Business Management Unit 3 Chapter 3.2 Sources of Finance PDF

3.2 SOURCES OF FINANCE Mtro. Ian M. Guillen  INTERNAL SOURCES OF FINANCE  PERSONAL FUNDS Key source for sole traders. Comes from personal savings. Maximizes their control over the business. Shows personal commitment. Good signal for investors or financial institutions....

3.2 SOURCES OF FINANCE Mtro. Ian M. Guillen  INTERNAL SOURCES OF FINANCE  PERSONAL FUNDS Key source for sole traders. Comes from personal savings. Maximizes their control over the business. Shows personal commitment. Good signal for investors or financial institutions.  A D VA N TA G E S Knows exactly how much money is available to run the business. Provides the sole trader with much more control over the finances than other finance options. No need to pay the funds back. Do not rely on outside investors or lenders who could decide to withdraw their support any time.  D I S A D VA N TA G E S Poses a large risk to the owners or sole traders because they could be investing their life's savings. If not sufficient it may prove difficult to start or maintain a business  R E TA I N E D P R O F I T S Profit that remains after the business has paid out dividends to its shareholders. Also known as ploughed-back profit and may be reinvested back into the business for growth purposes. One of the most important long-term sources of finance for a business.  A D VA N TA G E S Cheap, because it does not incur interest charges Permanent, as it does not have to be repaid Flexible, it can be used in any way the business deems fit. Owners have control over their retained profits without interference from others  D I S A D VA N TA G E S Start-up businesses will If too low, may not be High-retained profit may Could be less attractive nor have any retained sufficient for business to mean that either very to stock buyers than profits grow or expand. little or nothing was paid business that distributes out to shareholders as dividends generously. dividends.  SALE OF ASSETS Selling unwanted or unused Assets that are no longer To raise cash, business could assets to raise funds. required by the business also sell off any excess land include obsolete machinery or equipment they may not or redundant buildings. be using.  A D VA N TA G E S Good way of raising cash from No interest or borrowing cost are capital that is tied up in assets which incurred are not being used.  D I S A D VA N TA G E S Only available to Time-consuming established to find buyer for businesses as new assets, especially businesses may for obsolete lack excess of machinery. assets to sell  EXTERNAL SOURCES OF FINANCE  SHARE C A P I TA L  CHARACTERISTICS Money raised from the sale of shares od a company, also known as equity capital. Buyers are known as shareholders and may be entitled to dividends when profits are made. The term authorized share capital is the maximum amount the shareholders of the company intend to raise. Shares are sold in the stock exchange market, unlike privately held company.  Permanent source of capital as it will not need to be redeemed. If shareholders want to get their money back, they must find a buyer for their shares. A D VA N TA G E S There are no interest payments This relieves the business from additional expenses  Shareholders will expect to be paid dividends when the business makes profit. D I S A D VA N TA GES Ownership of the company may be diluted or change hands from the original shareholders to new ones. L O A N C A P I TA L  Also known as debt. From financial institutions such as banks. Interest ins charged on the CHARACTERIS loan to be repaid. TICS Payments are usually spread evenly. Interest rates may be fixed or variable (prevailing market conditions)  A D VA N TA G E S Accessible and can be arranged quickly for a firm's specific purpose. Repayment is spread out over a predetermined period, reducing the burden of having to pay a high amount. Large organizations can negotiate for lower interest charges depending on the amount they want to borrow. Owners still have full control of the business.  D I S A D VA N TA G E S The capital will have to be redeemed even if the business is making a loss. Collateral (security) will be required before any funds are lent Failure to repay the loan may lead to seizure of a firm's assets. If variable interest rates increase, a firm that has a variable rate loan may be faced with a high repayment burden. OVERDRAFTS  Withdraw more money than it currently has in its account. Overdrawn amount is an agreed amount that has limit placed on it. Interest is charged only on the amount overdrawn Exceeding the limit set may attract higher additional costs. CHARACTERISTICS  A D VA N TA G E S Provides the business an Helps settling short Flexible form of finance Charging interest only opportunity for them to terms debts such as as its demand will on the amount spend more money that paying suppliers or depend on the needs of overdrawn can make it they have in their wages for the staff. the business at a cheaper option than loan accounts. particular point in time. capital.  D I S A D VA N TA G E S Banks can request for the overdraft to be paid back at a very short notice. Due to the variable nature of an overdraft, the bank can at times charge high interest rates. TRADE CREDIT  AGREEMENT BETWEEN NO IMMEDIATE BUSINESSES THAT ALLOWS TRANSACTION OCCURS AT THE BUYER OF GOODS OR THE TIME OF TRADING. SERVICES TO PAY THE SELLER AT A LATER DATE. CHARACTERIS TICS THE CREDIT PERIOD OFFERED BY MOST CREDITORS OR SUPPLIERS USUALLY LASTS FROM 30 TO 90 DAYS.  A D VA N TA G E S By delaying payments to suppliers, businesses are left in a better cash flow position that if they paid in cash immediately. It is an interest free means of raising funds for the length of the credit period.  D I S A D VA N TA G E S Delaying payment to Debtors lose out the creditors or suppliers possibility of getting after they agreed discounts had they period may lead to purchased by paying further relations cash. between the debtors and suppliers. CROWDFUNDIN G  CHARACTERISTICS THIS IS WHERE A BUSINESS MAKES USE OF THE VAST ITS SUCCESS RELIES UPON EXAMPLES OF VENTURE OR PROJECT IS NETWORKS OF PEOPLE WHO THE ABILITY TO APPEAL TO A CROWDFUNDING FUNDED BY A LARGE CAN BE ACCESSED SUFFICIENTLY LARGE GROUP PLATFORMS INCLUDE NUMBER OF PEOPLE EACH PRIMARILY ONLINE THROUGH OF POTENTIAL INDIEGOGO, KICKSTARTER, CONTRIBUTING A SMALL CROWDFUNDING WEBSITES CONTRIBUTORS IN ORDER 40BILLION, AMOUNT OF MONEY. OR SOCIAL MEDIA. TO REACH A SPECIFIC FUNDINGFORLEARNING AND FINANCIAL TARGET FUNDABLE  A D VA N TA G E S Crowdfunding provides access to thousands of investors who can see interact with and share project’s fundraising campaign. It is a valuable form of marketing because pitching a project or business through the online platform can result in media attention that publicizes the business. it provides an opportunity for feedback and expert guidance by sharing the business idea suggestions about how to improve it can be provided by a team of experts. the business still maintains full control and won't have to forfeit control when raising funds. it is a good alternative finance option as it provides another pathway for businesses that have struggled to get bank loans or traditional funding.  D I S A D VA N TA G E S Businesses crowdfunding is there are The business is Having a solid Fees need to be many seeking quite popular numerous subject to idea does not paid. crowdfunding crowdfunding because of its projects on the thorough scrutiny mean it is going platforms take a have strong advantages and major platforms and rejection. to be accepted by percentage of the competition accessibility at any given the crowdfunding contributions time, so platform. raised. businesses need a detailed plan of attack and a clever way to differentiate themselves from the competition. LEASING  CHARACTERISTICS This is where a business enters into a contract with a leasing company to acquire or use particular assets such as: machinery, equipment or property. This allows a firm to use an asset without having to purchase it with cash. periodic or monthly leasing payments are made by agreement between the lesser and lessee. In some cases, business may get into a finance lease agreement where at the end of the leasing period, they are given the option of purchasing the asset. Large organizations such as airlines, electronics and car companies are also known to lease their assets.  A D VA N TA G E S Leasing is useful A firm does not The lessor takes on when particular need to have high the responsibility assets are required initial capital of repair and only occasionally outlay to purchase maintenance of the or for short periods the asset. asset. of time.  D I S A D VA N TA G E S Leasing can turn out to be more expensive a least acid cannot than the outright act as a collateral for purchase of an asset a business seeking a due to the loan as an additional accumulated total source of finance. cost of leasing charges. MICROFINANCE PROVIDERS  CHARACTERISTICS Offers banking services to low income or unemployed individuals or groups who would otherwise have no other access to financial services. These include small businesses that lack access to conventional banking services. Microfinance services include microcredit, microinsurance, among other services. The ultimate goal of microfinance is to reach excluded customers and provide them with an opportunity to become self-sufficient..  A D VA N TA G E S Most microfinance institutions do not seek any collateral for providing financial credit. They provide or disburse loans quickly and with less formalities to individuals, groups or small businesses, so they can meet any financial emergency. They have an extensive portfolio of loans, including working capital loans, housing loans, etcetera. They promote self-sufficiency and entrepreneurship. They do this by providing funds to individuals to set up a business that may need minimal investment but will provide a sustainable profit.  D I S A D VA N TA G E S Microfinance institutions They offer smaller loan can adopt harsh recovery amounts or financial The interest rates on their methods in the event of a capital than other loans are high and they default if the customer financial institutions that find it difficult to offer does not have the legal provide a much larger lower rates. representation. amounts. In addition, they borrow money from these banks This is partly because they in order to execute their do not operate in the functions, hence, their same way as traditional operating cost per banks that find it easy to transaction is quite high accumulate funds. despite the large volume of transactions every day. BUSINESS ANGELS  CHARACTERISTICS These are affluent individuals who will provide financial capital to small startups or entrepreneurs in return for ownership equity in their businesses. They invest in high risk businesses that show good potential for high returns or future growth. They may provide a one time initial capital injection or continually support the businesses through their lifetime.  A D VA N TA G E S They are usually successful Their flexibility and Business angels are entrepreneurs who risk-taking attitude more open to No repayment or understand the amount make them one of the negotiation than other interest is required. of risk involved with best sources of finance institutions. establishing a in this situation. business. If the business They offer valuable Angel investors fund succeeds, both the knowledge, and they the business and in business and Angel focus on helping a exchange get an investor benefit, if not, business succeed by ownership stake in the the Angel does not get using their extensive business. paid back. business experience.  D I S A D VA N TA G E S Business angels may They may expect a assume a large degree of substantial return on control or ownership in their investment within the businesses they the first few years, invest in, therefore sometimes equal to 10 diluting the ownership of times their original the entrepreneur. investment. S H O R T- A N D L O N G -T E R M FINANCE  SHORT TERM FINANCE This is the money needed for the day-to-day running of a business and therefore provides the required working capital. External short-term financing is usually expected to be paid back within 12 months or less. Examples of short-term finance include bank overdrafts short term loans and trade credit. The type of finance should match the type of asset being financed.  This is funding obtained for the It is normally used for overall Long term finance sources purpose of purchasing long term improvement of the business. include long term bank loans fixed assets or other expansion and share capital. requirements of a business. LONG TERM FINANCE FA C T O R S I N F L U E N C I N G T H E C H O I C E OF A SOURCE OF FINANCE Purpose or use of funds Cost Status and size Amount required Flexibility State of the external environment Gearing PURPOSE OR USE OF FUNDS Business will need to match the source of finance carefully to their specific requirements What exactly will the finance be used for? Will it be used for the purchase of long-term assets or for the short- term day-to-day running of the business? Long term loan capital may be appropriate when purchasing a fixed asset, well trade credit may be suitable if raw materials are needed urgently for the business  Businesses will need to consider thoroughly all of the costs associated with obtaining resource of finance. Such costs include interest payments, administration costs, and cost associated with a share issue. In addition, the opportunity cost is an important consideration when deciding on the most appropriate source of finance. The opportunity cost, is the last COST benefit that would have been derived from an alternative. S TAT U S A N D SIZE Public held companies have more options in obtaining finance compared to sole traders. This is because all traders are less well known and smaller in size than public held companies. Large organizations have added collateral that they can use to negotiate lower interest rates for financial institutions. AMOUNT REQUIRED For small amounts, for instance may consider mostly short-term sources of finance such as bank overdrafts, well for larger amounts, long term bank loans or the issuing of shares are available options  FLEXIBILITY The ease with which a business can switch from requiring one form or source of finance to another. Businesses may need additional finance at points during the trading period. This could be influenced by, for example, unexpected seasonal change in demand that may require additional financing.  S TAT E O F T H E E X T E R N A L ENVIRONMENT Involves factors that the for example business has no control over increases in interest rates or inflation purchasing cost  GEARING If a company has While a company Refers to a a large proportion that is low relationship of loan capital to geared has a between share share capital it is smaller proportion capital and loan said to be high of loan capital to capital geared. share capital. G E A R I N G R AT I O Gearing ratio = (long capital ÷ capital employed) × 100