E3 Sources of Finance
Businesses need money to operate. As well and ongoing running costs such as buying raw materials and paying wages, they need to cover start up costs in the early stages and investment as the business grows.
Internal sources of finance are funds that a business generates itself.
External sources of finance are funds that have come from outside of the business
Internal Sources of Finance
Owner’s capital is money invested into the business that personally belongs to the owner from their personal savings. They may have saved this over a long period of time, received a redundancy payment or inheritance. The benefits of this are that the business will not have to pay back interest on this. However, drawbacks may include it usually being a small amount of money and the negative impact on the owner’s personal life if the business fails and the money cannot be paid back.
Sale of assets is a method of raising money by selling assets that are no longer in use to improve liquidity. For example, if a business is not using a machine anymore, they could sell it and use the money to invest in a more useful asset. Benefits of this method is that the money does not have to be paid back, there are no interest payments and it frees up space. However, a drawback may be that the business needs the assets at a later date and has to buy or lease a new one.
Retained profit is the money from profits that is reinvested back into the business after owners have taken their share of the profits or dividends have been distributed to shareholders. The benefits of this source is that it is not a loan so does not have to be paid back and there are no interest payments. However, this is a slow method to raise money and investors may prefer larger dividends than reinvestment.
Net current assets is the money that a business has available for day to day spending. It is the difference between all of the current assets (stock, debtors and cash) and the current liabilities (short term loans and creditors). To ensure adequate liquidity, managers must maintain a higher level of current assets than current liabilities
External Sources of Finance
Mortgages (long term) are long terms loans, usually between 15 and 35 years, that can be taken out to purchase a property. The loan is secured against the property which means that if the borrower cannot pay their mortgage, the property can be repossessed to pay back the money they owe. Benefits of mortgages are that property can be bought immediately rather than saving and interest rates are low compared to other borrowing methods. Drawbacks are that over time the interest adds a lot to the repayment and the property can be taken away if payments are missed.
Share issue (long term) refers to selling a percentage ownership to an investor with the agreement that they receive a share of any profits and can vote in strategic decision making. Benefits of share issue include raising large amounts of finance quickly which does not have to be paid back. Drawbacks include the original owners losing some decision making power and having to split profits across more people.
Debentures are long term loans to businesses by individuals, usually for large sums. An agreement is made between the business and the investor on interest payments and when the debenture is to be repaid in full. Benefits include raising large sums of money without having to share ownership. Drawbacks include compulsory interest payments that must be made annually regardless of whether the business makes a profit.
Leasing (medium term) is the rental of assets from another company in exchange for regular, usually monthly, payments. Typical assets that are leased are vehicles and machinery. Benefits are that you can use an asset to enhance production without having to find large amounts of money in one go and the leasing company is responsible for the maintenance. Drawbacks are that over the long term, it works out to be an expensive way to access an asset and the assets is never owned.
Hire purchase (medium term) is a method of buying an asset by paying in installments. Usually a deposit is made as first payment and then monthly installments until the final payment. Benefits are that businesses can purchase assets they cannot afford to buy in one go and the asset is eventually owned, unlike with leasing. Drawbacks include the interest charges adding to the overall debt and the asset is not owned until the last payment so could be taken back if payments are missed.
Bank loans (medium term) are fixed amounts of money that are given to businesses by banks that are paid back in installments over an agreed amount of time. The installments include interest. Benefits include them being easy to arrange as they are a common product and repayment terms can be flexible so a business can arrange affordable payments. A drawback is the interest payment can make the asset being purchased much more expensive in the long run.
Trade credit is an agreement to make purchases from another business without having to make payment straight away. Standard trade credit periods are 30 days but longer can be negotiated. Benefits of trade credit include improvements to short term liquidity and being able to wait for your own debtors to make payments before you need to make yours. Drawbacks include missing out on early payment discounts and a mismatch in times of credit terms you give to your customers compared to what your suppliers give to you.
Venture capital (medium term) is investments made by investors to businesses that are a more risky investment, usually newer businesses. Investors may be individuals, banks or other financial institutions. Venture capitalists believe that these investments offer high potential growth. A benefit is that a business may receive investment when other options are unavailable to them. Drawbacks include having to give a large share of the business to the investor. Due to the risky nature, the investors may require a higher share for their investment.
Overdrafts (short-term) are facilities within your bank account where you have arranged for the bank to allow your balance to go below zero. Benefits include giving you the flexibility to purchase the materials and equipment you need while you are waiting for payments to come in, you can continue to operate during quieter periods or seasons and they are easy to arrange. Drawbacks include the high interest rates that are usually charged on overdrafts meaning they should only be used in the short term and they are only usually agreed for small amounts of money.
Debt factoring is a way of raising finance by selling your outstanding debtors (trade receivables) to another business who will then chase payments. Benefits include increasing your liquidity quickly and reducing the time and resources it takes to chase the debt. Drawbacks include the reduction in profits due to the fees that the debt factoring company charge for this service.
Invoice discounting is the use of a third party business to borrow money when you send out an invoice to a customer. The lender will lend the business money once an invoice is issued under the assumption that it can be repaid once the customer makes payment. Benefits include the immediate improvements to cash flow rather than waiting for 30 - 90 days which is normal credit terms. Drawbacks include the reduction in profits as a result of the fees charged.
Peer-to-peer lending is borrowing directly from another individual rather than from a financial institution. There are websites set up to match individuals or businesses that need to borrow money with lenders. Benefits include it being a fast process and interest rates can be competitive. Drawbacks include credit checks and application fees.
Crowdfunding is the gathering of small amounts of donations or investments from a large number of people. This is often promoted through social media or using organisations such as Kickstarter. Benefits include it being a potentially fast way of raising finance. Drawbacks include it being uncertain and having to publicly promote new business ideas and innovations that may be copied.