Accounts and FinanceSection 3

Unit 3.1 Sources of Finance

Finance is required for many activities

Setting up a business will require start-up capital of cash injections from the owner(s) to purchase essential capital equipment and, possibly, premises.

Finance is required for many activities

Businesses need to finance their working capital – • the day-to-day finance needed to pay bills

and expenses and to build up stocks

Finance is required for many activities

Business expansion needs finance to increase the capital assets held by the firm – and, often, expansion will involve higher working capital needs.

Finance is required for many activities

Expansion can be achieved by taking over other businesses. Finance is then needed to buy out the owners of the other firm.

Finance is required for many activities

Special situations will often lead to a need for greater finance. A decline in sales, possibly as a result of economic recession, could lead to cash needs to keep the business stable; or a large customer could fail to pay for goods, and finance is quickly needed to pay for essential expenses.

Finance is required for many activities

Apart from purchasing fixed assets, finance is often used to pay for research and development into new products or to invest in new marketing strategies, such as opening up overseas markets.

Finance is required for many activities

Note:• Some of these situations will need investment in

the business for many years. Others will need only short-term funding (for around one year or less).

• Some finance requirements of the business are for between one and five years (medium term financed).

• All of the situations will need different types of finance. No one source or type of finance is likely to be suitable in all cases.

Key Terms

Start-up capital – capital needed by an entrepreneur to set up a business

Working capital – the capital needed to pay for raw materials, day-to-day running costs and credit offered to customers. In accounting terms: • working capital = current assets – current

liabilities

Capital and Revenue Expenditures

Capital Expenditure – is the finance spent on purchasing fixed assets that are expected to last for more than one year, such as land, buildings, equipment and machinery.

Revenue Expenditure – is spending on all costs and assets other than fixed assets and includes wages and salaries and materials bought for stock.

Task

Hoang page 296 Question 3.1.1

Sources of Finance

Internal Sources of Finance

Funds that come from within the business, such as profits that have been

retained for business use or from the sale of goods and services that earn

money for the business.

Personal Funds

Main source of finance for sole traders and partnerships• Sole traders – a business in which one

person provides the permanent finance and in return has full control of the business and is able to keep all the profits

• Partnerships – a business formed by 2 or more people to carry on a business together, with shared capital investment and usually shared responsibilities

Family and Friends

Popular with sole traders and partnerships

Inexpensive compared to borrowing from a bank which might require a collateral (security) before authorizing a loan

Limited and could provoke disputes

Profits retained in the business

If a company is trading profitably, some of these profits will be taken in tax by the gov’t (corporate tax) and some is nearly always paid out to the owners or shareholders (dividends). If any of the profit remains, it is kept in the business and this retained profit becomes a source of finance for future activities.

Sale of Assets

Businesses could sell assets that are no longer fully employed to raise cash.

Some businesses will sell assets that they still intend to use, but which they do not need to own. Assets might be sold to a leasing specialist and leased back by the company. This will raise capital but there will be an additional fixed cost in the leasing and rental payment.

Working capital

This refers to the money that is available for the daily running of a business such as from the sale of goods and services.

Reduction in working capital acts as a source of finance for other uses.

Investing extra cash

Cash can be placed in interest-bearing savings account. This earns interest for the business, so acts as another source of finance.

The opportunity cost to keeping cash at hand rather than at the bank is the interest that could have been earned.

Evaluation: Advantages

No direct cost to the business although there may be opportunity cost

Does not increase liabilities or debts There’s no risk of loss of control by the

original owners as no shares are sold

Evaluation: Disadvantages

Is not available for all companies Can slow down business growth as the

pace of development will be limited by the annual profits or the value of the assets to be sold

EXAM TIP!Do not assume that a profitable

business is cash rich – and that it can use all of its profits as a source of finance for future projects. In practice, profits are often ‘tied up’ in money owed to the business by debtors or have been used to finance increased stocks or replace equipment.

EXAM TIP!Do not make the mistake of

suggesting that selling shares is a form of internal finance for companies. Although the shareholders own the business, the company is a separate legal unit, and therefore, the shareholders are ‘outside’ it.

External Sources of Finance

Long-term Financing:

To purchase fixed assets that will be used for many years, or to fund a take-over.

Issue New Shares (Share Capital)

Available to limited companies (PLC’s and LTD’s).

Advantages:• A permanent source of finance that does not

have to be repaid.• No interest is charged.• Large sums can be raised.

Issue New Shares

Disadvantages:• Shareholders will expect dividends to be paid.• Original owners may lose control of the company if

new shareholders are created (exception – a Rights Issue allows existing shareholders in plc’s to maintain their % shareholding).

• Can be expensive to organize (fees paid to advisors etc).

• May take some time to arrange.• Dividends paid after tax, so less money available to

shareholders.

Long-term Bank Loan

A loan for 10 years or more. Advantages:

• Quick to arrange (money immediately available).

• Flexibility over repayment term (eg 10 years-25 years).

• Discount rates often available if large sums borrowed.

• Interest is paid before the profits are taxed.

Long-term Bank Loan

Disadvantages:• Loans must be repaid.• Interest is charged and must be paid, even if

the firm makes a loss.• Interest rates may be variable which adds

risk.• Collateral or security is often required.

Debentures (long-term loan certificates)

Debentures are a type of long-term loan with the promise of fixed annual interest payments to the debenture holders and are repayable on maturity.

Debentures (long-term loan certificates)

Advantages:• Debenture holders can re-sell the debenture

(increased liquidity is an attraction for investors).

• Interest rate is fixed. This reduces risk for the business.

• Enables very long-term financing (eg. 25 years).

Debentures (long-term loan certificates)

Disadvantages:• Must be repaid in full on the maturity date.• A fixed rate of interest is charged throughout

the loan period.

Task

Hoang page 298 Question 3.1.2

External Sources of Finance

Medium-term Financing:

To purchase fixed assets that will be used for 3 - 10 years (eg. equipment & vehicles).

Medium-term Bank Loan

Advantages:• Quick to arrange (money immediately

available).• Flexibility over repayment term (eg 3 -10

years).• Discount rates often available if large sums

borrowed.• Interest is paid before the profits are taxed.

Medium-term Bank Loan

Disadvantages:• Loans must be repaid.• Interest is charged and must be paid, even if

the firm makes a loss.• Interest rates may be variable which adds

risk.• Collateral or security may be required

(especially for smaller and higher risk businesses).

Hire Purchase

The business pays monthly installments to a finance company. When the final installment is paid the asset becomes the business’s.

Advantages

• Enables businesses to buy assets when they have little cash available, or when they do not want to commit large amounts of cash to acquire assets.

• No collateral required (the asset being purchased is the collateral).

• Useful for businesses that have limited finance options.

Hire Purchase

Disadvantages• A large cash deposit may be required.• Interest rates are generally higher than for

bank loans.• Failure to make a payment may result in the

asset being taken back by the HP company.

LeasingBusinesses sign a contract with a leasing firm. They

effectively rent the assets they need from that firm for an agreed period of time.

Advantages:• Firms can make use of assets without the need for large

sums of money.• Frees money to be used elsewhere in the business (helps

cash flows).• Gives the firm flexibility. It can lease assets only when it

needs to use them (reduces costs).• The care and maintenance of the asset is the responsibility

of the leasing company.• Assets are kept up to date (ideal for computers and other

equipment that become obsolete quickly).

Leasing

Disadvantages:• In the long run, total costs will be higher than

buying the asset outright.• Businesses are committed to lease the asset

for the length of the lease agreement.

Sell and Lease-back

Businesses raise money by selling assets that they need, then lease them back.

Advantages:• Frees money tied up in assets for use by the

business.• The business is still able to make use of the

assets in return for monthly payments to the leasing company.

Sell and Lease-back

Disadvantages:• The firm will have fewer assets to provide as

collateral for loans in the future.• Day to day costs will be higher as there will be

an extra monthly payment for using the asset.• The firm will be committed to lease the asset

for the length of the lease agreement.

External Sources of Finance

Short-term Financing:Provides the working capital needed for the day-to-day expenses of the business.Covers the period from a few days to three years.

Bank Overdraft

The bank allows the current account of the business to become ‘overdrawn’. This means that it will have a negative balance. A facility to become overdrawn should be arranged with the bank before the money is required.

Advantages:• The most flexible form of financing as the amount of

money needed can change day-to-day.• Interest is only payable on the amount overdrawn.• Can be cheaper than a loan if overdrawn period is

kept short.

Bank OverdraftDisadvantages:

• Interest rates are generally higher than for a loan.

• A fee is often charged for having the facility.• Not generally available for a long period of time.• The bank can ask for repayment at any time

which could cause the business to be made bankrupt.

• There will be an upper limit to the facility. The firm cannot be overdrawn more than this.

Trade Credit

When a business delays paying its suppliers for an agreed period of time (usually 30 or 60 days).

Advantage:• Is like the business receiving an interest-free

loan for a month or two.• Allows the business to sell goods before

paying for them.

Trade Credit

Disadvantages:• Suppliers may refuse to send more supplies if

payments are left too long.• The firm cannot usually obtain a discount for

paying the supplier quickly.• Is generally limited to a period no longer than

60 days.

Debt Factoring

Debt Factors buy the debts of firms for cash.

Advantages:• The business receives most of the money

owed to it (around 90%) immediately.• Helps businesses that give their customers

long trade credit periods.• The risk of non-payment is taken on by the

Factor.

Debt Factoring

Disadvantage:• The firm only receives a % of the money

owed to it (around 90%).

External Sources of Finance

Grants & Subsidies

Grants

Money usually given by the government to assist firms with important expenditures. Advantages:• Enables businesses to fund important

projects like training, or the purchase of new equipment / technology.

• Encourages businesses to adopt new methods / technologies eg. alternative energy generators.

Grants

Disadvantages:• There are often ‘strings’ attached, eg firms

must locate in a certain area, create a certain number of jobs, or purchase a specific item.

Subsidies

Payments made by governments in order to keep businesses operational.

Advantages:• Money does not have to be returned.• No interest is charged.

Disadvantage:• Only available to businesses in certain

industries.