Section 2.1.30 Sources of Finance: Internal and External Flashcards
sources of finance
wherever the money comes from that a business needs
what do new businesses starting up need
- money to invest in long-term assets such as buildings and equipment
- cash to purchase materials, pay wages and pay the day-to-day bills (e.g. water and electricity)
what do inexperienced entrepreneurs often underestimate
the capital needed for the day-to-day running of the business
if the income from sales is greater than the operating costs, what does this mean
the business is making a profit. this should be kept and used to finance growth
what are other situations where the business will need additional funding
- cash flow problem
- a major customer refuses to pay for goods, causing a huge gap in cash inflows
- large order, requiring the purchase of additional materials
finance for business comes from two main sources:
1) inside the business: internal finance
2) outside the business: external finance
capital can be generated from within the business in three ways:
1) retained profit
2) sale of assets
3) improved management of working capital
(4) share capital)
two sources of external capital:
1) loan capital (debt)
2) share capital (equity)
external sources of finance include:
- family and friends
- banks
- peer-to-peer funding
- business angels
- crowdfunding
- other businesses
family and friends
can provide share capital (taking an equity stake in the business and its profits) or can lend money
banks
- very hard to get a bank loan
- if you can get one, bank will insist on rock-solid collateral
- banks are not interested in sharing the risks involved when starting a business. they want to provide finance, not become a partner
peer-to-peer funding
- if there is an attractive-sounding business, it seems to work well
- online matching platforms to match individuals who want to lend (at a relatively high rate of interest) to individual business borrowers
business angels
- take huge risks in the hope of the occasional blockbuster success
- in reality, the only businesspeople likely to find an angel investor are those whose families move in wealthy circles
crowdfunding
a way of getting small investors to put money into a new business - often with an incentive, such as to get a sample product or service in return for their investment
other businesses
some companies allocate a chunk of their capital to early-stage investments. the companies hope to get the occasional winner from among a number of duds
external methods of finance include:
- loans
- share capital
- venture capital
- overdrafts
- leasing
- trade credit
- grants
loans
- most usual way is through borrowing from a bank : either in the form of a bank loan or overdraft
- loan is usually for a set person’s of time:
: short term - one or two years
: medium term - three to five years
: long term - more than five years - loan can be repaid in either instalments over time or at the end of the loan period
- the bank will charge interest on the loan - fixed or variable - bank will demand collateral to provide security in case the loan cannot be repaid
share capital
- comes from private investors or venture capital funds
- venture capital providers are interested in investing in businesses with dynamic growth prospects - willing to take a risk on a business that may fail, or do really well
- once it has become a public limited company, the firm may consider floating on the stock exchange
loan capital vs share capital
loan capital:
- won’t dilute control of founder
- makes no claim on the company products
share capital:
- no need to repay
- dividends can be cut: flexibility
can bring wise heads into boardroom
venture capital
- way of getting outside investment for businesses that are unable to raise finance through the stock market or from banks
- venture capitalists invest in smaller, riskier companies
- to compensate for their risks, venture capital providers usually require a substantial part of the ownership of the company - also likely to want to contribute to the running of the business - dilutes owner’s control but brings in new experience and knowledge
- venture capital houses typically put money into businesses that have survived early stages and are looking to grow
overdrafts
- facility that allows a company to spend up to an agreed negative balance on its current account
- when the bank balance is negative, company is overdrawn and must pay interest calculated on a daily basis
- bank can dip in and out of ‘the red’ so its interest bill at the end of the year will usually be quite a lot lower than with a bank loan
- overdrafts are flexible and well matched to the ups and downs of small company cash flow but the risk level should not be underestimated
-overdrafts are on 24-hour recall so the bank can cancel them at any time, often leaving business unable to pay negative balance and forcing business into administration
leasing
- leasing the asset means agreeing to pay a fixed monthly rental for a fixed period of time
- good for small or fast-growing businesses
- many firms short-term needs outweigh long-term wishes
trade credit
- simplest form of external financing
- business obtains goods or services from another business but does not pay for these immediately
- good way of boosting day-to-day finance
- other businesses may be reluctant to trade with the business if they do not get paid in time
grants
- hand-outs to small firms, either from a local authority or central government
- may be given to encourage a start-up or relocation that is considered valuable - probably because banks refused to lend
angel investors definition
investors who back a business before it has opened its doors, taking a full equity risk, i.e. if it fails the angel investor will lose everything invested
collateral definition
an asset used as security for a loan. it can be sold by a lender if the borrower fails to pay back a loan
crowdfunding definition
obtaining external finance from many individual, small investments, usually through a web-based appeal
public limited company (plc) definition
a company with limited liability and shares, which are available to the public. its shares can be quoted on the stock market
seedcorn capital definition
the early stage (sowing a seed) finance that might come from an angel investor
share capital definition
business finance that has no guarantee of repayment or of annual income, but gains a share of the control of the business and its potential profits
stock market definition
a market for buying and selling company shares. it supervises the issuing of shares by companies. it is also a second-hand market for stocks and shares
venture capital definition
high-risk capital invested invested in a combination of loans and shares, usually in a small, dynamic business
why might a business finance expansion using debt rather than equity
issuing more equity dilutes the value of shares, putting the founder’s control of the business at risk
why should companies be wary of overusing their overdraft facility
because of the risk that their bank might withdraw the facility with no more than 24 hours’ notice - making it almost impossible to repay
why might a bank refuse to lend to a business
it may doubt the firm’s ability to repay, i.e. see it as too risky; or the bank may think it can make more profit elsewhere, e.g. property speculation
why might a business collapse from overtrading (growing too fast)
if sales increase outstrip the firm’s capital base, it can run out of cash and slide into administration
why do venture capital companies invest in some businesses but not others
venture capitalists seek huge potential gains. therefore, they love ‘scalability’: a high potential for the business to grow massively
how might crowdfunding prove harmful to a new small business
getting a bank loan for $250,000 is simple to administer; 50,000 crowdfunders investing $5 each could become an administrative nightmare
