Chapter 9

• Businesses need finance to:
  start a business (start-up capital)
  expand
  avoid insolvency/bankruptcy

• Capital expenditure: the money spent on fixed assets which will last more than a year
• Revenue expenditure: the money spent on day-to-day expenses which do not involve the purchase of a long term asset

Sources of Finance

• Internal: the money which is obtained from within the business itself
• External: venues for obtaining funds that come from outside an organization

Internal Finance

1. Retained Profit

• The profit kept in the business after the owners have taken their share of the profits
• It does not have to be repaid
• However
• A new business will not yet have any retained profits
• The profits may be too low to finance the expenses
• Withholding profits results in less payment to the owners

2. Sales of Existing Assets:

• Those assets which are no longer required by the business
• Better use of the capital tied up in the business
• However
• It may take time to sell these assets
• New businesses may not be able to benefit from this

3. Running Down Stocks to Raise Cash:

• Reduces opportunity cost and storage of high stock
• Must be done carefully to avoid disappointing customers

4. Owner’s Savings:

• Owner investing personal money into unincorporated business
• Quickly available
• No interest is paid
• However
• Savings may be too low
• Increases risk taken by owner

External Finance

• Short term: up to 3 years
• Medium term: 3-10 years
• Long term: 10+ years

Short-Term Finance

1. Overdrafts:

• The bank gives the business the right to overdraw its bank account
• Very flexible form of borrowing
• Interest is only paid on the amount overdrawn
• Cheaper than loans
• However
• Interest rates are variable
• The bank can ask for repayment at any time

2. Trade Credit:

• When a business delays paying its suppliers
• Interest-free loan
• However
• The supplier may refuse to supply or give discounts

3. Factoring of Debts:

• Debt factors are specialist agencies that ‘buy’ the debt of a firm for immediate cash
• Immediate cash is made available
• The risk is of the debt factor’s
• However
• The firm does not receive 100% of the value of its debt

Medium-Term Finance

1. Bank Loans:

• Quick to arrange
• Can be for varying lengths of time
• Can be offered low rates of interest
• However
• Security is required
• Will have to be repaid eventually with interest
• Smaller companies may not get low interest rate

2. Hire Purchase:

• Allows a business to buy a fixed asset over a long period of time with monthly payments including an interest rate
• Firm does not have to pay a large sum of money at once
• However
• A cash deposit must be paid at the start
• Interest payments may be quite high

3. Leasing:

• Allows a firm to use an asset without having to purchase it
• Firm does not have to pay a large sum of money at once
• Care and maintenance of the asset is carried out by the leasing company
• However
• The total cost will be higher than that of purchasing the asset

Long-Term Finance

1. Issue of Shares [Equity Finance]:

• Permanent capital which does not have to be repaid
• No interest payments
• However
• Dividends are paid after tax
• Only available to limited companies
• Balance of ownership may be threatened

2. Long-Term Loans & Debt Finance:

• When a firm raises money selling bonds, bills, or notes
• Interest is paid before tax
• Interest must be paid every year but dividends do not
• Must be repaid (not permanent)
• Secured against particular assets

[see loans for advantages and disadvantages]

3. Selling Debentures:

• Long-term loan certificates issued by limited companies
• Very long-term finance
• However
• They must be repaid with interest

4. Grants and Subsidies:

• Do not have to be repaid
• However
• There are always strings attached

How Choice of Finance is Made

• Purpose
• Time-Period
• Amount Needed
• Status and Size of Company
• Control
• Risk and Gearing

[Gearing is a measure of risk. It is the proportion of total capital raised from long-term loans]

When Will Banks Lend and Shareholders Invest?

• Financial information is provided about the firm’s trading record and forecasts about its future:
  business plan
  cash flow forecast
  forecasted profit and loss account
  gearing ratios
  security
  reason behind the loan
  future prospects

• Comparison of dividends with other companies
• Variation of company’s share price
• Forecast shows solvency
• Experience of people in the business and how convincing they are

Business Plans

• A document containing the business objectives and important details about the operations and finance of the firm
• It must contain:
  Name
  Type of Business
  Aim
  Product
  Price
  Market aimed for
  Market research
  H/R plan
  Details of senior staff
  Production details
  Business cost
  Location
  Main equipment
  Forecasted profit
  Cash flow
  Finance/ Sources of Finance