Sources of finance

Question 1

Why do businesses need finance?

Answer 1

Businesses need finance because…

1) Business set up
2) Day to day trading (working capital)
3) Growth

Question 2

What are the factors that will affect the type and amount of finance required?

Answer 2

WHAT IS THE FINANCE REQUIRED FOR?
- E.g. is it to finance long-term assets like a factory or a short term increase in stock?

THE COST OF THE FINANCE

• Bank finance incurs interest costs
• Share capital also has a cost - the dividends (returns) required by the shareholders

THE FLEXIBILITY OF THE FINANCE
- What repayments might be required (and when)

THE BUSINESS ORGANISATIONAL STRUCTURE
- E.g. limited companies normally find it easier to raise finance than sole traders

Question 3

What are the internal ways to raise finance in a larger business?

Answer 3

• Retained profits

- Sales of assets

Question 4

What are the external ways to raise finance in a larger business?

Answer 4

• Issue shares
• Bank overdrafts
• Bank loans

Question 5

What are retained profits?

Answer 5

After taxes have been paid to the tax man and dividends to the shareholders to the profit that is left is called retained profits

The most important and significant source of finance for an established, profitable business

Question 6

What is sale of assets?

Answer 6

-Selling spare or surplus assets is a way to achieve a short term boost to the cash flow
However not all businesses have spare assets

Question 7

Give a few examples of some spare assets

Answer 7

• Spare land

- Surplus equipment

Question 8

What happens if a business needs a their assets back?

Answer 8

If a business needs it assets it can arrange a SALE AND LEASEBACK deal

• For example they could sell a building to a leasing company and then that leasing company would charge them an annual leasing charge (like a rental)
• This would allow them to get the finance but also carry on using the asset

Question 9

What is a new share issue and how is it a way to raise finance?

Answer 9

• A business can raise finance by selling more shares - this is quite easy to do if the firm is already a PLC
• If they are not already a PLC this will be very costly exercise and will take them a long time
• This is an external source of finance (the business is getting finance from people outside of the business - those that buy shares)

Question 10

What is a loan and what happens to the business?

Answer 10

A loan is an external source of finance (the bank is outside the business)

• If a firm takes a loan it will have to pay back the amount it has taken + interest
• The payments will be made in agreement with the bank - they are likely to be monthly but could be yearly
• The loan could be short term e.g to increase stock for the next 3 months
• It can also be long term e.g to buy equipment and pay over 5 yrs
• An overdraft is an example of a loan but it is very expensive and would only be used for a very short term uses

Question 11

What is collateral?

Answer 11

Collateral is an asset that a bank holds as security for the repayment of a loan

Question 12

What is a mortgage and what does it consist of?

Answer 12

A mortgage is a long term loan used to buy property such as a factory or office space

• Usually re-payed over 15-20 years
• The interest on this loan is lower because it is secured and so it is less of a risk to the bank
• The building itself is used as COLLATERAL so if the business cannot pay the bank, the bank will take over ownership of the property and sell it to get their money back

Question 13

When are retained profits most used?

Answer 13

For long term expansion

Question 14

When are selling unwanted assets used the most?

Answer 14

To pay for expansion or to pay off debts

Question 15

When are share issue used the most?

Answer 15

To pay for long term expansion (e.g. buying another business)

Question 16

When are loans used the most?

Answer 16

For short or long term purposes e.g. to buy machinery or to pay for increases in stock).

Question 17

What are the advantages of using retained profits as a source of finance?

Answer 17

• No interest and does not have to be repaid

- No loss of control to new owners/ shareholders

Question 18

What are the advantages of selling unwanted assets as a source of finance?

Answer 18

• No interest paid and the finance raised does not have to be repaid
• No loss of control of the business

Question 19

What are the advantages of using share issues as a source of finance?

Answer 19

• No interest paid and the finance raised does not have to be repaid
• Share capital does not have to be repaid

Question 20

What are the advantages of taking out a loan as a source of finance?

Answer 20

• Overdraft is flexible - can be varied on a daily basis up to an agreed limit
• No loss of control by existing owners
• Lower interest rate than overdraft or unsecured loan
• No loss of control by existing owners

Question 21

What are the disadvantages of using retained profits as a source of finance?

Answer 21

• Many businesses may expand but still not be very profitable. Profits may be too low to finance growth
• When profits are low business growth will be slow so loans or share issues might be better options

Question 22

What are the disadvantages of selling unwanted assets as a source of finance?

Answer 22

• The asset is no longer owned.

- The asset may still be needed by the business so there will be leasing costs

Question 23

What are the disadvantages of share issuing for a source of finance?

Answer 23

• Dividends will be expected by shareholders

- May be loss of control by original owners

Question 24

What are the disadvantages of taking out loans for a source of finance?

Answer 24

• Interest costs may be high
• Must be repaid - this could be at short notice if the bank is worried about the future of the business
• Property is used as security - will be given up by business if debt cannot be repaid
• Interest costs