© Boardworks Ltd 2009 1 of 20 Teacher’s notes included in the Notes PageFlash activity Icons key: For more detailed instructions, see the Getting Started

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Teacher’s notes included in the Notes PageFlash activity

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Sources of FinanceUnit 6: Financial Planning

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Learning objectives

What sources of finance are available to businesses?

Which sources of finance are internal sources and which are external sources?

Which sources of finance are short-term, which are medium-term and which are long term?

What are the advantages and disadvantages of different sources of finance and what factors affect a business’s choice of source?


When does a business need finance?


Sources of finance

External sources: finance from outside the business.

Internal sources:finance from within the business.

Sources of finance are classed as being either internal or external.


Internal sources of finance

Internal finance is a quick and easy way to solve short-term financial problems for most firms. It saves a business from borrowing from a lender and having to pay back interest.

What are the disadvantages of each source of internal finance?

Retained profits: profits that owners have reinvested into the business after paying costs and tax.

Owners’ funds: money put in by the owners themselves.

Sale of assets: a one-off way to raise money, generally used during financial struggles.


External sources of finance

External sources of finance come from outside a business and are more difficult to arrange than internal sources.

Short-term finance: is used for daily expenses. It is sourced from an overdraft and is usually repaid in a year.

Long-term finance: is used to pay for major expenditure, such as buying new premises. Sources include: issuing shares, debentures, mortgages, venture capital and government grants. It is paid back over many years.

Medium-term finance: is used to pay for repairs and small improvements. Sources include: loans, hire purchase, trade credit and debt factoring. It is usually paid back over 1–5 years.


Short-, medium- and long-term finance


Owners’ funds

The owners of businesses often use their own savings to help them to start up. It is common for two or three people to combine their money to start up a business.

Advantages Disadvantages

Avoids interest on loans.

Owners keep complete control of the business.

If the owners remortgaged and the business fails, they could lose their homes.

There is a limit to how much money can be raised.

What are the advantages/disadvantages of this source?


Retained profits

When a business is performing well financially, it may choose to reuse some of the profits it made in previous years to help fund development/expansion projects.

It is similar to owners’ funds as there are no interest costs to pay.

What are the advantages/disadvantages of this source?

However, the business keeps full control of the new development/expansion because it will be using money that it already has.

But it may not leave the business with a buffer of funds to use if the project fails.


Selling assets

A business can sell off some of its assets to raise finance.

However, buyers can be scarce, advertising costs money, and the assets may have to be sold cheaply.

buildingsvehicles

landmachinery

What assets could a business sell to raise finance?


Overdrafts


Loans

When a business needs a substantial amount of finance, it is likely to apply for a bank loan.

the interest rates are often high

banks usually require security for loans in the form of assets which the business could lose if it starts missing repayments

banks do not take control of the business but they do ask for regular updates on its progress.

The disadvantages of banks loans are:


Government grants

The British Government and European Union offer some financial assistance to help businesses which meet certain criteria, such as small businesses starting up, businesses in assisted areas or ones developing new technology.

These bodies give out grants, so no costs are involved. However, a grant can be recalled if a business does not keep to the conditions attached to it. Grants can also be small, meaning that other sources of finance can still be required.

The Department of Trade and Industry (DTI) is the government department responsible for helping UK businesses to operate efficiently.


Hire purchase and leasing

When a business cannot afford to buy assets outright, such as vehicles, machinery and equipment, it could choose to hire purchase or lease them.

Leasing involves paying monthly instalments to use an asset, but a business doesn’t own it afterwards. Interest is charged for both sources, and the assets can be reclaimed if the repayments are not made.

When hire purchasing, a business must pay a deposit and monthly payments for the term of the agreement. At the end of the contract the business owns the assets.


Issuing shares

A limited company (Ltd or plc) can issue shares in the company to raise extra finance.

The company keeps control of its day to day operations, but the shareholders become the owners and in theory would be able to vote for changes. A plc also becomes vulnerable to a hostile takeover.

Issuing shares poses no risk for a company but it will have to pay dividends to the shareholders every year to reward them for their investments. The shareholders do take on a risk as the value of shares can fluctuate.


Venture capital

Venture capital businesses are large businesses which lend money to smaller businesses, not plcs.

Venture capital companies often play an active role in the business in which they are investing. For example, they may choose to appoint people onto the board of directors or may even become involved in the running of it.

Look at the website of the TV programme Dragon’s Den to find out more about venture capital.

The lender becomes a shareholder in the business. Their aim is for the business to grow rapidly over a 3–7 year period so that the share price increases. Then the venture capitalist would sell its shareholding at a profit.


Factors affecting choices


Question time

1.Give four reasons why businesses need to raise finance.

2.What are the main types of internal finance?3.What are the three different categories under which

sources of external finance can be classified?4.What factors affect a business’s choice of method?5.Name an advantage and a disadvantage of using

owners’ funds as a source of finance.


Who wants to be an A* student?


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© Boardworks Ltd 2009 1 of 20 Teacher’s notes included in the Notes PageFlash activity Icons key: For more detailed instructions, see the Getting Started