3.1 Sources of Finance

1. 3.1 Sources of Finance Chapter 18 Part 1

2. What is finance? • The ability to access money in order to fund business activities. • Many different business activities need finance. • Can you name some?

3. Business Activities to Finance What is Capital?Can be Cash, Equipment, Buildings • Startup Capital • Money needed to start a business to: buy equipment, rent/buy a building, purchase inventory • Working Capital • Money needed to operate the day-to-day activities of the business: pay bills, pay employees, buy supplies • Business Expansion • Move to a larger location, hire more people, equipment upgrades

4. Business Activities to Finance • Business Expansion • Expansion can occur by purchasing other businesses; may need extra money to do this • Special Situations • Decline in sales could leave company without enough cash; a customer could fail to pay his bill in time; unexpected repair expenses • Research and Development • Invest in new markets, create new products

5. Time to Finance • Short-Term Financing • One year or less • Medium-Term Financing • One to five years • Long-Term Financing • Over 5 years

6. Financing Expenditures • Capital Expenditures • Purchasing fixed assets that will last over one year (things that aren’t consumed in the day-to-day operation of the business) • Buildings, machinery, or cars (What are ASSETS?) • Revenue Expenditures • Spending that occurs in order to produce your product or service • Wages, inventory, supplies, utilities Financing these two different types of spending will be very different as the length of time for “pay back” is different.

7. Sources of Financing • Internal Money • Money raised by the business’s own assets or from the profits left over from the business. • Profits Retained by the business • Sale of Assets • Reductions in Working Capital • External Money • Sources from outside the business • Bank Overdrafts (Credit Line) • Trade Credit • Debt Factoring (Selling Receivables at a discount)

8. Internal Sources of Finance • Profits retained by the business • Profit that is kept by the business after taxes and dividends are paid • New companies or companies that experience a LOSS may not have access to this type of financing. • This type of financing is permanent because it is not “paid back” Revenue $100,000 Expenses 30,000 Profit $ 70,000 Taxes @10% - 7,000 Dividends paid - 20,000 Profits Retained $ 43,000

9. Internal Sources of Finance • Sale of Assets • Companies can sell assets they no longer need or use to raise cash for financing. Example: A company owns 2 cars worth $10,000 each Total: $20,000 in Asset Value NOT Cash $20,000 Liquidate car asset to raise cash. $10,000 CASH $20,000

10. Internal Sources of Finance • Lease Option • Company sells equipment that has a loan outstanding to a leasing company; then leases the equipment back for a cheaper price. Raising cash by reducing cash outlay. Example: A company is buying a car worth $20,000 and bank loan balance $15,000 with a monthly loan payment of $500. Loan Payment $500 Sell car to leasing company for $18,000 - $15,000 loan=$3000 raised cash Lease Payment $175 $3000 raised cash + $325 cash extra cash per month

11. Internal Sources of Finance • Reductions in Working Capital Working Capital = Assets -Liabilities Money owed to the business (Asset) = $20,000 Liabilities (loans on cars) = $5,000 Working Capital = $15,000 Debt to Asset Ratio: 1:4 For every $1 in debt, I can pay it back 4X Collected Money owed (Assets)= $5,000 Cash = $15,000 Spend Cash=$15,000Total Assets = $5,000 Liabilities = $5,000 Working Capital = $15,000Debt to Asset Ratio: 1:1But $20,000 now in cash For every $1 in debt, I can pay it back 1X

12. External Sources of Finance • Bank Overdrafts (Credit Line) • Most Flexible types of financing • Pre-arranged with a banking/lending institution • Expensive with high interest rates • Used on a day-to-day basis to cover the cash needs of a business

13. External Sources of Finance • Trade Credit • Delaying payment of your vendors • Early payment discounts cannot be taken • Suppliers may not be happy if you take to long to pay your bills • What is “Trade” – buying from a supplier in your industry.

14. External Sources of Finance • Debt Factoring • Selling Accounts Receivable at a discount to a collector(What is Accounts Receivable? Money owed to you by your customers.) Money Owed You: Accounts Receivable: $10,000 You Sell to a Debt Collectorfor immediate cash: $ 7,000 Debt Collector Profitswhen debts are collected: $ 3,000 This is not BAD Debt Collection.

15. Evaluation of Internal Financing • No direct cost to the business • Does not increase the debt of the company • No risk of loss of control of the company to another party • No shares are sold to others • New or unprofitable companies have few assets to sell to raise cash • Growth will be constrained by limited cash resources

16. More Vocabulary • Hire Purchase (A LOAN) • Purchasing an asset over a period of time • Example: buying a car, equipment using a loan Ownership • Leasing • A contract with a company to pay a fee but not actually acquire ownership of the item. • Example: leasing a car, or equipmentNo Ownership

17. More Vocabulary • Debentures (Corporate Bonds) • Bonds issued by a company to raise money and they are usually issued with a fixed rate of interest Savings Interest Rate to Depositors @ 1% Interest Loan @ 15% Interest Bank makes 14% Profit Bond @ 10% Interest to People People make 10% Profit vs 1% at the bank Business SAVES 5% on Loan Interest by NOT using the bank

18. More Vocabulary • Rights Issue • Existing shareholders have the right to purchase more stock at a discount in order to raise capital for the business. • Grants • Government agencies willing to fund businesses that will establish themselves in particular locations or create jobs. (Economic Development Funds)