Sources of Finance Loan capital l l Money

Sources of Finance

Loan capital l l Money received by an organisation in return for the organisation’s agreement to pay interest during the period of the loan and to repay the loan within an agreed time Providers of loan capital = creditors

Bank loans l l l Business must provide a form of security Repay the loan + interest on a regular basis over an agreed period of time Bank loans tend to have fixed rates of interest (but not always) New & small firms usually pay higher rates of interest than large established firms Medium-term to long-term source of finance

Bank loans Advantages • Repayments fixed in advance so easy to budget for • If provide security, interest rate is lower than that for an unsecured loan • Size of loan & repayment period can be organised to match firm’s exact needs Disadvantages • Size of loan may be limited by amount of collateral • Less flexibility - may be penalties for paying loan off earlier than agreed • More expensive than personal finance • Start-ups charged high interest as unable to provide guarantees

Bank overdrafts l l l When a bank allows an individual or organisation to overspend its current account in the bank up to an agreed (overdraft) limit for a stated time period Widely used & flexible Rate of interest is variable & charged daily Interest rate tends to be higher than loans as security is not usually required Used to ease cash-flow problems Short-term source of finance

Bank overdrafts Advantages l Extremely flexible & can be used on a short-term basis for temporary cash-flow problems l Interest is only paid on the amount of the overdraft being used l Security not usually required Disadvantages l Interest rate is higher than that charged for a loan l Banks can demand immediate repayment (rare) l May need to prove to the bank manager why an overdraft is needed

Personal sources l Money that is provided by the owner(s) of the business from their own savings or personal wealth l l Personal savings Mortgages Borrowing from friends & family Selling private assets

Personal savings Advantages l Savings are a cheap source of finance - do not involve paying interest l Opportunity cost is low (banks pay lower rates of interest to savers than rates charged to borrowers) l Owner keeps control of business Disadvantages l Risk - high failure rates among new businesses l Lack of savings

Mortgages Advantages l Property is many people’s major financial asset – second mortgage enables them to raise enough money to start a business l Interest rates tend to be lower than those on other loans due to collateral provided (lower risk) Disadvantages l If the business is unsuccessful, owner may lose their property l Many entrepreneurs do not own a sufficiently valuable property l Reluctant to take such a high-level risk – effect on whole family?

Selling private assets Advantages l Asset that was previously of no real use can be used productively l Asset can be leased back by the owner – sale & leaseback Disadvantages l May cause family tensions l Unlikely that large sums of money can be raised by selling off assets that are not needed

Borrowing from family & friends Advantages Disadvantages l They may be prepared to l Add to the stress, especially lend money where a bank if business gets into may not difficulties l Easier repayment terms, e. g. l Undermine friendships – interest-free loan cause of possible disputes l Additional money raised through friends & family may encourage a bank to offer a further loan

Capital expenditure l l l Spending on items that can be used time and time again (fixed assets) Long-term source of finance is ideal May take a long time before these items generate enough revenue to pay for themselves Long-term is usually greater than 5 years Medium-term is usually between 2 – 5 years

Revenue expenditure l l l Spending on current, day-to-day costs such as the purchase of raw materials & payment of wages Provides a quick return Short-term source of finance suitable, usually repayable within 1 year, but possibly within 2 years

How do you choose a suitable source of finance? l l l Legal structure Use of finance Amount required Firms’ profit levels Level of risk Views of the owners