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Sources of finance
Sources of finance
Why do new firms need finance?
New businesses need finance to:
• buy or rent premises and equipment, pay for insurance,
promotion and initial stock in order to begin trading (known as
start-up costs)
• pay running costs — power, telephone, wages, more stock etc.
— until cash inflow is sufficient to do so
Many new businesses sell on credit to their customers in order to
attract sales.
The gap between having to pay for supplies and receiving payment for
sales can lead to business failure unless the business is sufficiently
financed.
Sources of finance
Why do existing firms need finance?
Established firms may require additional funds to:
• finance growth — as orders increase, more stock will need to
be purchased, more staff may need to be taken on and
equipment and machinery hired or bought. The firm may
even need to move to larger premises
• deal with late payment — selling to customers on credit can
cause cash flow problems unless payment is not received
when due
• cope with a change in market conditions — a fall in demand
due to increased competition or an economic downturn
can also lead to a deterioration in cash flow.
Sources of finance
Internal sources of finance
Internal finance refers to the funds generated from within the
business itself – for example:
• Selling off fixed assets, such as machinery or premises.
Such assets can be leased back from the new owner if they
are still needed by the business.
• Managing cash flow by reducing the length of time that
customers have to pay invoices, while taking longer to pay
suppliers.
• Retained profit: the difference between the revenue
generated from sales and costs incurred in making them,
which can be invested back into the business.
Sources of finance
Relying on internal finance
• Financing a business via internal sources may be desirable.
As it is generated by the business, it does not need to be
repaid, nor does it involve paying interest or other charges.
• Unfortunately it may not always be possible for a business to
fund its operations by relying entirely on internal sources.
• Retained profit may be too low to meet the needs of new
businesses or those experiencing a fall in sales.
• Small or new firms may have little choice but to offer
generous credit periods in order to win customers.
• Late payment of invoices could damage relations with
suppliers and even lead to legal action.
Sources of finance
External sources of finance
External finance refers to funds generated from outside of a
business.
The main sources of external finance are:
• Share capital: where funds are invested on a
permanent basis into the business, in return for a claim
on any profits made.
• Loan capital: where funds are borrowed, to be repaid
at some point in the short, medium or long term.
Sources of finance
Share capital
• Owners of small businesses may use funds from personal
sources, e.g. their own savings or those of friends and
family.
• Limited companies can increase the level of ordinary share
capital by selling additional shares to new or existing
shareholders.
• Venture capital providers invest significant sums by buying
shares in small- or medium-sized companies with potential
for rapid growth, but where the degree of risk involved is
high enough to deter other investors.
Sources of finance
Share capital: benefits & drawbacks
• A key advantage of share capital is that the capital invested
does not have to be repaid during the business’ lifetime.
• Shareholders are not automatically entitled to an annual
dividend, for example, if the company does not make a
profit after tax or if directors decide to reinvest profits.
• However, raising finance by selling shares dilutes the control
of the original owners.
• Venture capitalists usually demand a substantial slice of a
company’s shares and direct involvement in the way it is
run, although they may also offer valuable business
experience and expertise.
Sources of finance
Loan capital
Most businesses obtain loan capital by borrowing from banks,
in the form of a bank loan or overdraft.
Bank loans are:
• usually fixed term, for one or more years,
• repaid in regular instalments or at the end of the loan
period
Overdrafts are:
• short term
• allow customers to withdraw money up to an agreed
limit
Sources of finance
Loan capital: benefits & drawbacks
• A key advantage of using loan capital is that it does not
result in a dilution of ownership or a loss of control.
• The size and term of both bank loans and overdrafts can be
negotiated to suit the needs of individual businesses.
• However, loan capital must be repaid according to the terms
agreed with the lender. Firms are often required to provide
assets as security against a loan — these assets could be
seized if the loan terms are broken.
• Interest is also charged on loan capital, increasing costs and
reducing profit levels. Interest charges on overdrafts are
high if they are not repaid quickly.
Sources of finance
Sources of finance: factors to
consider
•
How much finance should be raised? The level should be
sufficient to meet any likely future, as well as current,
needs.
•
For how long will the finance be needed by the business?
Using short-term sources to finance long-term projects is
likely to be expensive, putting pressure on cash flow.
•
Are current owners prepared to give up some control over
the business by bringing in new investors?
•
Are current owners prepared to take the risks involved with
loan finance?