Chapter 21 - Business Finance: needs and sources (Long-term Finance …
Chapter 21 - Business Finance: needs and sources
Will shareholders invest?
the company has a good reputation and has plans for future growth
other companies do not seem such a good investment
dividends are high - or profits are rising so dividends might increase in the future
the company's share prices has been increasing
Will banks lend?
a business plan to explain clearly what the business hopes to achieve in the future and why the finance is important to these plans
evidence that 'security' is available to reduce the bank's risk if it lends
details of existing loans and sources of finance being used
an income statement - for the last time period - and a forecast one for the next
a cash flow forecast which shows why the finance is needed and how it will be used
How businesses makes the choice
risk and gearing - does the business already have loans?
The gearing of a business measures the proportion of total capital raised from long-term loans. If this proportion is high, more than 50 percent, it is highly geared. This is risky because interest must be paid on loans whether business is making profits or not.
Owners of businesses may lose control of that business if they ask other people to invest in their firm. Owners may have to decide what is more important, to expand or keeping control of it.
legal form and size
Companies, especially public limited companies, have a greater choice of sources of finance. Issuing shares or debentures is not an option for sole traders and partnerships. These businesses, if they have plans to expand, may have to depend on the savings of their owners - personal capital.
Different sources will be used depending on the amount of money needed
purpose and time period
The general rule is to match the source of finance to the use that will be made of it. Whether to use short or long term
Long-term loans or debt finance
loans differ from share capital in following ways:
loans are often 'secured' against particular assets
loans must be repaid, as they are not permanent capital
loan interest must be paid every year but dividends do not have to be paid if, for example, the firm has made a loss
loan interest is paid before tax and is an expense
Issue of shares
Public limited companies have the ability to sell a large number of shares to the general public. These new issues, as they are called, can raise very large sums of money but can be expensive to organise and advertise
This issue is available only to limited companies. Shares are often referred to as equities - therefore the
sale of shares is sometimes called equity finance
allows the firm to use an asset but it does not have to purchase it.
the total cost of the leasing charges will be higher than purchasing the asset
the care and maintenance of the asset are carried out by the leasing company
the firm does not have to find a large cash sum to purchase the asset to start with
Monthly leasing payments are made. The business could decide to purchase the asset at the end of the leasing period. Some businesses decide to sell off some fixed assets for cash and lease them back from a leasing company. This is called sale and leaseback.
. This allows a business to buy a fixed asset over a long period of time with monthly payments which include an interest charge.
interest payments can be quite high
a cash deposit is paid at the start of the period
the firm does not have to find a large cash sum to purchase the asset
This is available for more than a year - and sometimes for very many years. Usually this money would be used to purchase long-term fixed assets, to update or expand the business or to finance a takeover of another firm
This provides the working capital needed by businesses for day-to-day operations.
Shortages of cash in the short term can be overcome in three main ways:
Factoring of Debts
is when a business delays paying its suppliers, which leaves the business in a better cash position
the supplier may refuse to give discounts or even refuse to supply any more goods if payment is not made quickly
it is almost an interest-free loan to the business for the length of time that payment is delayed for
the bank can ask for the overdraft to be repaid at very short notice
interest rates are variable, unlike most loans which have fixed interest rates
overdrafts can turn out to be cheaper than loans in the short term
interest will be paid only on the amount overdrawn
the overdraft will vary each month with the needs of the business - it is said to be a 'flexible' form of borrowing
the firm could use this finance to pay wages or suppliers but, obviously, it cannot do this indefinitely
the bank gives the business the right to 'overdraw' its bank account (that is, spend more money than is currently in the account)
Sources of Finance
= Obtained from sources outside of and separate from the business
= Providing financial services - including small loans - to poor people not served by traditional banks.
Banks do not lend because:
the poorer groups in society often have no asset to act as 'security' for loans - banks are usually not prepared to take risks by lending without some form of security (assets they can sell if the borrower cannot repay)
the size of the loans required by poor customers - perhaps a few dollars - meant that the bank could not make a profit from the loans
Grants and subsidies from outside agencies
they are often given with 'strings attached,' for example, the firm must locate in a particular area
these grants and subsidies usually do not have to be repaid
Factoring of Debts
. Debt factors are specialist agencies that 'buy' the claims on debtors of firms for immediate cash.
the firm does not receive 100 per cent of the value of its debts
the risk of collecting the debt becomes the factor's and not the business's
immediate cash is made available to the business
. These are long-term loan certificates issued by limited companies
as with loans, these must be repaid and interest must be paid
debentures can be used to raise very long-term finance, for example, 25 years
security or collateral is usually required. this means the bank may insist that it has the right to sell some of the firm's property if it fails to pay interest or does not repay the loan. a sole trader may have to put up his or her own house as security on bank loan.
a bank loan will have to be repaid eventually and interest must be paid
large companies are often offered low rates of interest by banks if they borrow large sums
they can be for varying lengths of time
these are usually quick to arrange
Issue of shares
. This source of finance is only possible for limited companies
The ownership of the company could change hands if many shares are sold
Dividends will be expected by the shareholders
Dividends are paid after tax, whereas interest on loans is paid before tax is deducted
no interest has to be paid
this is a permanent source of capital which would not have to be repaid to shareholders
= Obtained from within the business itself.
. A sole trader or members of a partnership can put more of their savings into their unincorporated business.
it increases the risk taken by the owners
savings may be too low
no interest is paid
it should be available to the firm quickly
Sales of inventories to reduce inventory levels
it must be done carefully to avoid disappointing customers if not enough goods are kept as inventory
This reduces the opportunity cost and storage cost of high inventory levels
Sales of existing assets
are those items of value which are no longer required by the business, for example, redundant buildings or surplus equipment.
this source of finance is not available for new businesses as they no surplus assets to sell
it may take some time to sell these assets and the amount raised is never certain until the asset is sold
it does not increase the debts of the business
this makes better use of the capital tied up in the business
is profit kept in the business after the owners have taken their share of the profits. Often called as "ploughed-back profit"
keeping more profits in the business reduces payments to owners, for example dividends to shareholders
many small firms' profits might be too low to finance the expansion needed
a new business will not have any retained profits
there is no interest to pay - the capital is raised from within the business
retained profit does not have to be repaid unlike, for example, loan
Why is capital needed?
Additional working capital
= Money spent on day-to-day expenses which do not involve the purchase of a long-term asset, for example wages and rent.
= Money spent on fixed assets which will last for more than one year.
= The finance needed by a business to pay its day-to-day costs. "life blood' of a business. Constantly needed by firms to pay for all their day-to-day activities.
Expanding an existing business
The owners of a successful business will often take a decision to expand it in order to increase profits.
Additional fixed assets
could be purchases - such as
buildings and machinery
could be purchased through a
to reach new markets.
starting up a business
= The finance needed by a new business to pay for essential fixed and current assets before it can begin trading.
The owner of the firm will need to obtain finance to purchase other assets such as inventories before goods can be sold to customers
Roles & Responsibilities
making important financial decisions
forecasting cash flows
producing accounting information for managers
preparing final accounts
recording all financial transactions, such as payments and sales revenue