business finance: needs and sources
what do finance departments do?
record all financial transactions (payments & sales revenue)
preparing final accounts
producing accounting information for managers
forecasting cash flows
making important financial decisions (which source of capital to use for different purposes within the business)
why do businesses need finance?
why is capital needed?
starting up a business
expansion of an existing business
increasing working capital
starting up a business
consider all the buildings, land and equipment to start trading (fixed assets)
owner of the firm needs to obtain finance to purchase other assets
finance needed to launch a new business is called start-up capital
additional working capital
"life blood" of a business
constantly needed by firms to pay for day-to-day activities
pay wages, raw materials, electricity bills and so on
important for the business to have sufficient working capital to meet all of its requirements
expanding an existing business
additional fixed assets could be purchased (buildings & machinery)
another business could be purchased through a takeover
could develop new products to enter new market (requires substantial amount of finance for research and development)
expenditure
revenue expenditure
day-to-day expenses (wages or rent)
capital expenditure
spent on fixed assets for more than 1 year (buildings)
internal sources of finance
retained profit
profit kept in business after the owners have taken their share (often called "ploughed-back profit"
advantages
does not have to be repaid (like loan)
no interest to pay- capital is raised from within the business
disadvantages
a new business will not have any retained profit
many small firms' profit might be too low to finance expansion
keeping more profits in the business reduces payments to owners (dividends to shareholders)
sale of existing assets
items that are no longer required by the business (redundant buildings or surplus equipment)
advantages
makes better use of the capital tied up in the business
does not increase debts of the business
disadvantages
may take some time to sell these assets and the amount raised is never certain until it is sold
not available for new businesses as they have no surplus assets
sale of inventories to reduce inventory levels
reduces opportunity cost and storage costs of high inventory levels
must be done carefully to avoid disappointing customers if not enough goods kept at inventory
owners' savings
owners of unincorporated businesses are not separate from their businesses, so this is internal
advantages
it should be available to the firm quickly
no interest is paid
disadvantages
savings may be too low
increases the risk taken by the owners
external sources of finance
issues of shares
only possible for limited companies
advantages
permanent source of capital which would not have to be repaid to shareholders
no interest has to be paid
disadvantages
dividends are paid after tax, whereas interest on loans is paid before tax is deducted
dividends will be expected by the shareholders
the ownership of the company could change hands if many shares are sold
bank loans
sum of money obtained from a bank which must be repaid and on which interest is payable
advantages
quick to arrange
can be for varying lengths of time
large companies are often offered low rates of interest if borrowed large sum
disadvantages
bank loan will have to be paid eventually and interest must be paid
security or collateral is usually required. the bank may insist that it has the right to sell firm's property if it fails to pay interest or does not repay the loan.
selling debentures
long term loan certificates issued by limited companies
debentures can be used to raise very long-term finance (25 years)
must be repaid and interest must be paid
factoring of debts
debt factors- specialist agencies that "buy" the claims on debtors of firms for immediate cash
advantages
immediate cash is made available to the business
the risk of collecting the debt become the factor's and not the business's
the firm does not receive 100% of the value of its debts
grants and subsidies from outside agencies
e.g. governments
usually do not have to be repaid
often given with "strings attached" e.g the firm must locate in a particular area
micro-finance or micro-credit
low-income developing countries, traditional banks have been very unwilling to lend to poor people, even if they wanted the finance to set up an enterprise
why?
the size of loans required by poor customers meant that the bank could not make a profit from the loans
the poorer groups in society often have no asset to act as "security" for loans. banks aren'r prepared to take risks by lending money without security (assets they can sell if the borrower cannot repay)
specialist institutions (postal saving banks, finance cooperatives, credit unions, development banks), focus on lending small sums of money to people
short-term finance
overdrafts
the bank gives the business the right to overdraw it's account
the firm can use the money to pay wages or suppliers (cannot do this indefinitely)
the overdraft will vary each month with the needs of business
interest will be paid only on the amount overdrawn
overdrafts can turn out to be cheaper than loans in the short term
interest rates are available, unlike most loans which have fixed interest rates
the bank can ask for the overdraft to be repaid at very short notice
trade credit
it is almost an interest-free loan to the business for the length of time that payment is delayed for
the supplier may refuse to give discounts or even refuse to supply any more goods if payment is not made quickly
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 which include an interest charge
the firm does not have to find a large cash sum to purchase the asset
a cash deposit is paid at the start of the period
interest payments can be quite high
leasing
leasing an asset allows the firm to use an asset but it does not have to purchase it
the firm does not have to find a large cash to purchase the asset to start with
the 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
issues of shares
only to limited companies
shares are often referred to as equities
the sale of shares is sometimes called equity finance
debentures
long-term loans or debt finance
loan interest is paid before tax and is an expense
loan interest must be paid every year but dividends do not have to be paid if (e.g. firm has made a loss)
loans must be repaid as they are not permanent capital
loans are often "secured" against particular assets