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