Sources of Finance

All you need to know regarding sources of finance under unit 5 of AQA's new specification in business.

  • Created by: GeorgeB16
  • Created on: 12-01-17 18:40

Short-Term Finance

Finances the day to day trading of the business. Current liabilities.

  • Bank overdraft
  • Trade creditors
  • Short-term bank loans
  • Factoring
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Medium-Term Finance

Finances major projects or assets with a long life.

  • Bank loans
  • Leasing
  • Hire purhcase
  • Government grants
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Long-Term Finance

Finances the whole business over many years.

  • Share capital
  • Retained profits
  • Venture capital
  • Mortgages
  • Long-term bank loans
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The Need For Finance

Finance is needed for business set-up, day to day trading, and growth and development.

Key Considerations:

  • Amount of finance needed
  • When the finance is required
  • Problems with the finance
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Factors Affecting Finance

  • What the finance is for (short-term / long-term).
  • The cost of the finance such as interest rates on loans and dividends as a result of share capital.
  • Flexibility of the finance such as what repayments may be required and when.
  • The organisational structure of the business, as limited companies find it easier to raise finance than sole traders due to the issue of shares and reliability when taking out loans.
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Main Sources Of Finance For Startup Businesses

Internal:

  • Founder finance
  • Retained profits
  • Friends and family

External:

  • Bank loan
  • Bank overdraft
  • Business angels
  • Government grants
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Types Of Founder Finance

  • Cash and investments
  • Redundancy payments
  • Inheritances
  • Personal credit cards
  • Re-mortgages
  • Putting in free time for the business
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The Importance Of Founder Finance

  • Cheap compared to bank loans
  • Entrepreneur keeps more control over the business
  • The more the founder puts in, the higher the business confidence which encourages others to invest
  • Little red tape or delay
  • Focuses the mind
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Main Sources Of Finance For Established Businesses

Internal:

  • Retained profits
  • Working capital
  • Asset disposals

External:

  • Issue shares
  • Bank loans / overdrafts
  • Debentures
  • Venture capital
  • Suppliers
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Retained Profits

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

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Benefits Of Retained Profits

  • Cheap as the "cost" of retained profits is the opportunity cost for shareholders of leaving profits in the business.
  • Very flexible as management control how they're reinvested and shareholders control the proportion retained.
  • Do not dilute the ownership of the company unlike the issue of new share capital.
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Drawbacks of Retained Profits

  • Danger of hoarding cash which doesn't earn the business much - especially if interest rates are low.
  • Shareholders may prefer dividends if the business is not achieving sufficiently high returns on investment.
  • High profits and cash flows suggest the business could afford debts (higher gearing).
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Working Capital

  • Reducing working capital is a one off benefit of lowering working capital, but it needs to be sustained.
  • Finance is often wasted in excess stock and trade debtors.
  • Look for very low inventory turnover ratio or high debtor days.
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Asset Disposals

  • Potentially another one off boost to finance
  • Examples include spare land and surplus equipment
  • Not all businesses will have spare assets and often occurs after acquisitions
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Share Capital Evaluation

Advantages:

  • Able to raise substantial funds if the business has good prospects
  • Broader base of shareholders
  • Equity rather than debt allows for a lower risk finance structure

Disadvantages:

  • Can be costly and time consuming
  • Existing shareholders' earnings may be diluted
  • Equity has a cost of capital that's higher than debt
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Bank Loans

  • Provide long term finance over a fixed period. The rate of interest can either be fixed or variable. Timing and amount of repayments are set. Ideal if interest rates are low.
  • Good for financing investment in fixed assets.
  • Generally a lower rate of interest than bank overdrafts.
  • Little flexibility.
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Bank Loans Evaluation

Advantages:

  • Greater certainty of funding provided loan terms are followed.
  • Lower interest rates than bank overdrafts.
  • Appropriate method of financing fixed assets.

Disadvantages:

  • Requires security.
  • Interest paid on full amount outstanding.
  • Harder to arrange.
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Bank Overdrafts

  • Short term finance widely used by businesses of all sizes.
  • Loan facility allowing the business to borrow money from the business once their bank balance goes below zero, in return for a high rate of interest.
  • Flexible source of finance in the sense it's only used when needed.
  • Excellent for helping a business handle seasonal fluctuations in cash flow or when the business runs into short term cash problems such as a major customer failing to pay on time.
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Bank Overdrafts Evaluation

Advantages:

  • Easy to arrange.
  • Flexible as only used when cash flow requires.
  • Interest only paid on the amount borrowed under the facility.
  • Not secured on assets of the business.

Disadvantages:

  • Can be withdrawn at short notice.
  • Interest rates vary.
  • Higher interest rate than bank loans.
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Debentures

A debenture is a form of bond or long term loan which is issued by the company, usually with a fixed rate of interest.

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Venture Capitalists

  • Specialist investors in private companies.
  • Often back management buy outs.
  • Manage investment funds designed to achieve high rates of returns.
  • Tend to focus on large business investments.
  • Seek a large share of the share capital and representation on the Board.
  • Look to sell their investment in the medium term (5-7 years).
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Benefits Of Venture Capital

  • Can raise substantial funds.
  • Businesses benefit from specialist investor support.
  • Brings better discipline to business management and strategy.
  • Helps original business owners realise investment.
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Drawbacks Of Venture Capital

  • Requires a high rate of return.
  • Investment often supported by high level of debt in the business.
  • Not a long term investment as venture capitalists aim to sell in 5-7 years.
  • Loss of control as venture capitalists may take a majority share in the company.
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Raising Finance From Suppliers

  • Suppliers provide goods and services in advance of payment, making them trade creditors.
  • As a business expands, the amounts owed to suppliers at any one time also grows.
  • If a business has a strong relationship with suppliers, may be able to obtain better payment terms.
  • Buying in bulk along with good negotiation could allow companies to achieve buying economies of scale.
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