Business Finance: Needs and Sources
Why do Businesses need Finance?
What do Finance Departments do?
Recording all financial transactions, such as payments and sales revenue
Preparing final accounts
Producing accounting information for managers
Forecasting cash flows
Making important financial decisions e.g. which source of capital to use for different purposes within the business
Starting up a business
Buildings, land equipment
Inventories
Often called start-up capital
Expansion of an existing business
Additional fixed assets, such as buildings and machinery
Another business could be purchased through a takeover
Developing new products to reach new markets
Additional working capital
Constantly needed by firms to pay for all their day-to-day activities.
Pay wages, raw materials, electricity bills and so on
Vital to have sufficient working capital to meet all its requirements
Expenditures
Capital expenditure
Money spent on fixed assets such as buildings which will last for more than a year
Revenue expenditure
Money spent on day-to-day expenses, for example wages or rent.
Internal Source of Finance
Retained Profit
Profit kept in the business after owners have taken their share of the profits
does not have to be repaid unlike, for example, a loan
No interest to pay
A new business will not have any retained profits
Many small firms' profits might be too low to finance expansion
Reduces payments to owners, e.g. dividents are reduced
Sale of existing assets
Existing assets that could be sold are those items of value which are no longer require by the business
Makes better use of the capital tied up in the business
Does not increase the debts of the business
May take some time to sell these assets and the amount raised is never certain until the asset is sold
Not available for new businesses, as they have no surplus assets to sell
Sale of inventories to reduce inventory levels
Reduces the opportunity cost and storage cost of high inventory levels.
Must be done carefully to avoid disappointing customers if not enough goods are kept as inventory
Owners' savings
A sole trader or members of a partnership can put more of their savings into their unincorporated businesses.
Should be available to the firm quickly
No interest is paid
Savings may be too low
It increases the risk taken by owners
External Source of Finance
Issue of Shares
For limited companies
This is a permanent source of capital which would not have to be repaid
No interest has to be paid
Dividends are paid after tax
Dividends will be expected by shareholders
The ownership of the company could change hands if many shares are sold
Bank Loans
A sum of money obtained from a bank which must be repaid and on which interest is payable
Quick to arrange
Can be for varying lengths of time
Large companies are often offered low rates of interest by banks if they borrow large sums
Will have to be repaid eventually and interest must be paid
Security or collateral is required
Selling Debentures
Long-term loan certificated issued by limited companies
Can be used to raise very long-term finance
Must be repaid and interest must be paid
Factoring of Debts
Sell debts to a debt factor for instant payment of money owed (with a cut taken out by the factor)
Immediate cash
Risk of collecting the debt becomes the factor's
Does not receive 100 percent of the value of its debts
Grants and subsidies from outside agencies
E.g The government
Grants and subsidies usually do not have to be repaid
Often given with terms and conditions
Micro Finance
In many low-income developing countries, traditional commercial banks have been very unwilling to lend to poor people - even if they wanted the finance to set up an enterprise. Banks did not lend
Reasons
The size of the loans required by poor customers are too small, and are not profitable
The poorer groups in society often have not asset to act as security for loans
Firms such as postal savings banks, finance cooperatives, credit unions and development banks focus on lending small sums of money to people
Short-term finance
Overdrafts
Give the business the right to spend more moeny than is currently in the account
Could us this finance to pay wages or supplies but not indefinitely
The overdraft will vary each month with the need of the business, 'flexible'
Interest will be paid only on the amount overdrawn
Overdrafts can turn out to be cheaper than loans in the short term
Interest rates can vary
The bank can ask for the overdraft to be repaid at very short notice
Trade Credit
When a business delays paying its suppliers
Interest-free
The relationship with the supplies might be damages
Factoring of debts
Long-term Finance
Bank Loans
Hire Purchase
Allows a business to buy a fixed asset over a long period of time with monthly payments with an interest charge
Does not require a large cash sum to purchase the asset
A cash deposit is paid at the start
Interest payments can be quite high
Leasing
Allows the firm to use an asset but it does not have to purchase it. Monthly leasing payments are made
Firm does not have to find a large sum to purchase the asset
Care and maintenance of the asset are carried out by the leasing company
The total cost of the leasing charges will be higher than purchasing the asset
Issue of shares
Only available to limited companies
Shares are often referred to as equity
Sale of shares is sometimes called equity finance
Long-term loans or debt finance
Loan interest is paid before tax and is an expanse
Loan interest must be paid every year but dividends do not have to be paid if, for example, the firm has made a loss
Loans must be repaid
Loans are often secured against particular assets
Debentures
How business make the choice
Purpose and time period
Long term
Short term
Amount needed
Legal form and size
Control
Risk and gearing
Does the business already have loans