Sources of Finance

Sources of finance are the options available to a business when seeking to raise funds to support future business actions

For a start-up business this might be raising sufficient capital to establish the business

For an established business this might be to fund growth or implement a new strategy e.g. relocation

Sources of finance can be:

Internal i.e. from within the business e.g. retained profit

External i.e. from outside of the business e.g. loans

Internal sources of finance include:

Retained profit

Net current assets

Sale of assets

Profit kept within a business from profit for the year to help finance future activities

Retained profit can be used as a short term source e.g. to fund day to day activities or accumulated over time and used as a long term source

Advantages:

Avoids interest repayments

Does not dilute the business ownership

Disadvantages:

Only an option if sufficient retained profit exists within the business

May cause shareholder dissatisfaction if this is at the expense of dividend payments

Reduces the security blanket of keeping retained profits for unforeseen situations or to take advantage of new opportunities

Current assets are items of value owned by a business that will be used and change in value within a year

Inventory

Trade receivables

Cash and cash equivalents

Current liabilities are items owed by a business that are to be repaid within a year

Trade payables

Overdrafts

Net current assets = current assets – current liabilities

Advantages:

No interest repayments or loss of ownership

Disadvantages:

May lower profitability if lose discounts for early payments

Sale of assets refers to the sale of a long term or fixed assets

Fixed assets will stay in the business for more than a year e.g. machinery and vehicles

These assets can be sold in order to get an immediate injection of cash in to a business and thereby provide finance

The benefits are:

No interest charges or repayments

May be turning an obsolete asset into finance Immediate lump sum cash injection

However:

May be expensive in the long run if need to lease the asset back

Loss of use of the asset and future value Is only a one off option

External finance is capital raised from outside of the business

A source of finance is where the finance is coming from i.e. the provider e.g.

- family and friends

- banks

- peer to peer funding

- business angels

- crowd funding

- other businesses

A method of finance is how the finance is provided e.g.

- loans

- share capital

- venture capital

- overdrafts

- leasing

- trade credit

- grants

Owner’s capital is how much the owner has invested in the business

Owner’s capital shows the proportion of the business’ assets that are owned by the business owner rather than creditors

Owner’s capital can be from:

personal savings e.g. an entrepreneur setting up as a sole trader or partnership

share capital when a business sells shares in return for part ownership in the business

The benefits are:

Do not have to repay

No interest charges

Owner(s) maintain control

Risking own savings can be motivational

Do not have to go through any lengthy application procedures

However:

May only be limited amounts available T

hreat to personal finances and family

Finance raised from the sale of shares

This is a form of equity capital i.e. the shareholder becomes a part owner of the business

Shareholders will be rewarded for their investment by the payment of dividends but may also benefit from an increase in share price increasing the value of their shares

Only an option for incorporated businesses i.e. Ltds and Plcs

Issuing shares is a complex and costly process so only really an option for raising large amounts of finance to fund long term projects

Advantages:

Only need to pay dividends if a profit is being made and the amount of dividend is not fixed

Possible to raise large amounts of finance

No interest repayments

Disadvantages:

Loss of ownership as shareholders are part owners

Potential risk of loss of control for a Plc with a threat of hostile takeovers

Complex and costly process of issuing shares, especially for a Plc

A set amount of money provided for a specific purpose, to be repaid with interest, over a set period of time

May be secured against an asset and if there is a default on repayments the asset can be taken

Financial institutions can vary interest rates depending upon the amount of risk placed on the loan

An external source of finance generally considered to be more suitable for longer-term projects

However this will depend upon the size of the loan and the repayment period

Advantages:

Quick and easy to secure

Fixed interest rates allow firms to budget

Improved cash flow

The borrower retains ownership of the company

Disadvantages:

Interest must be paid regardless of financial performance

A firm that is highly geared may be seen as high risk

A firm normally provides security known as collateral and is often more expensive than other forms of finance

Can be charged a penalty for early payment

Crowd-funding involves raising finance from a large number of people each investing different, often small, amounts of money

The business uses the internet to explain how much money is required, how it will be used and the exit strategy stating predicted return on the investment

The investor is only tied into their promised contribution if the total amount is raised

Investment from an established business into another business in return for a percentage equity in the business

Also known as private equity finance

Venture capitalists will normally look for a high rate of return in a specific time period

The business or entrepreneur may also benefit from expertise and mentoring from the venture capitalist

Often associated with high risk start-ups

Advantages:

Potential for large sums of money for investment

Expertise to help the business

Makes it easier to attract other sources of finance

Provides the required capital for expansion

Disadvantages:

A long and complex process

Expert financial projections are likely to be required

Initially expensive for the firm e.g. legal and accounting fees

Partial loss of ownership

Risk of conflict or perceived interference

The process of selling the debts owed to a business to a financial institution

The business will receive funds immediately but at a reduced rate e.g. may only receive 80% of the total value of the debt

After the debt has been paid the business will receive further payment but the financial institution will keep a percentage of the repayment as a fee

An external source of finance

Advantages:

Receives a large amount of the debt immediately

Good source of short-term finance to address cash flow problems

Debts are chased by experts saving managers time

Reduces the risk of bad debts

Disadvantages:

Reduces profitability of the firm as a result of the fee paid to the financial institution

May damage the reputation of the firm as they are seen to be in need of short-term finance

Allows a business to enjoy the use of an asset whilst paying for it in regular instalments

The asset remains the property of the seller up until the point where all instalments have been made at which point it becomes the property of the buyer

Avoids one off lump sum payments

Interest will normally be charged on top of the cost of the asset

Leasing allows a business to benefit from the use of an asset without owning it or buying it outright

The business pays a set amount in instalments to lease the asset for a pre determined period of time

The asset remains the property of the leasing company and at the end of the time period the asset is returned to the lease company and the business stops making the payments

Avoids the need to finance the asset but may be more costly in the long run

However the lease company is responsible for any repairs and maintenance

At the end of the lease period the business may start a new lease agreement for the latest model e.g. new spec photocopier!

Trade credit is paying suppliers a period of time after the goods or services have been received

In effect the supplier is providing the business with finance for the period of the trade credit e.g. 30 days

The business may lose out on discounts offered for immediate or quick payment increasing costs

Grants are fixed amounts of capital provided to business by the government or other organisations to fund specific projects

Often conditions are attached to the grants for example:

Locate in an area of high deprivation

Provide employment

Reduce negative environmental impacts

Support a good cause

Finance provided by an individual or organisation to support the activities of another organisation

Normally only available to non-profit organisations such as charities and social enterprises

Relies on the generosity of others

May be severely cut at times of economic difficulties

Have to ensure the cost of receiving the donations does not outweigh the amount received in donations!

The practise of an individual lending to other individuals (peers) with whom there is no relationship or contact

Borrowers are given a credit rating

Normally an unsecured personal loan although on some occasions collateral may be offered

Cuts out the use of traditional intermediaries e.g. banks

Lending is done online

Lenders decide who they want to lend to then compete to win the lending opportunity in a reverse auction i.e. the lender willing to offer the lowest interest rate wins

The lenders motive is profit

Business may be able to negotiate a discount on invoices from suppliers

This in affect reduces costs, hence freeing up finance for other purposes

This may be achieved as a result of early payment or bulk buying

Although finance is received helping cash flow in the short term this may have a negative effect on profitability in the longer term