BUSINESS & MANAGEMENT

BUSINESS & MANAGEMENT Unit 3.1 Sources of Finance

KEY TOPICS Standard Level • Internal and external finance • Finance in the long, medium and short term • Evaluate the advantages and disadvantages of each form of finance • Evaluate the appropriateness of a source of finance for a given situation

Introduction • Finance is involved with controlling money for an organization. • Different sources of finance are proper for different types of businesses. • Example: A sole trader might use savings and profits to expand a business while a public company may use shares or bonds.

Business finance can be broken into two forms • Capital expenditureis money spent on fixed assets (i.e. things that have a long term value such as land buildings and equipment). • Ex. Starting a factory you may need a building and large machines to get started. • Revenue expenditureis money spent on things that you need to run a business. • Ex. Money spent on staff salary, materials, utilities and other operating expenses.

Internal Finance Is money that comes from within the business from savings or from profits that are made.

Sources of internal finance • Personal fundsis money that is put together from a person (sole trader) or from a group of partners (partnership). • Family and friends • Many people borrow money from people they know to get there business started. It can be beneficial because loan rates tend to be less than borrowing from a bank. The downside can be that borrowing can be limited and can lead to problems amongst people.

Sources of internal finance • Working Capitalis money that is brought in through sales of a good or services. Many business use this to pay for revenue expenditures. • Retained profits is money that is kept by a business after paying back shareholders (in the form of dividends) and paying taxes. • It is usually used to pay for fixed assets. Can be very useful because companies that keep a lot of profits tend to need to borrow less; often limiting costs such as interest charges on various loan types from banks and financial institutions.

Sources of internal finance • Selling assets • Selling fixed assets like machinery or computer equipment that is out of date. Can raise cash in case of an emergency as well. • Investing extra cash • Some businesses use their extra cash to raise finance through interest at a bank. Can be effective except for the low rate of return from a bank as well as opportunity costs of not having money readily available.

Why do companies sell their assets? • No money especially in times of emergency • Requires money for some transaction • Company on the verge of winding up • Relocation • Selling the company away • Asset is getting out-of-date (e.g. computers and machinery) • Asset is no longer maintainable as spare parts are not available (e.g. main manufacturer winds up or stops sales of spare parts and/or support for the product) • Upgrade asset (e.g. changing to a better car) • Extra asset (e.g. due to lesser staff employed) • Cut loss (e.g. selling the iPhone 4S before iPhone 5 is launched) • Selling asset to a Joint Venture company

Where can extra cash be used? • Bank • Shares & Commodities • Fixed Deposits, Securities, Bonds, Derivatives and etc. • Invest in other companies (i.e. be a business angel or venture capitalist) NOTE: Different options carry different risks and rate of return. The higher the risks, the higher the rate of return.

Types of Shares • Preference (Preferred) Shares • Receive a fixed dividend every year. They do not take advantage of very profitable years because of the fixed rate. Can be a steady revenue stream. Always receive profits first but usually do not have voting rights. • Ordinary Shares • Most shares are this kind. The dividend received is not fixed so can take advantage of extreme years of profitability. Receive dividend payments after preference shares but are granted voting rights.

External sources of finance come from outside of a business

External sources of finance • Share capital • Limited companies float their shares on a stock exchange. • Can raise huge amounts of money. The down side is that the owners give up control of the companies to the shareholders. • Companies only make money on the initial sale of the shares not on money made in the secondary or stock exchanges.

External sources of finance • Loan capital • Money that is borrowed from commercial lenders like banks. Lends tend to be long to medium term. Mortgages is a secured loanfor land if the borrower defaults(i.e. does not pay back the loan) the lender takes the collateral. • Business development loans are used to start and expand businesses. Can also be used to boost working capital.

Why government give business development loans? • Assist small businesses to expand especially in times of recession • Increase the participation rate of the economy so as to reduce unemployment rate • Improve the professionalism of the trade • Improve & expand the scope of specialization in the country • Attract foreign/local investment • Increase the PPF (Production Possibility Frontier) of the country • Increase the tax revenue of the government

External sources of finance • Overdrafts • Allows a business to take more money from their account than they have. • They tend to have high interest rates but can be used as short term loans for a business. • They can come in handy for businesses that have cash flow problems possibly from selling on credit. • Trade Credit • Allows businesses to buy now and pay later. The sale is final but some businesses will give 30-60 days for their clients to pay them back. • Can help businesses with short term cash flow problems.

External sources of finance • Government Grants • Money given by governments to start small businesses in order to stimulate the economy of an area. • Can be very hard for most businesses to obtain. • Government Subsides • The government gives money to some businesses if they provide some service that is considered beneficial to society like hospitals and schools. • The idea is to keep prices low for consumers.

External sources of finance • Donations • Money given from private citizens or organizations to help a business (most likely charities, schools and hospitals. • Sponsorships • A company gives money, products or services in return for displaying the companies brand or logo. Nike, Adidas and McDonalds are examples of companies that participate in corporate sponsorship. • They tend to give to local events and sports teams in order to be advertised.

External sources of finance • Debenturesare long-term loans that the buyer receives a certificate. They do not have ownership or voting rights. Most receive interest payments can be fixed or variable (changing). • Some are used for sports teams and the owners receive some sort of benefit for buying them. Is useful for businesses that do not want to lose control but need to raise capital.

Accounting Terminology People who owe a business money are known as debtors. • Giving credit to other businesses can be a good way to keep and get clients but can be risky in times of low economic output (i.e. recession and/or trough). • Businesses that give credit and borrowers need to worry about this the most.

Debt factoring • Factoring services will buy debt from businesses for a profit. • Can be helpful to businesses that don’t want to spend a lot of time collecting from their clients. Also can be handy to raise immediate cash in businesses that give credit. Most of the time businesses are still held accountable for any bad debt they pass on. • Non-recourse factoring means that businesses will receive money from the factoring company no matter if the client pays or not. • There is added charges for this extra service. • Note: In general the fees associated with using debt factoring can make it unrealistic for some businesses. The larger and riskier the debt the larger the fees will be for this service.

Leasing • Leasing is like renting. • Some businesses use this instead of buying property and equipment. • The lesser is responsible for maintenance of the equipment. • Leasing in the short term is cheaper for businesses that do not have a lot of money for capital expenditures. • This allows a business to use their finance in different ways. • Also, the leasing company can use the money spent as a tax write off. In the long run though it can be more expensive for businesses because the leasing company owns the property or equipment.

Hire purchase • Allows a purchaser to buy something over an extended period of time. • Since it is a form of loan interest is charged to the buyer but this has the added benefit of at the end the business owns the equipment.

Venture Capitalists • Venture capital is money that is given by an organization or person to a business that is usually starting out. • It is perceived as a high risk venture that many times fails. The profits that are made can be substantial which is why people will try them. • People or businesses looking for venture capital will need to spend lots of time on their business plans to make sure to attract the high risk taking people.

Business Angels • Wealthy private investors who will get involved directly in a business that they think could be profitable. • Businesses that take on Business angels tend to lose some control because they tend to be more involved than venture capitalists. • But because they tend to be entrepreneurs with a lots of experience they can help businesses to grow.

Things that venture capitalists and Business angels look at in a business. • Return on investment - Because of the high failure rate they tend to make sure the potential profits are extremely high for any business they get involved with. • The business plan - They to want to see high growth industries with few competitors. Also they want to make sure the business owners or managers understand the business they wish to enter. • People - Human resources management is very important and the B.A. and V.C. will want to know that the business knows how to properly use people to the best of their abilities. • Track record - How well have the business owners performed in the past.

Financial responsibilities of a business • Managers need to keep the cash flow positive. • From time to time they will have to think about different ways to get finance for different kinds of goals. • If businesses don’t keep up with their cash flow it can cause liquidation or bankruptcy. • Paying off creditors is extremely important for any business.

Different time frames for businesses(is not set or cast in stone) • Short term – current fiscal year • Medium term – one year to five years • Long term - more than five years ( the hardest to determine ahead of time).

Time frame perceptions • Different types of business will think in different time frames. • Long term for a IT business could be 2 years while a pharmaceutical (drug company) might think 5 years is short term. Reasons why: Advancements made in the IT industry is extremely rapid. There are new advancements made every week. Hence, 2 years is considered long-term. Conversely, advancements in the drug industry comes in terms of years and thus 5 years is considered short-term.

Public sector finance • They charge for their services in some case but also receive money from governments or through donations. Examples: 1. Health Organizations (e.g. hospitals) 2. Rescue Organizations (e.g. Red Cross) 3. Public Schools 4. Libraries 5. Museums • Usually provides public and/or merit goods.

Managers need to be careful when selecting which type of finance option they choose.

Factors when considering finance options • Purpose of finance – What is the plan usage for the money. • Cost - What will the administration costs be and what is the opportunity cost. • Amount required – Different amounts may limit options available. • Time – how quickly will the loan be repaid. • Status and size of firm – Well known and large firms can raise money in a variety of ways. (share issues, easier bank loans)

Factors when considering finance options • Financial situation – firms that have cash flow problems will have less options on raising finance in the future. Also companies with a high gearing ratio will have a harder time raising money because they seem more risky. • External factors – the confidence level and the state of the economy will determine the interest rates and the ease of raising the required finance.

Choosing the wrong finance option can severely hurt a business!

BUSINESS & MANAGEMENT