Sources of finance Sources of finance Why do

Sources of finance

Sources of finance Why do new firms need finance? New businesses need finance to: • buy or rent premises and equipment, pay for insurance, promotion and initial stock in order to begin trading (known as start-up costs) • pay running costs — power, telephone, wages, more stock etc. — until cash inflow is sufficient to do so Many new businesses sell on credit to their customers in order to attract sales. The gap between having to pay for supplies and receiving payment for sales can lead to business failure unless the business is sufficiently financed.

Sources of finance Why do existing firms need finance? Established firms may require additional funds to: • finance growth — as orders increase, more stock will need to be purchased, more staff may need to be taken on and equipment and machinery hired or bought. The firm may even need to move to larger premises • deal with late payment — selling to customers on credit can cause cash flow problems unless payment is not received when due • cope with a change in market conditions — a fall in demand due to increased competition or an economic downturn can also lead to a deterioration in cash flow.

Sources of finance Internal sources of finance Internal finance refers to the funds generated from within the business itself – for example: • Selling off fixed assets, such as machinery or premises. Such assets can be leased back from the new owner if they are still needed by the business. • Managing cash flow by reducing the length of time that customers have to pay invoices, while taking longer to pay suppliers. • Retained profit: the difference between the revenue generated from sales and costs incurred in making them, which can be invested back into the business.

Sources of finance Relying on internal finance • Financing a business via internal sources may be desirable. As it is generated by the business, it does not need to be repaid, nor does it involve paying interest or other charges. • Unfortunately it may not always be possible for a business to fund its operations by relying entirely on internal sources. • Retained profit may be too low to meet the needs of new businesses or those experiencing a fall in sales. • Small or new firms may have little choice but to offer generous credit periods in order to win customers. • Late payment of invoices could damage relations with suppliers and even lead to legal action.

Sources of finance External sources of finance External finance refers to funds generated from outside of a business. The main sources of external finance are: • Share capital: where funds are invested on a permanent basis into the business, in return for a claim on any profits made. • Loan capital: where funds are borrowed, to be repaid at some point in the short, medium or long term.

Sources of finance Share capital • Owners of small businesses may use funds from personal sources, e. g. their own savings or those of friends and family. • Limited companies can increase the level of ordinary share capital by selling additional shares to new or existing shareholders. • Venture capital providers invest significant sums by buying shares in small- or medium-sized companies with potential for rapid growth, but where the degree of risk involved is high enough to deter other investors.

Sources of finance Share capital: benefits & drawbacks • A key advantage of share capital is that the capital invested does not have to be repaid during the business’ lifetime. • Shareholders are not automatically entitled to an annual dividend, for example, if the company does not make a profit after tax or if directors decide to reinvest profits. • However, raising finance by selling shares dilutes the control of the original owners. • Venture capitalists usually demand a substantial slice of a company’s shares and direct involvement in the way it is run, although they may also offer valuable business experience and expertise.

Sources of finance Loan capital Most businesses obtain loan capital by borrowing from banks, in the form of a bank loan or overdraft. Bank loans are: • usually fixed term, for one or more years, • repaid in regular instalments or at the end of the loan period Overdrafts are: • short term • allow customers to withdraw money up to an agreed limit

Sources of finance Loan capital: benefits & drawbacks • A key advantage of using loan capital is that it does not result in a dilution of ownership or a loss of control. • The size and term of both bank loans and overdrafts can be negotiated to suit the needs of individual businesses. • However, loan capital must be repaid according to the terms agreed with the lender. Firms are often required to provide assets as security against a loan — these assets could be seized if the loan terms are broken. • Interest is also charged on loan capital, increasing costs and reducing profit levels. Interest charges on overdrafts are high if they are not repaid quickly.

Sources of finance: factors to consider • How much finance should be raised? The level should be sufficient to meet any likely future, as well as current, needs. • For how long will the finance be needed by the business? Using short-term sources to finance long-term projects is likely to be expensive, putting pressure on cash flow. • Are current owners prepared to give up some control over the business by bringing in new investors? • Are current owners prepared to take the risks involved with loan finance?