Unit 3.2 Sources of finance

Question 1

Internal sources of finance

Answer 1

Refer to money or funds that come within the business

Question 2

What are the three internal sources of finance

Answer 2

1. Personal funds
2. Retained profit
3. The sale of assests

Question 3

Definition of personal funds

Answer 3

refers to the use of an entrepreneur’s own savings

Question 4

Advantages of personal funds (4)

Answer 4

-Personal funds do not need to be repaid.

-There are no interest charges incurred either, unlike with external finance.

-By investing their personal funds, sole traders and partners have a better chance of being able to borrow money if they need to, as it shows greater commitment to the business venture.

-Whilst internal sources of finance are the cheaper of the two options, external sources of finance usually generate much more funds for a business.

Question 5

Disadvantages of personal funds (3)

Answer 5

-As sole traders represent relatively high risk, they are less likely to be able to secure external sources of finance, so need to rely on their personal funds.

-Personal funds are rarely sufficient for most small businesses.

-Many entrepreneurs risk their entire life savings in a business venture. In particular, sole traders and partners risk losing all their personal funds if the business venture fails.

Question 6

Definition of retained profit

Answer 6

Retained profit comes from having a financial surplus. These funds are reinvested in the business, rather than being distributed to the owners (shareholders).

Question 7

Advantages of retained profit (3)

Answer 7

-As an internal source of finance, retained profit does not incur any interest charges.

-As the money belongs to the business, it is considered as a permanent source of finance, because it doesn’t have to be repaid. If a business project fails, the use of retained profit does not necessarily pull the organization into debt.

-The business also has great flexibility in the use of retained profit - the business can use this for any purpose within the business. By contrast, bank loans are approved for specific uses only.

Question 8

Disadvantages of retained profit (3)

Answer 8

-Start-up business don’t have any retained profit, so this is not a possible source of finance for creating a new business.

-Retained profit is rarely enough as a sole source of finance for most businesses in their pursuit of growth and evolution.

-Using the funds as retained profits for use to grow the business means there is less dividends paid out to shareholders and owners of the business.

Question 9

Definition of profit

Answer 9

Profit is when a firm’s total revenue exceeds its total costs

Question 10

Assest

Answer 10

asset is anything that a business owns and has a marketable value, such as buildings, vehicles, computers, equipment and intellectual property

Question 11

Non-current assets

Answer 11

items a business owns and:
-uses for a period of more than 12 months
-can be used repeatedly
-generates income for the organization.

Question 12

advantages of using the sale of assets as an internal source of finance include (3)

Answer 12

A large sum of money can be raised. For example, selling a fleet of old motor vehicles or a redundant (unused) office building can raise much needed finance for a business.

The sale of excess resources, redundant assets or obsolete (outdated) belongings is a sensible way for a business to raise finance. The alternative is that these resources would tie up much needed working capital for the organization.

Again, there are no costs of borrowing involved or interest repayments to make.

Question 13

disadvantages of the sale of assets as an internal sources of finance too, (3)

Answer 13

The sale of certain non-current assets can hinder a firm’s productive capacity. For example, a struggling business that sells some of its computer equipment or machinery, which may actually be needed for production.

It can be very time consuming to find a suitable buyer for second-hand assets, especially if these are obsolete. Even if a buyer can be found, the purchase price is likely to be very low as the business is in a weaker bargaining position, especially if the business is desperate for cash.

The option of asset sales is only available to established businesses; new businesses are unlikely to be in such a position.

Question 14

External source of fiance

Answer 14

refers to money or funds that come from outside the business

Question 15

What are the 8 sources of external finance

Answer 15

-Share capital
-Loan capital
-Overdrafts
-Trade credit
-Crowdfunding
-Leasing
-Microfinance providers
-Business angels

Question 16

what is Share capital

Answer 16

is finance raised through the issuing of shares via a stock exchange/ stock market

long-term source of finance for limited liability companies, obtained by selling shares in the company.

Question 17

what is an IPO ( initial public offering)

Answer 17

When a limited liability company sells its shares for the very first time on a public stock exchange

Question 18

main functions of a stock exchange are to: (3)

Answer 18

-enable existing companies to raise share capital (through a share issue)

-oversees the initial public offering (IPO) of new publicly held companies

-to provide a market for trading of second-hand shares (and government bonds,).

Question 19

Advantages of a share capital (4)

Answer 19

-It is permanent capital as it does not need to be repaid (shareholders sell their shareholdings to other buyers via the stock exchange).

-There are no interest payments made to shareholders, thus this reduces the expenses of the company.

-Unlike loan capital, share capital does not involve debt or incur interest repayments.

-Any publicly held company can raise further finance by selling additional shares (a process known as a share issue).

Question 20

Disadvantages of share capital (3)

Answer 20

-Shareholders need to (at some point) be paid dividends if the company earns a profit.

-Although share capital can raise a lot of money for a company, the ownership and control of the organization may be diluted.

-Only publicly held companies can trade their shares using the stock market.

Question 21

what is Loan capital

Answer 21

refers to borrowed funds from financial lenders, such as commercial banks.

Loan capital is typically used to purchase non-current assets, such as machinery and property.

Question 22

what are the types of loan capital (4)

Answer 22

Bank loans
Mortgages
Debentures
Corporate bonds

Question 23

What is debenture

Answer 23

long-term loans issued by organizations that borrow money from investors and commit to repaying it with interest. Unlike secured loans, debentures are not backed by specific assets but depend on the borrower’s creditworthiness

Question 24

what are corporate bonds

Answer 24

These are debt securities (guarantees) sold to investors

Question 25

Advantages of loan capital (3)

Answer 25

-It enables the borrower to repay in regular instalments, making loan capital more accessible and affordable for many businesses as it is not burdened by having to pay a large lump sum of money.

-Large businesses are often able to negotiate a lower rate of interest on their loans (financial economies of scale).

-Loan capital is suitable if the owners need to raise finance but do not want to dilute their ownership or potentially lose control through issuing shares.

Question 26

Disadvantages of loan capital (3)

Answer 26

-Interest is charged on the amount of borrowed funds. The interest rate can be a fixed or variable rate.

-In many cases, businesses have to offer collateral (security) before loans can be approved. Failure to repay the loan can lead to the lender being able to legally seize the firm’s assets to pay for the outstanding amount borrowed.

-Firms that borrow loan capital on variable interest rates may suffer from liquidity problems if the rate of interest increases, because their debt repayment burden will increase.

Question 27

What is an overdraft

Answer 27

a financial service that allows a business to temporarily overdraw on its bank acccount,
i.e. to take out more money than it has in the account

Question 28

Advantages of overdrafts (3)

Answer 28

• when there is a need for a large cash outflow
  -Overdrafts are quite easy to obtain, (so are an important source of external finance for small businesses in particular).

-Overdrafts provide businesses with emergency funds to finance their operations, such as making payment to suppliers / wages to staff, during times when liquidity is a problem.

-It provides great flexibility for businesses as overdrafts are only used as and when needed.

Question 29

Disadvantages of overdraft (4)

Answer 29

-Interest is charged on the amount overdrawn, usually at rates higher than those charged for ordinary bank loans.

-Banks usually only lend a small amount of money, in order to keep a business operation; it is not a suitable source of finance for purchasing non-current assets, for example.

-Banks can ask for overdrafts to be repaid at very short notice.

-It is essentially a high cost, short-term loan for businesses.

Question 30

what is trade credit

Answer 30

Trade credit enables a customer to purchase and obtain goods and services but to pay for these at a later date. (typically 30-60 days)

Question 31

Advantage of trade credit (2)

Answer 31

-Buying goods and services on trade credit does not incur any interest charges if the amount owed is paid in full within the trade credit period.
-can help when firms are struggling with cashflow

Question 32

what is crowdfunding

Answer 32

raising small amounts of money from a large number of people to fund a particular business project or venture

Question 33

equity crowdfunding

Answer 33

involves the sale of a stake in a business to a number of investors in the crowd

Question 34

donation-based crowdfunding

Answer 34

individuals donate small amounts of money to help fund a specific charitable project while receiving no financial stake or return for doing so.

Question 35

Advantages of crowdfunding(4)

Answer 35

-As each individual lends a relatively small amount of money to the fundraiser, this limits the risks and impacts should the business project fail to succeed.

-It avoids the need for business owners or entrepreneurs to deal with commercial banks, which is often a time-consuming and bureaucratic process.

-Many people can invest in the business, so this can help to raise lots of much-needed finance for small to medium-sized enterprises.

-Unlike business angels, individuals of the crowd do not take any controlling interest in the organization.

-Crowdfunding is usually less costly than being listed on a public stock exchange.

Question 36

Disadvantages of crowdfunding (3)

Answer 36

-There are legal challenges and considerations, such as transparent disclosure of legal documents, holding annual general meetings with investors, and publication of annual reports. This adds to the costs of the business.

-There needs to be due diligence Investors have the option to ask for additional information from the fundraiser, so this can delay decision making and incur additional costs for the business.

There are a lot of cases of crowdfunding scams. The loose regulatory requirements for crowdfunding in many parts of the world exposes investors to fraud.

Question 37

Leasing

Answer 37

involves the business or customer drawing up a contract with the leasing company to use particular non-current assets for an agreed fee. Examples: machinery, tools, equipment,

Question 38

Advantages of leasing (3)

Answer 38

-The lessor does not have to purchase the expensive equipment, machinery, vehicles or other type of capital. Instead, its money can be used for revenue expenditure purposes.

-The lessor takes responsibility for the maintenance of the capital equipment and other leased property. This helps to cut the operating costs of the lessee.

-Leasing is particularly advantageous if the business only needs to use the fixed capital for a short period of time, or if it does not want to deal with the hassles and costs of repairs and maintenance.

Question 39

Disadvantages of leasing (2)

Answer 39

With leasing, the lessee never owns the asset. Ownership remains with the lessor (the leasing company) before, during and after the leasing contract.

Over a long period of time, leasing can be more expensive than buying the asset outright due to the accumulated costs of leasing the asset over time.

Question 40

Sale-and-leaseback

Answer 40

Involves a business selling a particular fixed assets and immediately leasing th property back.

i.e. the business transfers ownership although the asset does not physically leave the business

Question 41

Microfinance providers

Answer 41

for-profit social enterprises that offer a financial service to those without a job or on very low incomes.

Question 42

aim of microfinance

Answer 42

help entrepreneurs struggling to finance their business start-ups to gain access to loans of a small amount. Microfinance can give these people the opportunity to become self-sufficient and empower them to run their businesses. As with the majority of loans, interest is charged on the amount borrowed, although these are typically lower than what commercial banks would charge.

Question 43

Advantages of microfinance providers (4)

Answer 43

-Microfinance can help many people to get out of poverty by making them become financially independent.

-can help to create new job opportunities

-Microfinance can create benefits for the wider community, such as improved healthcare, education and employment opportunities.

-Microfinance can help to build and foster a culture of entrepreneurialship and economic independence.

Question 44

Disadvantages of microfinance providers (5)

Answer 44

Due to relatively low profitability, microfinance providers may struggle to attract and/or retain employees and managers, given that their remuneration packages are unlikely to be matched by larger for-profit financial companies such as commercial banks and insurance companies.

Microfinance only provides finance on a small scale, so is unlikely to be sufficient to make a real difference to society as a whole.

Microfinance loans incur interest charges, so can be rather expensive for small business owners who find it difficult to earn enough revenue to keep up with their loan repayments.

Microfinance increases the debts of entrepreneurs who may subsequently struggle in their business venture.

Some people regard the practice of microfinance providers as being unethical as they earn profits from low-income individuals and households.

Question 45

Who are business angels

Answer 45

are wealthy and successful private individuals who risk their own money in a business venture that they perceive has high growth potential.

i.e. high-risk, high-return business ventures

Question 46

what business angles consider before investing(4)

Answer 46

-Return on investment (positive)
-The business plan
-People (good team of people)
-Track record

Question 47

Advantages of business angels (3)

Answer 47

-Business angels provide an essential source of finance for start-ups and small businesses that are unable to secure finance from conventional providers of finance, such as commercial banks and other financial institutions.

-The business can benefit from the expertise and experiences of the business angels, who are likely to provide their input in order to secure a significant return on their investment (ROI).

-It is particularly useful for small businesses and inexperienced entrepreneurs who are unable to raise sufficient finance on their own, such as those which are unable to secure loan capital or those that are not permitted to sell shares on a public stock exchange.

Question 48

Disadvantages of business angels (4)

Answer 48

-For the business angels, such business ventures are extremely high risk, especially as they risk losing their personal money. Hence, the amount of finance available is often not easily available for start-ups and small businesses.

-This also means that there are no guarantees than angel investors will earn a satisfactory ROI, despite the high potential returns.

-Such finance is difficult to come by, not only due to the risks involved but also due to the large number of entrepreneurs competing for such funds.

-The use of business angels will dilute the firm’s control and ownership as the angel investors will want a share and say in the organization.

Question 50

Short-term finance

Answer 50

refers to sources of finance needed for the day-to-day running of a business, i.e., its revenue expenditure.

Question 51

examples of short-term finance (4)

Answer 51

Personal savings
Sale of assets
Overdrafts
Trade credit

Question 52

Long-term finance

Answer 52

refers to sources of finance of more than one year from the balance sheet date.

The finance is used mainly to pay for fixed assets, i.e., capital expenditure such as the purchase of capital equipment, machinery, and motor vehicles.

Question 53

Examples of long-term finance (6)

Answer 53

-Share capital
-Loan capital, such as mortgages
-Leasing
-Business angels
-Microfinance providers
-Crowdfunding

Question 54

Appropriateness of sources of finance for a given situation (SPACED)

Answer 54

• Size and status of the firm
  -purpose of finance
• amount required
• cost of finance
  -external factors
  -duration