IB Business and Management: Sources of Finance

IB Business and Management: Sources of Finance Sources of Finance ● Finance is money used by the business ● It is needed for: 1. Start-up, 2. Daily Cash Flow, 3. Expansion ● It is used for: 1. Capital expenditure – the finance spent on buying fixed assets, 2. Revenue expenditure – payments for the daily running of a business – e.g. wages & raw materials Factors affecting choice: 1. What is it needed for? 2. How much is needed? 3. Company situation (1. Size, 2. Financial health) 4. External factors (- PESTLE, PORSCHE) 5. What is available? 6. Cost of the finance? ● Business finance can be categorized in terms of its purpose: capital expenditure & revenue expenditure ● capital expenditure is the finance spent on purchasing fixed assets (items of monetary value which have a long term function and can be used repeatedly, such as land, buildings, equipment & machinery). ● Because they are meant to help the business make money, fixed assets are not meant for immediate resale. ● Revenue expenditure refers to payments for the daily running of a business such as wages & raw materials. It also includes the payment of indirect costs Internal Finance: (comes from within the business) ● Personal funds – main source of finance for sole traders and partnerships. Advantage is that theres little bureaucracy but you are putting your years of savings on the line. ● Family & friends – reasonably straightforward and inexpensive compared to borrowing from a bank that may require collateral (security) before authorization. However, it is usually very limited and borrowing from family & friends often provokes disputes ● Working capital – this refers to the money available for the day to day running of a business, such as from the sale of goods and services. Vital source of finance as it is needed to pay for everyday costs of utility ● Retained profits – value of profits business keeps (after tax and dividend payouts) to use within the business. Aka plowed-back profits, they are often used for purchasing or upgrading fixed assets. Some may even be kept in a contingency fund in case of emergencies and unforeseeable expenditure in the future. This reduces the business’ reliance on borrowing ● Selling of assets – businesses can sell their dormant assets (unused assets) such as old machinery that has been replaced or selling of land. They can do it to survive a liquidity problem. Problem is that in a hurry it may be sold for less than its potential ● Investing extra cash – cash that does not need to be spent immediately can be placed in an interest-bearing savings account earning interest for the business. There is also an opportunity cost with keeping cash on hand which is the interest that could have been earned External finance: (comes from outside the business) ● Share capital – money raised from the selling of shares. Can provide huge amounts of finance. Companies often ‘float’ their shares to raise capital and provide a market for second hand shares and government stocks ● When a company decides to go public for the first time by floating share on a stock exchange, it is known as an IPO ● After the IPO, a company can still release share in what is called a share issue (aka share placement). However, there are many legalities and admin procedures with their associated costs including the dilution of ownership & control ● Ordinary shares are standard shares without any special rights or restrictions. They however do have the highest potential financial gains possible but this means that they have highest risk too. Ordinary share holders are the last to get paid if a company fails. Have voting rights. ● Preference shares typically carry a right that gives the holder preferential treatment when annual dividends are distributed to shareholders. These shares receive a fixed dividend meaning that the shareholder would not benefit from an increase in company profits. They have first rights to dividends over ordinary shareholder. Also, when the business is going to go bankrupt, they are likely to be repaid the same or little less in value of shares ahead of ordinary shareholders. The are non voting shares though and ordinary share holders may earn more during profitable periods ● Cumulative preference: These shares give holders the right that, if a dividend cannot be paid in one year, it will be carried forward to successive years. Dividends on cumulative preference must be paid regardless of the financial position of the business, provided the company has distributable profits ● Redeemable shares come with the agreement that the company can buy them back at a later date which can be fixed or at the choice of the business. (A company cannot only issue redeemable shares) ● Note: Shareholders are not affected by the shares being bought and sold as its already on the secondary market ● Loan capital – medium to long-term sources of finance obtained from commercial lenders such as banks. Interest changes are imposed (can be fixed or variable), depending on the agreements made. Paid back in installments over a predetermined period. A mortgage is a type of secured loan which is for the purchase of property. If the borrower defaults (fails to repay) on the loan, the lender can repossess (take back) the property. Another example is a business development loan which is catered to meet the specific development needs of the borrower. They can use this finance to do almost anything (very flexible) such as purchase equipment and other assets, or even boost working capital ● Overdraft – a facility allowing businesses to temporarily overdraw on its account. Often have high interest rates. They are also repayable on demand without prior notice from the lender. They do however provide flexibility and enhance cash flow ● Trade credit – allows a business to ‘buy now, pay later’. Although a sale is made at the time of purchase, the seller or credit provider does not receive any cash until a later date from that buyer. Creditors (organizations providing credit) usually offer 30-60 days for their customers (debtors) to pay ● Credit cards – acts as a cash advance to holder. Allows holder to buy based on the promise of paying at a later date ● Government grants – very hard to obtain as do not need to be repaid (think of economics) ● Government subsidies – do not cut into profit margins – although firms may charge lower prices, this is made up by the government subsidy (think economics) ● Donations – financial gifts from individuals or organizations to a business in return for prominent display of their presence. Not a likely source of finance for private sector businesses (not too sure about this…) ● Sponsorships – occurs when an organization gives financial support (in the form of cash, product/services) to another business in return for prominently displaying the sponsors brand or logo. It is a form of promotion. Difficult to obtain. Costs of stuff like clothing (sports) reduces ● Debt factoring – bad debt = debtors who are unable to repay the money owed. A financial service that allows a business to raise funds based on the value owed by its debtors, i.e. customers who have bought on credit. Most factoring service providers offer between 80-85% of the outstanding payments from debtors within 24 hours once the application has been approved. Very quick. Selling your accounts receivable. Service provider chases up debtors. Non recourse debt factoring is an option for the provision of bad debts. Normally, factoring providers do not hold responsibility for bad debts so the business has to absorb these as losses. With non-recourse, even if debtors don’t pay, the factoring service will absorbs the loss or insure itself against any loses. Reduces risk of doing business. Gives peace of mind but is more expensive. However, high fees by providers. Comparable with those of overdrafts. Additional charges for management, admin, maintenance of accounts. Not everyone is eligible ● Leasing – form of hiring whereby a contract is agreed between a leasing company (lessor – legal owner) and the customer (lessee). Useful for startups who have big opportunity costs. Also, added services such as maintenance & upgrading are provided by the lessor. Tax bill also reduced as it is classified as a business expense. However, in long term, charges make it more expensive than it would normally be ● Hire purchase (HP) – allows business to pay creditors in installments (variable timeframe). Asset is legal property of the HP firm until all payments have been made. Down payment (needed) = deposit. If buyer defaults, asset is repossessed by HP firm. A form of buying on credit, interest charged. In the end, buyer owns the asset on payment of last installment ● Debentures – long-term loans. Holders can be anyone but do not have ownership of voting rights. Receive interest (fixed/variable depending on type of debenture) before shareholders get dividends. Even if business makes a loss. Low risk but provide VIP benefits (e.g. seats in meetings). Safest type is a secured debenture where loan is tied to the financing of a particular fixed asset. Means holder has legal interest in the asset, rather like a mortgage with collateral. Long term source of finance without losing ownership & control. However, increases a firms gearing – means firms has more borrowing as a % of cap. employed and therefore this not only raises interest repayments, but also increases risk if interest rates increase. Advantages are fixed returns, no chance to lose money. Also, safe & guaranteed income for long term. Priority over everyone else when it comes to debt repayment. However, no ownership & control – no right to vote. Potential gains in share may outweigh these.