting rights at AGMs.
4) Interest expense is tax-deductible

Question 21

What are the advantages of equity finance?

Answer 21

1) Equity is a permanent capital and never has to be repaid

2) Companies can opt not to declare and pay dividends every year, unlike interests

Question 22

What are the other external SOF?

Answer 22

grants, venture capital and crowd funding

Question 23

What is grants?

Answer 23

only for innovation/potential to export

Question 24

What is venture capital?

Answer 24

funds provided by venture capitalists, who are specialist orgs, or sometimes wealthy indvs prepared to lend risk capital to, or purchase shares in biz start-ups or SMEs that might find it difficult to raise capital from other sources due to the risks involved

Question 25

What is crowd funding?

Answer 25

the use of small amts of capital from a large number of indvs to finance a new biz venture/pdt idea

Question 26

What are the factors affecting SOF?

Answer 26

cost, risk-bearing by fund providers, flexibility, legal structure and desire to retain ctrl

Question 27

How does cost affect choice of SOF?

Answer 27

During a period of increasing interest rates, loans can be very expensive. If a company decides to become publicly-listed to raise funds, floating on the stock exchange can be costly in terms of fees and promotion of the share sale. Even internal SOF can incur opp costs

Question 28

How does risk-bearing by fund providers influence choice of SOF?

Answer 28

Bizs which have high existing debts would rep a higher risk to banks and FIs if they wish to borrow more -> gearing position. If a biz decides to raise funds by issuing shares/rights, investors would bear the potential risk of the share price dropping in the future. it depends on the willingness of the fund providers to bear risk

Question 29

How does flexibility affect choice of SOF?

Answer 29

If biz has a variable need for finance, eg seasonal pattern of sales and cash receipts. then flexible form of finance like bank OD is better than LT and inflexible SOF.

Question 30

How does desire to retain ctrl affect choice of SOF?

Answer 30

selling shares would result in the current owners losing some ctrl, except if a rights issue is used. Hence, a sale of shares would be unwise if the desire of owners is to retain ctrl of the biz as much as possible.