Sources of finance

Question 1

why is finance not readily available for new businesses?

Answer 1

because they will rely on capital provided by the entrepreneur themself and friends and family so their sources of finance will be limited and they are likely going to continue to struggle to find external sources of finance until they establish an effective trading record

Question 2

what things does the most suitable finance option depend on? give 6

Answer 2

how much funding is needed?

the amount of time the money is required for

what will the finance be used for

the affordability of repayments

whether or not personal or business assets are available as security

whether or not the business owner is willing to give up a share of ownership, perhaps through taking a partner or selling shares

Question 3

what are four sources of internal finance?

Answer 3

owners capital

retained profit

working capital

sale of assets

Question 4

define owner’s capital

Answer 4

the money that the entrepreneur may have saved/gained from other sources

Question 5

what is an advantage and disadvantage of owner’s capital?

Answer 5

adv:
does not need to be repaid and no interest is incurred

disadv:
unlikely that it will be adequate to finance the entire business/start-up and carries a high level of risk as if the business fails the owner has lost all it’s capital

Question 6

define retained profit

Answer 6

the profits kept after dividends have been paid to shareholders

Question 7

what is an advantage and disadvantage of retained profit?

Answer 7

adv:
cheap and readily available and doesn’t incur any interest as long as profit is made

disadv:
there is an opportunity cost involved eg shareholders may prefer to be paid by retained profits

Question 8

define working capital

Answer 8

money that is used to run the business day-to-day and this can be increased by reducing their trade credit period offered to customers and collecting debts quickly

Question 9

what is an advantage and disadvantage of working capital?

Answer 9

adv:
it is a short-term source of finance and can help businesses manage their cash flow better

disadv:
can dent reputation if demand cannot be met if stock is not available
customers may go elsewhere if their trade credit is reduced

Question 10

define sales of assets

Answer 10

when the business can sell premises, machinery and other assets

Question 11

what is an advantage and disadvantage of sales of assets?

Answer 11

adv:
it will bring in a lump sum immediately and in the long run will reduce the cost of running that asset

disadv:
business has lost the use of the assets
smaller businesses unlikely to have unwanted assets
if growth is an objective, more likely to acquire more and keep assets

Question 12

what are 11 external sources of finance?

Answer 12

borrowing from friends and family

bank loans

overdraft

trade credit

factoring

leasing

commercial mortgage

sale and leaseback

share capital

venture capitalists

government grants

Question 13

define borrowing from friends and family

Answer 13

where the business owners borrow money from their family and friends and tends to be informal

Question 14

what is an adv and disadv of borrowing from friends and family?

Answer 14

+
low rates/no interest
easy to negotiate/set up
immediately available

-
informal so people may fall out
if circumstances change, urgent repayments may be required
if business fails, owner has lost friends/family’s captal

Question 15

define bank loans

Answer 15

borrowing a fixed amount for a fixed period of time

monthly payments are made up of interest and capital

Question 16

what is an adv and disadv of bank loans?

Answer 16

+
can be difficult for small businesses to secure but once agreed all of the money is readily available immediately
fixed repayments spread across longer periods help businesses manage their cash flow

-
interest must be paid on top of the capital borrowed which increases fixed costs
banks require proof that a business can repay their debt
it’s difficult to get for those with no proven track record

Question 17

define overdraft

Answer 17

the facility to withdraw more from an account than is in the bank account resulting in a negative balance

Question 18

what is an adv and disadv of an overdraft?

Answer 18

+
flexible way of borrowing
useful for day-to-day transactions easing cash flow needs
only pay interest when account is overdrawn

-
expensive form of borrowing as interest is much higher than other loans
maybe an arrangement fee
can be called in withdrawn by a bank with 30 days of notice - repayable on demand

Question 19

define trade credit

Answer 19

a business buys from its suppliers and pays at a later date so a short-term interest free loan

Question 20

what is an adv and disadv of trade credit?

Answer 20

+
useful short-term finance to help manage cash flow better as the firm can sell their goods and generate profit before paying suppliers
usually interest free if the business pays suppliers within the agreed credit terms

-
if business owes too much suppliers may stop supplying
won’t benefit from cash discounts related to prompt payment
source of finance is limited to goods supplied and can’t be used for general business expenses or growth

Question 21

define factoring

Answer 21

for larger firms it’s possible to let a debt factoring company buy problem debts
it’s where the business sells customer accounts that have outstanding bills to a third party business who will recover this debt

Question 22

what is an adv and disadv of factoring?

Answer 22

+
business receives a lesser amount than the original debt but receives it quickly and can now spend this cash
factoring firm will take responsibility for recovering the money owed to the business, improving cash flow

-
will not receive the full amount which was originally owed
not suitable for start-up businesses as they won’t have big debts

Question 23

define leasing

Answer 23

where a business pays for the use of an asset but will never own it, improving short-term cash flow compared to buying the asset outright
they will never own the asset

Question 24

what is an adv and disadv of leasing?

Answer 24

+
likely to get a replacement machine if it breaks down
useful if machinery is only needed occasionally
a form of renting - no large sums of money required

-
more expensive over machine lifetime than buying it
will never own it

Question 25

define commercial mortgage

Answer 25

business gets a long-term loan in order to purchase a property

Question 26

what is an adv and disadv of commercial mortgage?

Answer 26

+
may run for 10-15 years and have predictable costs which helps budgeting and cash flow

-
failure to make repayments may lead to property getting repossessed

Question 27

define sale and leaseback

Answer 27

business sells assets to a finance company and leases the asset back

Question 28

what is an adv and disadv of sale and leaseback?

Answer 28

+
asset can be turned into capital for reinvestment in the business and growth
carries potential tax benefits as the leasing costs are offset as an operating expense

-
no longer owns the asset
may not receive market-rate for the asset

Question 29

define share capital

Answer 29

selling a share of the company to investors who seek a return on their investment via increasing share price and dividends

Question 30

what is an adv and disadv of share capital?

Answer 30

+
business doesn’t have to pay interest
can sell more shares as and when funds are needed in the business

-
can dilute the control of the business owners
can leave original owners vulnerable to takeover threats

Question 31

define venture capitalists

Answer 31

selling shares to a business/individual that specialises in investing in SMEs that are expected to grow quickly

Question 32

what is an adv and disadv of venture capitalists?

Answer 32

+
business doesn’t pay interest
can benefit from the expertise of the venture capitalist

-
vc will want a say in how the business is run and share the profits of the business
only invest in businesses expected to grow quickly

Question 33

define government grants

Answer 33

gov. may offer finance to start-up businesses but the qualifying criteria tend to be narrow and businesses setting up in regions of high unemployment are more favoured

Question 34

what is an adv and disadv of government grants?

Answer 34

+
money doesn’t need to be repaid
interest-free

• there are administration requirements - strict criteria
  certain conditions must be met
  amount available is relatively small and for a limited time

Question 35

what are 6 factors that must be considered when deciding upon a source of finance?

Answer 35

existing borrowing

risk

short vs long-term source

interest rates

security against loans

availability of finance

Question 36

evaluate the 6 factors that need to be considered when deciding a source of finance to a start-up business

Answer 36

existing borrowing -
not applicable

risk -
high risk as 80% that business will fail within 18 months
may have to use personal assets as security against loans

short vs long-term source -
short-term is better as less risky since the business may be unsuccessful or not have a high enough turnover rate to afford longer term borrowing with additional interest repayments

interest rates -
significant cost for the business
affects level of profit made

security against loans -
unlimited liability for sole-traders
they will have to use personal assets as security against borrowing

availability of finance -
usually rely on personal savings/money from family
smaller range of sources available
external borrowing harder as business hasn’t made any sales

Question 37

evaluate the 6 factors that need to be considered when deciding a source of finance to an existing business

Answer 37

existing borrowing -
need to consider the amount of existing borrowing and interest to be paid

risk -
less risk as they are more established in the market
proven track record so can take advantage of supplier discounts and trade credit

short vs long-term source -
depends on how established business is
easier to get large sums of money that require longer payback periods due to higher sales value/volume

interest rates -
affects cost and profits made if interest rates rise

security against loans -
owners are a separate legal entity in limited companies, only the assets of the business will need to be used as security

availability of finance -
more sources available to established businesses
can take up better credit terms due to proven track record of sales/success