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iB Business Management > Unit 3.1 : Sources of Finance > Flashcards

Unit 3.1 : Sources of Finance Flashcards

1
Q

Role of finance for businesses

A
  1. All activities need money to finance their various activities
  2. 3 most common or for the initial setting up for the business, day-to-day operations, or for expansion purposes
  3. Businesses can obtain their finance from a range of sources and the appropriateness of the sources of finance depends on several factors including size and type of business organization
  4. The role (purpose) of finance can be categorised into capital expenditure or revenue expenditure
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2
Q

Capital expenditure

A
  1. Capital expenditure is the finance spent on fixed assets
  2. These are items of monetary value that have a long-term function (are used for more than a year) so they can be used repeatedly such as land, buildings, machinery, etc
  3. Fixed assets determine the scale of a firm’s operations. They are not intended for resale but for the purpose of generating money for the business
  4. The sources of finance for capital expenditure tend to come from medium and long-term sources because of the high cost of financing fixed assets
  5. These assets can also provide collateral for securing additional loan capital
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3
Q

Revenue expenditure

A
  1. Revenue expenditure refers to payments for the daily running of a business such as wages, raw materials,, rent, and electricity
  2. It also includes the payment of indirect costs such as insurance and advertising
  3. Costs must be controlled in revenue expenditure so that the business can generate enough revenue to earn a profit
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4
Q

Internal sources of finance

A

Finance that comes from within the business

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5
Q

Types of internal sources of finance

A
  1. Personal Funds
  2. Retained Profit
  3. Sale of assets
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6
Q

Personal Funds

A
  1. This is the main source of finance for sole traders and for partnerships
  2. A sole trader or members of a partnership can put more of their savings into the unincorporated businesses
  3. Short-term source of finance
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7
Q

Retained Profit

A
  1. Profit kept in the business to use after the owner has taken their share of the profits
  2. This profit has to be after paying both taxes to the government and dividends to its shareholders
  3. Retained profits are often used for purchasing and/or upgrading fixed assets
  4. Some retained profit might also be kept in a contingency fund in case of emergencies or unforeseeable expenditure
  5. Can be a short/middle/long-term source of finance
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8
Q

Pros of retained profit

A
  1. Does not have to be repaid like a loan
  2. There is no interest to pay as the capital is raised from within the business
  3. Permanent source of finance
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9
Q

Cons of retained profit

A
  1. A new business will not have any retained profit
  2. Many small firms’ profit may be too low to finance the expansion needed
  3. Keeping more profits in the business reduces payments to owners
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10
Q

Pros of personal funds

A
  1. It should be available to the firm quickly

2. No interest is paid

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11
Q

Cons of personal funds

A
  1. Savings may be too low

2. It increases the risk taken by the owners as they have unlimited liability

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12
Q

Sale of Assets

A
  1. Businesses can sell their dormant assets (unused assets - assets no longer of value or use), such as old machinery or outdated computers, that have been replaced
  2. If a business has chosen to relocate, it might be able to raise finance through the sale of land and buildings
  3. In more extreme cases, businesses can raise finance by selling some of their fixed assets to survive a liquidity problem
  4. This could be current assets (fixed like machinery) or non-current assets (raw materials, inventory etc)
  5. Short term source of finance
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13
Q

External sources of finance

A

External sources of finance come from outside the business

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14
Q

Types of external sources of finance

A
  1. Share capital
  2. Loan Capital
  3. Debentures
  4. Overdrafts
  5. Trade credit
  6. Debt factoring
  7. Leasing
  8. Grants and Subsidies
  9. Hire Purchase
  10. Venture Capitalists
  11. Business Angels
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15
Q

Share Capital

A
  1. This is the main source of finance for most limited liability companies
  2. Share capital happens through a process of issuing shares of a company.
  3. It is the money raised from selling shares in the company.
  4. Private limited companies cannot sell their shares to the general public whereas public limited companies can issue their shares on a stock exchange
  5. Many businesses decide to “go public” by floating their shares on a stock exchange for the first time. This is known as IPO
  6. Long-term source of finance
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16
Q

Function of a stock exchange

A
  1. A stock exchange (or stock market) enables companies to raise capital and to provide a market for second-hand shares and government stock
  2. The london, tokyo, and new york stock exchange are among the biggest in the world
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17
Q

IPO

A
  1. Initial Public Offering
  2. IPO refers to a business converting its legal status to a public limited company by floating or selling their shares on a stock exchange for the first time
  3. Popular IPOs are heavily oversubscribed, which pushes up the share price
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18
Q

Pros of share capital

A
  1. Permanent source of capital which would not have to be repaid to shareholders
  2. No interest is paid
  3. Can raise large sums of capital
  4. No parameters on how to spend the money
  5. Can act as marketing for the business
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19
Q

Cons of share capital

A
  1. Dividends are paid after tax whereas interest on loans is paid before tax is deducted
  2. Dividends will be expected by the shareholders
  3. The ownership of the company could change hands if many shares are sold which the owners might object to
  4. Can only be done for incorporated companies so it is not available for sole traders and partnerships
  5. Financial records are made public if you are a public limited company
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20
Q

Loan Capital

A
  1. Medium/Long term sources of finance that are obtained from commercial lenders such as banks
  2. Money is borrowed which is to be paid back in instalment over a predetermined period such as 5, 10, or 25 years.
  3. Interests charges are imposed and can be fixed or variable
  4. e.g. mortgage or business development loans
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21
Q

Mortgage

A
  1. A secured loan for the purchase of property such as land of buildings
  2. If the borrower defaults on the loan (unable to pay back) then the lender can repossess the property (take back)
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22
Q

Business development loan

A
  1. These are catered to meet the specific development needs of the borrower
  2. Businesses can use these loans to start or expand their business
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23
Q

Debentures

A
  1. There are long-term loans issued by a limited liability business in the form of a debenture certificate to lenders
  2. Debenture holders (people buying certificates) can be individuals, governments, or other businesses
  3. The debenture holders receive interest payments even if the business make a loss and before shareholders and paid any dividends. The interest can be fixed or variable
  4. Unlike shareholders, debenture holders usually do not have ownership or voting rights so it provides the business a long-term source of finance without the business loosing any control
24
Q

Pros of Debentures

A
  1. Debentures can be used to raise very long-term finance
  2. Huge sums of money
  3. Does not result in the business loosing any control
25
Q

Cons of Debentures

A
  1. As with loans, these must be repaid and interest must be paid
  2. Can increase a firms gearings (more borrowing as a percentage of its capital employed). This will raise interest payments to the lender and increase the firm’s exposure to risk
26
Q

Pros of loan capital

A
  1. Paid in instalments which help with cash flow
  2. Generate a large amount of cash
  3. Usually quick to arrange
  4. Large companies are often offered low rates of interest by banks if they borrow large sums
27
Q

Cons of loan capital

A
  1. As with loans, these must be repaid and interest must be paid
  2. Not available for all businesses (small businesses may not be able to get a loan)
  3. Can cease assets if the loan is not paid back
  4. Security or collateral is usually required which may mean that if the business fails to repay the loan or the interest, the bank can take property of the business (for a sole trader possible their own house)
28
Q

Overdrafts

A
  1. Arranged by a bank
  2. The overdraft allows the business to temporarily continue withdrawing money even when the account has no funds in it or has insufficient funds to cover the amount of the withdrawal.
  3. Bank can be below 0. Interest is charged on a daily basis if a business overdraws on its account
  4. Overdrafts are commonly used when businesses have minor cash flow problems such as retailers stocking up for peak trading periods or when businesses sold items on credit
  5. Short-term source of finance
29
Q

Pros of overdrafts

A
  1. The business could use this finance to pay wages or suppliers but it cannot do this indefinitely
  2. The overdraft will vary each month with the needs of the business so it is flexible
  3. Interest will be paid only on the amount overdrawn
  4. Overdrafts can be cheaper than short-term loans
  5. Can provide flexibility for businesses that might occasionally face cash flow problems
30
Q

Cons of overdrafts

A
  1. Interest rates are variable, unlike most loans which have fixed interest rates (variable is harder to predict and is usually bigger)
  2. The bank can ask for the overdraft to be repaid at very short notice. Overdrafts are repayable on demand from the lender
31
Q

Trade Credit

A
  1. When a business makes or buys a sale at the time of purchase, the seller or credit provider does not receive any cash from the buyer until a later date
  2. also known as Buy now and pay later
  3. Organizations that offer trade credit (known as creditors) usually allow between 30-60 days for their customers (known as debtors) to pay
  4. Short-term source of finance
32
Q

Pros of trade credit

A
  1. It is almost an interest-free loan to the business for the length of time that payment is delayed for
  2. Helps with flexibility on cash flow problems
33
Q

Cons of trade credit

A

The supplier may refuse to give discounts or even refuse to supply any more goods is payment is not made quickly

34
Q

Grants and Subsidies

A
  1. Outside agencies like the government give grants and subsidies.
  2. Grants are usually offered as one-off payments which help small business start-ups or help to stimulate economic activity
  3. Subsidies are similar to grants but they are ways to reduce costs of production. Subsidies are often approved for essential products and services such as healthcare and education
  4. Can be short/medium/long-term sources of finance
35
Q

Pros of grants and subsidies

A
  1. Often do not have to be repaid
  2. Do not cut into profit margins
  3. Although firms may have to charge lower prices, profit is made up by the financial support of government subsidy
36
Q

Cons of grants and subsidies

A
  1. They are often given with “strings attached” for eg the firm must locate in a particular area
  2. They are often hard to obtain (especially from the government)
37
Q

Debt Factoring

A
  1. A debtor is a customer who owes a business money for goods bought.
  2. Debt factors are specialist agencies that buy the claims on debtors of business for immediate cash
  3. The debt factors demand a fee (usually a percentage of how much is owed) and they take on the debt and chase down the customer for the outstanding debt
  4. Most debt factoring service providers offer between 80-85% of the outstanding payments from debtors within 24 hours once the application has been approved so it is an immediate source of finance
  5. Short-term source of finance
38
Q

Pros of debt factoring

A
  1. Immediate cash is made available to the business

2. The risk of collecting the debt becomes the factor’s and no the business’s

39
Q

Cons of debt factoring

A
  1. The business does not receive 100% of the value of its debt
  2. Usually a last resort
  3. There are also additional charges for management and administration of accounts. The larger the value of debtors, the higher the charges tend to be due to the increased risks involved
  4. Not eligible to all firms especially smaller ones
40
Q

Leasing

A
  1. Leasing an asset allows the business to use the asset without having to purchase it. The legal owner of the asset is still the lessor
  2. A contract has to be agreed between a leasing company (the lessor) and the customer (the lessee)
  3. Monthly leasing payments are made. The business could decide to purchase the asset at the end of the leasing period
  4. Usually fixed assets
  5. Can be short/medium/long term sources of finance
41
Q

Pros of leasing

A
  1. The business does not have to find a large cash sum to purchase the asset to start with so it is suitable for businesses that do not have the initial capital to buy such assets which releases cash for other purposes in the business
  2. The care and maintenance of the asset are carried out by the leasing company
  3. The spending on leased assets is classed as a business expense so the tax bill of the lessee is reduced
42
Q

Cons of leasing

A
  1. The total cost of the leasing charges will be higher than purchasing the asset
  2. You don’t actually own the asset - you have to return it at the end of the leasing contract
43
Q

Sale-and-leaseback

A
  1. Involves a business selling a particular fixed asset (to raise finance) and immediately leasing the property back
  2. The business transfers ownership although the asset does not physically leave the business
44
Q

Hire purchase

A
  1. Allows a business to pay its creditors in instalments, usually over 12 or 24 months
  2. The asset is legally the property of the creditor until all payments have been made
  3. A deposit or down payment is usually required
  4. It is different from leasing because the buyer eventually owns the asset on payment of the last instalment
45
Q

pros of hire purchasing

A

The business does not have to find a large cash sum to purchase the asset

46
Q

cons of hire purchasing

A
  1. A cash deposit is paid at the start of the period

2. Interest payments can be quite high

47
Q

Venture Capitalists

A
  1. This is a form of high-risk capital usually in the form of loans or shares that is given by venture capital firms, usually at the start of a business idea
  2. Venture capitalists try to invest in small to medium sized businesses that have high growth potential
  3. There is a big chance of business failure but also significant returns if the business succeeds hence it is important to present a coherent and convincing business plan to venture capitals
  4. Venture capitalists can also provide advice about the strategic direction of the business
  5. Short/Medium/Long-term source of finance
48
Q

Criteria for a venture capitalist of business angel to invest in a firm

A
  1. Return on Investment: Investors want a return on their capital so venture capitalists know a huge majority of business start-ups fail outright, so each business in their investment portfolio has to have good potential to be highly profitable
  2. Business Plan: This should outline the long-term aim and purpose of the business venture. This creates both direction and an identity for the business so investors feel confident that the business understands the market it is in
  3. People: Show that you have a capable team who can help the business succeed as no individual can have all the skills, experiences or contacts required to run a business successfully
  4. Track Record: Investors will assess the past track record of a business and its management before investing any capital
49
Q

Pros of venture capitalists

A
  1. Can help a business to grow quickly due to it being a fast way to obtain cast
  2. Venture capitals can provide advice and vital networking to help your business
  3. Usually provides large sums of money
  4. Usually there is no obligation to return the money
50
Q

Cons of venture capitalists

A
  1. The investors will own a stake in your company
  2. Your company may not be ready to grow
  3. Risky
  4. Lengthy and complicated process
  5. It is very hard to get a venture capitalist to invest in your business/firm
51
Q

Business angels

A
  1. These are extremely wealthy individuals who are choosing to invest their own money in businesses that might offer high growth potential
  2. It is unlike venture capital in the sense that those are usually a pool of professionally funds while business angels provide funds for firms that are usually unable to secure loans from banks or are too small to attract the attention of venture capitalists
  3. Usually less aggressive than venture capitalists
  4. Short/Medium/Long-term source of finance
52
Q

Pros of business angels

A
  1. Can provide a wealth of experience and financial backing
  2. Can help a business to grow quickly due to it being a fast way to obtain cast
  3. Provide funding for firms that are usually unable to secure loans from banks or are too small to attract the attention of venture capitalists
53
Q

Cons of business angels

A
  1. The investors will own a stake in your company
  2. May lose control as the business angel is most likely taking a proactive role in the setting up or running of the business venture
  3. Business may eventually have to buy out the stake owned by the business angel
  4. They may have a lack of experience on a specific field or industry
  5. Business angels tend not to make follow-on or continual investments in the same firm
54
Q

Short-term sources of finance

A
  1. Refers to the current fiscal (tax) year.

2. For external sources of finance, it is anything that has to be repaid to creditors within the next twelve months

55
Q

Medium-term sources of finance

A
  1. Refers to the time period of more than twelve months but less than five years
  2. Medium term sources of finance include commercial loans in excess of a year
56
Q

Long-term sources of finance

A
  1. Refers to any period of five years or longer

2. The longer the time period in question, the harder it becomes to plan effectively

57
Q

Share issue

A
  1. aka share placement

2. Share issue exists when an existing public limited company raises further finance by selling more of its shares

iB Business Management (14 decks)

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