Source of Finance Notes

2. SOURCES OF
FINANCE
BUSINESS
FINANCE

3. THE NEED FOR FUNDS
1. Short Term Needs
- Once a business starts trading it will earn revenue.
This money can be used to meet the day-to-day
running costs of the business, such as wages, raw
materials, components, and premises and utility bills.
- Sometimes, the revenue from sales may not over all
expenditure. This is when the business will need to
borrow money.
- The finance needed to fund day-to-day expenditure is
called short-term finance; this is because it is
usually repaid within one year.

4. THE NEED FOR FUNDS
2. Long –Term Needs –
- When businesses raise money by borrowing and are
repaid for more than one year it is called Long-Term
Finance.
- Some long-term finance comes from the owners. This
is called Capital.
- Capital often remains in the business permanently or
until the business stops trading.
- Other long-term sources may be borrowed from
financial institutions, such as banks. Long term
finance may be used to purchase resources that may be
used repeatedly in a business such as cars, furniture…

5. THE NEED FOR FUNDS
3. Start-Up Capital –
- Funds are most needed when first setting up a
business. This is because a lot of resources are needed
before trading can begin.
- Some of the resources are ‘one-off’ items and may take
many years before they need to be replaced in the
business. This include equipment, vehicles etc.
- Other start-up costs include research, converting
premises, legal fees, website design and marketing.

6. THE NEED FOR FUNDS
4. Expansion -
- Once a business is established, the owners often
want to expand. They may want to;
- Expand capacity to meet growing orders
- Develop new products
- Branch into overseas markets
- Diversify
Businesses often need to raise finance to help fund their
expansion plans; this is because expansion usually requires
heavy expenditure.

7. INTERNAL SOURCES OF FINANCE

8. 24. INTERNAL FINANCE
 The main internal sources of finance for a start-up are as follows:
 Owners' savings: These are the most important sources of
finance for a start-up; they are personal savings of an entrepreneur. Only
applies to businesses that do not have limited liability. Since the legal
identity of the business and owners are the same, this method is
considered to be internal.
 Advantages

 Available quickly
 No interest paid
 Disadvantages

 Limited capital- may not be
enough
 Increases risks for owners

9. 24. INTERNAL FINANCE
 Retained profits

 This is the cash that is generated by the business when it trades profitably. Note that
retained profits can generate cash the moment trading has begun. For example, a start-up
sells the first batch of stock for £5,000 cash which it had bought for £2,000. That means that
retained profits are £3,000 which can be used to finance further expansion or to pay for other
trading costs and expenses.

 Advantages

 Does not have associated costs. No interest
charges
 Does not have to be repaid unlike loans.
 Convenience: Retained profits are the most economical and convenient source of
finance. No advertisement or prospectus has to be issued. No expenses or legal
formalities are involved.
 Goodwill: Retained profits add to the financial strength, credibility and earning capacity
of the business. The company’s borrowing capacity is increased. It can safely face
business cycles and other crisis. Retained profits provide a cushion of security during
adverse conditions.
 Dependable: As an internal source of finance; retained profits are more dependable than
external sources. The amount of funds is not dependent on investors preference and
market conditions.

10. 24. INTERNAL FINANCE
 Disadvantages
 Depends on whether the business makes
profit or losses,
 Retained profits from small firms are
not enough for expansion.
 Low Dividends: Reduces payment to owners/shareholders.
Ploughing back of profits reduces the current rate of
dividends. This may result in dissatisfaction among the
shareholders as they do not get the expected rate of dividend.
 Improper Utilization of Funds: If the purpose for utilization
of retained earnings is not clearly stated, it may lead to
careless spending of funds

11. 24. INTERNAL FINANCE
 Sale of Assets

 Firms can get rid of their unwanted or unusual assets for cash

 Advantages

 Business makes better use of capital that is not used for anything.
Makes sense to dispose of underused assets
 The business is able to raise cash
 Finance development without
extra borrowing
 They can sale and lease it back
 Disadvantages

 Business loses assets which are usually used to judge
the strength of the business
 Takes time to sell some of the assets
 Not suitable for new businesses since they do not have assets to sell

12. 24. INTERNAL FINANCE
ADVANTAGES OF INTERNAL FINANCE DISADVANTAGES OF INTERNAL
FINANCE
The capital is available immediately – there is
no time delay between identifying a need for
finance and obtaining it.
Internal finance can be limited – a business
may not be sufficiently profitable to use
retained profit or may not have unwanted
assets to sell.
Internal finance is cheap – there are no
interest payments which means costs such as
administration costs will be lower and profits
higher.
Internal sources of finance cannot be
subtracted from business profits to reduce tax
owed. If external finance is used, the interest
paid on a loan or leasing charges for assets can
be treated as a business cost and subtracted
from business profits to reduce tax owed.
The business will not be subject to credit
checks. External financed often requires
investigations into credit history of the
borrowers.
Internal finance can be inflexible compared to
external. There are a wide variety of funding
options for external finance, which can give
the business flexibility.
There is no need to involve third parties There are no inflationary benefits with
internal finance. Inflation can reduce the value
of debt if external sources are used.
Opportunity cost of using internal sources of
finance can be high.

13. External Sources of Finance
 External Finance comes from outside the business.
 There is a wide variety of both short-term and long-
term external sources of finance.
 Short-term sources, where money is borrowed for less
than one year, may be needed for the following
reasons;
 Some businesses have seasonal trade.
 A manufacturer may need finance to pay for raw
materials and wages to meet a larger order
 A firm might be short of money because it is waiting for
a customer to pay.
 A business may need to meet emergency expenditure

14. External Sources of Finance
 The three main sources of short-term finance
are; Bank overdraft, Trade payables and Credit
cards
i. Bank Overdraft – it means a business can
spend more money than it has on its account.
- The bank will set an overdraft limit and
interest is only charged when the account is
overdrawn.
- Bank overdrafts are simple and flexible.
However, the bank has the right to call in the
money owed at any time.

15. External Sources of Finance
ii. Trade Payables
- Businesses often buy resources and pay them at a
later date, usually within 30 to 90 days.
- It is a cheap way of raising finance. It means a
business holds on to its cash for longer.
- However, its has its own downsides;
- Many suppliers encourage early payments by
offering discounts
- The cost of goods is often higher if firms buy on
credit
- Delaying payment may upset suppliers.

16. External Sources of Finance
iii. Credit Cards
- Popular because they are convenient, flexible
and avoid interest charges if accounts are
settled within the credit period.
- However interest rates on credit cards are very
high if accounts are not settled within the
credit period, usually 56 days.

17. External Sources of Finance
 Business often need to borrow finances for a longer
period, usually for more than a year.
 Some key sources of long-term finance are;
 Loan Capital –Unsecured bank loans, Mortgages,
Debentures, Hire Purchase
 Share Capital
 Venture Capital
 Crowdfunding

18. External Sources of Finance
1. LOAN CAPITAL
A loan is a fixed agreement between a business
and the bank.
The amount borrowed, and interest, must be
repaid in regular instalments over a fixed
period.
Bank loans can be short-term or long-term
sources of finance.
The main advantage of a bank loan is that a
business will know exactly what it has to pay
every month.

19. External Sources of Finance
 Unsecured Bank Loans - This means that the bank
lends money without the security of having a claim
in your assets of you do not pay it back.
-If the business collapses, the bank will not get its
money back.
- Banks will consequently prefer secured loans i.e.
having a collateral attached to the loan.
- Interest rates are higher for unsecured loans
compared to secured loans.
- Banks will determine the risk profile of a business
before giving them unsecured loans.

20. External Sources of Finance
 Mortgages – is a long-term loan and the
borrower must use land or property as
security/collateral.
 This means that if the borrower fails to make
repayments, the lender can repossess the
property.
 Mortgages are popular because the interest
rates are usually lower than those on
unsecured bank loans.
 Mortgages may be taken out for up to 25 years.

21. External Sources of Finance
 Debenture – Debenture holders are creditors
of a company, not owners.
 Debentures are entitled to a fixed rate of
return, but have not voting rights. They must
also be repaid on a set date - when the
debenture matures.
 Public limited companies (PLCs) use this long-
term source of finance.

22. External Sources of Finance
 Hire Purchase - A type of loan used to in buying
specific goods with a loan often provided by a
finance house.
 Businesses may use Hire Purchase to buy tools,
equipment, vehicle and machinery.
 The features of a Hire Purchase Agreement are;
 The business usually makes a down payment
 The remaining fee is paid in monthly installments
 The goods bought do not legally belong to the buyer until the
very last instalment has been paid.
 If the buyer falls behind with repayments, the goods can be
repossessed
 HP agreements can be short term or long term.
HP is usually more expensive than a bank loan.

23. External Sources of Finance
2. SHARE CAPITAL
 Share Capital is a permanent source of capital. This
means it is not repaid. (As long as the company is
still trading).
 For limited companies, share capital is an important
source of external finance. The sale of shares can
raise very large amounts of money.
 The advantage of selling shares to raise capital is
that interest payments are avoided.
 The disadvantages of issuing shares to raise capital
is the cost of administration and dividends has to be
paid to the shareholders.

24. External Sources of Finance
3. VENTURE CAPITAL
Venture capitalist are specialists in the provision of
funds for small and medium-sized businesses.
- They may invest in the businesses after the initial
start-up and often prefer tech companies with high
growth potential. They prefer to take a stake in the
company, which means they have some control
and are entitled to a share in the profit.
- Venture capitalists raise their funds from
institutional investors, such as pension funds,
insurance companies and wealthy individuals.
They are also likely to exit after about 5 years.

25. External Sources of Finance
 Business angels are individual venture
capitalists. They invest between £10 000 and
£100 000, sometimes more, usually in
exchange for a stake in a business.
 CROWDFUNDING
- is where a large number of individuals (the crowd)
invest in a business venture using an online platform
and therefore avoiding using a bank.
- Fundraisers tend to be businesses or groups who are
involved in a particular venture, such as putting on a
concert, building a school or setting up a community
project.

26. External Sources of Finance
 Transactions are conducted online. Specialists
websites allow those seeking finance to
publish details of their business idea, or
project, including how much cash they need,
how they will use business idea, or project,
including how much cash they need, how they
will use it and how investors stand to profit (if
at all) in the future.
 Peer-to-Peer Lending is where banks are
excluded and individuals can lend money via
the internet to others without previous
knowledge of them.