Sources of Finance Essay
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Finance is the study of how investors allocate their assets over time under conditions of certainty and uncertainty. A key point in finance, which affects decisions, is the time value of money, which states that a unit of currency today is worth more than the same unit of currency tomorrow. Finance aims to price assets based on their risk level, and expected rate of return. Finance can be broken into three different sub categories: public finance, corporate finance and personal finance.
Why Do Businesses Need Finance?
Finance is the money available to spend on business needs. Right from the moment someone thinks of a business idea, there needs to be cash. As the business grows there are inevitably greater calls for more money to finance expansion. The day to day running of the business also needs money. The main reasons a business needs finance are to:
* Start a business:
Depending on the type of business, it will need to finance the purchase of assets, materials and employing people. There will also need to be money to cover the running costs. It may be some time before the business generates enough cash from sales to pay for these costs.
* Finance expansions to production capacity:
As a business grows, it needs higher capacity and new technology to cut unit costs and keep up with competitors. New technology can be relatively expensive to the business and is seen as a long term investment, because the costs will outweigh the money saved or generated for a considerable period of time. And remember new technology is not just dealing with computer systems, but also new machinery and tools to perform processes quicker, more efficiently and with greater quality.
* To develop and market new products:
In fast moving markets, where competitors are constantly updating their products, a business needs to spend money on developing and marketing new products e.g. to do marketing research and test new products in “pilot” markets. These costs are not normally covered by sales of the products for some time (if at all), so money needs to be raised to pay for the research.
* To enter new markets:
When a business seeks to expand it may look to sell their products into new markets. These can be new geographical areas to sell to (e.g. export markets) or new types of customers. This costs money in terms of research and marketing e.g. advertising campaigns and setting up retail outlets.
* Take-over or acquisition:
When a business buys another business, it will need to find money to pay for the acquisition (acquisitions involve significant investment). This money will be used to pay owners of the business which is being bought.
* Moving to new premises:
Finance is needed to pay for simple expenses such as the cost of renting of removal vans, through to relocation packages for employees and the installation of machinery. * To pay for the day to day running of business:
A business has many calls on its cash on a day to day basis, from paying a supplier for raw materials, paying the wages through to buying a new printer cartridge.
* Special situations:
For example, a decline in sales, possibly as a result of economic recession, could lead to cash needs to keep the business stable.
Types of finance:
It is pivotal to have access to money, in order to start and run a business. There are many ways to get money, all businesses need money. Where the money comes from is known as ‘sources of finance’. Now there are two different types of sources of finance: internal (finance from inside the business) and external (finance from outside the business). New businesses starting up need money to invest in long-term assets such as buildings and equipment. They also need cash to purchase materials, pay wages, and to pay the day-today- bills such as water and electricity. In-experienced entrepreneurs (or social entrepreneurs) often underestimate the capital needed for the everyday running of the business. Generally, for every £1000 required to establish the business, another £1000 is needed for day-to-day needs. This is why sources of finance are crucial for any business.
Internal sources of finance:
* Retained earnings:
For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend. The major reasons for using retained earnings to finance new investments, rather than to pay higher dividends and then raise new equity for the new investments, are as follows: a) The management of many companies believes that retained earnings are funds which do not cost anything, although this is not true. However, it is true that the use of retained earnings as a source of funds does not lead to a payment of cash. b) The dividend policy of the company is in practice determined by the directors.
From their standpoint, retained earnings are an attractive source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders. c) The use of retained earnings as opposed to new shares or debentures avoids issue costs. d) The use of retained earnings avoids the possibility of a change in control resulting from an issue of new shares. The advantage of using retained profits is that it does not have to be repaid as in the case of loan while the disadvantages can be that new business or loss making business may not have any retained profits and a business may have retained profits which are too few to finance the expense needed.
• Own savings:
Personal saving is an advantage for entrepreneurs; this will prevent stress and pressure of gathering money from scratch. Savings can be from previous employments, inheritance, and redundancy. This will be a positive head start for the business and a helping hand also advantage is its interest free. Moreover there is no need to borrow money externally and it is a quick way for the firm to obtain finance. On the other hand savings may be too low to finance the expense needed.
This is when two savings is used to help start the business. This is an advantage as there is more money and less pressure. There is a disadvantage for this scheme; sometimes entrepreneurs may fall out over disagreements.
* Sale of assets:
Some companies often find that they have assets that are no longer fully employed. These could be sold to raise cash. In addition some businesses will sell assets that they still intend to use, but which they do not need to own. In these cases the assets might be sold to a leasing specialist and leased back by the company. This will raise capital and there will be better use of the existing capital in the business. However it may take some time to sell off these assets.
* Decrease the amount of stock held:
Its advantage is that it reduces the opportunity cost and storage cost of high stock level while a drawback might be that stock level should be kept to avoid disappointing customers.
External sources of finance:
This option is only applicable to limited companies. They can raise finance by issuing shares. Public limited company will obviously be able to raise more finance since it can sell its shares to the public. There are two ways in which businesses can issue shares. They can either go for a new issue or right issue. Selling shares to a new issue will simply mean that new members will be invited to join the business as shareholders. This method of rising capital can be expensive to organize. In addition the more share sold would mean a loss of control to the original shareholders.
A right issue of share is where existing shareholders obtain the right to buy new shares in proportion to their current holding. This will avoid the problem of new shareholders changing the balance of ownership. The benefit is that issue shareholders is permanent source of capital which does not have to be repaid back unlike bank loans while a disadvantage may be that if the business is going for a new issue of shares, it might be costly and at the same time implies a loss of control for the original owners.
* Bank lending:
Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium-term lending is quite common these days. Short term lending may be in the form of:
a) An overdraft, which a company should keep within a limit set by the bank. Interest is charged (at a variable rate) on the amount by which the company is overdrawn from day to day; b) Long term loan may be offered at either a variable or a fixed interest rate. Lending to smaller companies will be at a margin above the bank’s base rate and at either a variable or fixed rate of interest. Lending on overdraft is always at a variable rate. A loan at a variable rate of interest is sometimes referred to as a floating rate loan. Longer-term bank loans will sometimes be available, usually for the purchase of property, where the loan takes the form of a mortgage. When a banker is asked by a business customer for a loan or overdraft facility, he will consider several factors, known commonly by the mnemonic PARTS.
The advantage is that it is quickly to arrange and the business can obtain different sums of money, sometimes huge amount which can be paid over a long period of time. However the bank will have to be paid in addition with interest and also banks may ask for collateral security.
* Hire purchase:
Hire purchase is a form of installment credit. Hire purchase is similar to leasing, with the exception that ownership of the goods passes to the hire purchase customer on payment of the final credit installment, whereas a lessee never becomes the owner of the goods. The advantage is that the firm does not need to pay for the good immediately especially if it requires a huge sum of money while on the other hand interest rate has to be paid and this often makes the goods more expensive.
* Government assistance:
The government provides finance to companies in cash grants and other forms of direct assistance, as part of its policy of helping to develop the national economy, especially in high technology industries and in areas of high unemployment. For example, the Indigenous Business Development Corporation of Zimbabwe (IBDC) was set up by the government to assist small indigenous businesses in that country. Its benefit is that it does not have to be repaid back and the drawback is that businesses can only obtain help if they follow the conditions attached to it. For example, the need to locate in areas which are poorly developed.
* Venture capital:
Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A businessman starting up a new business will invest venture capital of his own, but he will probably need extra funding from a source other than his own pocket. However, the term ‘venture capital’ is more specifically associated with putting money, usually in return for an equity stake, into a new business, a management buy-out or a major expansion scheme. Venture capital firms usually look to retain their investment for between three and seven years or more. The term of the investment is often linked to the growth profile of the business.
Investments in more mature businesses, where the business performance can be improved quicker and easier, are often sold sooner than investments in early-stage or technology companies where it takes time to develop the business model. Just as management teams compete for finance, so do venture capital firms. They raise their funds from several sources. To obtain their funds, venture capital firms have to demonstrate a good track record and the prospect of producing returns greater than can be achieved through fixed interest or quoted equity investments.
Most UK venture capital firms raise their funds for investment from external sources, mainly institutional investors, such as pension funds and insurance companies. Venture capital firms’ investment preferences may be affected by the source of their funds. Many funds raised from external sources are structured as Limited Partnerships and usually have a fixed life of 10 years. Within this period the funds invest the money committed to them and by the end of the 10 years they will have had to return the investors’ original money, plus any additional returns made. This generally requires the investments to be sold, or to be in the form of quoted shares, before the end of the fund.
* Borrowing from friends and family:
This is also common. Friends and family who are supportive of the business idea provide money either directly to the entrepreneur or into the business. This can be quicker and cheaper to arrange (certainly compared with a standard bank loan) and the interest and repayment terms may be more flexible than a bank loan. However, borrowing in this way can add to the stress faced by an entrepreneur, particularly if the business gets into difficulties.
By delaying the payment of bills for goods or services received, a business is, in effect, obtaining finance. Its suppliers are providing goods and services without receiving immediate payment and this is as good as `lending money`. Its advantage is that it is an interest free of financial rate. However the suppliers might not agree or even refuse to supply the goods in the future if ever payment is not made quickly.
It is where a firm can use an asset without the need to purchase it. The advantage is that there is no need to find large sums of money to purchase the asset and care and maintenance of the asset is the responsibility of the leasing company whereas a disadvantage might be that the total cost of the leasing charges may be higher than purchasing the asset.
* Factoring debt:
Debt factors are specialist agencies that buy the debts of firms for immediate cash. However they will only give the company selling its debts 90% of the existing debts, the remaining will represent the factor`s profit. The benefit is that the company selling is debts will obtain immediate cash and the risk of collecting the debt is transferred to thee debt factor. On the other hand, the firm selling its debt does not receive the total value of its debts.
Factors to be considered when choosing sources of finance:
When a firm needs finance, it becomes crucial to pick how much finance they need and for how long. It can ruin or make a business. A firm will have a wide range of sources to choose finance from such as a bank loan or overdraft, share capital, venture capital, profit, or trade credit. However, some sources of cash are suited best for short term while others are best for long term and some are suited for little injections of cash while others are suited to huge injections of cash. Before a business decides what source of finance it should choose, they need to ask the question:
* How Much Finance Can the Business Obtain?
* The type and amount of finance that is available will depend on several factors. These are as follows: The type of business – a sole trader will be limited to the capital the owner can put into the business plus any money he or she is able to borrow. A limited company will be able to raise share capital. In order to become a public limited company, it will need to share capital of £50,000+ and a track record of success. This will make borrowing easier. The stage of development of the business – a new business will find it much harder to raise finance than an established firm. As the business develops it is easier to persuade outsiders to invest in the business. It is also easier to obtain loans as the firm has assets to offer as security. The state of the economy – when the economy is booming, business confidence will be high.
It will be easy to raise finance both from borrowing and from investors. It will be more difficult for businesses to find investors when interest rates are high. They will invest their money in more secure accounts such as building societies. Higher interest rates will also put up the cost of borrowing. This will make it more expensive for the business to borrow. These factors will help make the firm decide how much it needs or can borrow. So, at this stage the business knows how much it needs and in the space period it needs it for. Here are the most logical solutions to sources of finance for short/long term and high/low finance:
* Amount needed:
* Shares issue and sales of debentures, because of the administration and other costs, would generally be used only for large capital sums.
* Small bank loans or reducing debtor`s payment period could be used to raise small sums.
* Cost: * Obtaining finance is never free, even internal finance may have opportunity cost.
* Loans may become very expensive during a period of rising interest rates.
* A stock exchange flotation can cost millions of dollars in fees and promotion of the share sale.
* Legal structure and desire to retain control:
* Share issues can only be used by limited companies- and only limited companies can sell shares directly to the public. Doing this runs the risk of the current owners losing some control – except if a right issue is used.
* If the owners want to retain control of the business at all costs, then a sale of shares might be unwise.
* Size of existing borrowing:
* This is a key issue- the higher the existing debts of a business (compared with its size), the greater the risk of lending more. Banks and other lenders will become anxious about lending more finance.
* This concept is referred to as gearing.
* When a firm has a variable need for finance- for example, it has a seasonal pattern of sales and cash receipts- a flexible form of finance is better than a long term and inflexible source.