2.1 Raising Finance

Question 1

What is finance required for?

Answer 1

Capital expenditure: (spending on fixed assets such as equipment, buildings, IT equipment and vehicles

Revenue expenditure: (spending on raw materials or day-to-day expenses such as wages or utilities)

Question 2

What is an internal source of finance?

Answer 2

Where the finance comes from inside the business

Question 3

What is an enternal source of finance?

Answer 3

Where the finance comes from outside the business

Question 4

Where do internal sources of finance come from?

Answer 4

• owner’s capital (personal savings)
• retained profit
• the sale of assets

Question 5

What is owner’s capital?

Answer 5

Personal savings

Owners may introduce their savings or another lump sum e.g. money received from a redundancy payment (where a job role is no longer needed by a business and a worker is dismissed, usually with compensation)

Owners may invest more as the business grows or if there is a specific need, e.g. a short-term cash flow problem

Question 6

What is retained profit, why is it good and what is the opportunity cost that comes about with it?

Answer 6

The profit that has been generated in previous years and not distributed to owners is reinvested back into the business.

Retained profits are good as they are a cheaper source of finance, as it does not involve borrowing and therefore there is no interest.

The opportunity cost of investing the money back into the business is that shareholders do not receive extra profit for their investment

Question 7

What is sale of assets?

Answer 7

Selling business assets which are no longer required (resources owned by the business e.g. machinery, buildings, stock and cash)

Question 8

What are the advantages of using internal finance?

Answer 8

Advantages:

Internal finance is often free (e.g. it does not involve the payment of interest or charges)

It does not involve third parties who may want to influence business decisions

Internal finance can usually be organised very quickly and without significant paperwork

Businesses that may fail credit checks (necessary for a bank loan) can access internal finance sources more easily

Question 9

What are the disadvantages of using internal finance?

Answer 9

Disadvantages:

There is a significant opportunity cost involved in the use of internal finance, e.g. once retained profit has been used, it is not available for other purposes

Internal finance may not be sufficient to meet the needs of the business

Using an internal finance method is rarely as tax-efficient as many external methods, e.g. loan repayments may be treated as a business cost and offset against tax

Question 10

What are the sources of external finance?

Answer 10

• family and friends
• banks
• peer to peer lending
• business angels
• crowdfunding
• other businesses

Question 11

What is obtaining finance from family and friends and what are the advantages and disadvantages?

Answer 11

Where small business owners approach close acquaintances to invest or lend money to a business

Advantages:

Usually a very cheap source of funds
May have ‘no strings attached (e.g. a share of the business) and can be provided to the business on very flexible terms

Disadvantages:

Relationships may be damaged if the finance is not repaid

Question 12

What are the advantages and disadvantages of bank loans?

Answer 12

Banks provide several different kinds of loans to businesses, e.g. a small business loan

Advantages:
May offer both short term finance (e.g. overdrafts) and long term finance (e.g. loans or mortgages) if a business qualifies

Banks are often keen to provide free advice and guidance to businesses that use their services

Small sums may be borrowed from unsecured

Disadvantages:
A business plan is usually required to access bank finance

Banks can be cautious about lending to new, untested businesses

Interest (and often an arrangement fee) is payable

Businesses must be customers of the bank (i.e. hold a banking account) to access some loans

For larger amounts, businesses may need to provide security to be granted a loan

Question 13

What is peer to peer funding and what are the advantages and disadvantages?

Answer 13

Peer to peer funding is an alternative form of business finance which allows individuals or businesses to lend directly to other people or businesses, bypassing traditional banks

Advantages:
Loans can usually be made available to businesses very quickly

Usually has ‘no strings attached (e.g. a share of the business)

Disadvantages:
Borrowers are charged a small fee to access finance in this way and have to pay interest in the same way as a bank loan
The individuals who made the money available in the first place receive some of this interest as compensation

Question 14

What is a business angel and what are the advantages and disadvantages?

Answer 14

business angels are wealthy, entrepreneurial individuals who provide capital in return for a proportion of your company’s shares

Advantages:
Business angels tend to be more willing to take a risk than banks

Angels often offer advice and guidance to the businesses in which they invest

Investment is usually for a determined period of time so owners regain shares in the future

Disadvantages:
Finding the ‘right’ business angel (e.g. with appropriate experience, expertise or interest) can be challenging
So networking is vital when entrepreneurs seek this kind of investment

As business angels own a stake in the business, they may be involved in decision-making and will receive a share of business profits

Question 15

What is crowdfunding and what are the advantages and disadvantages?

Answer 15

Crowdfunding is finance provided by a large number of small investors on online platforms such as kickstarter.

Advantages:
Creates an organic customer base and the platform provides a form of free marketing

A good credit rating is not required so new businesses that lack a trading record can attract funding

Disadvantages:
Businesses need to provide a persuasive business plan to convince individuals to invest in their product as they will be competing with many other projects online

The potential for negative publicity if the project is not successful in attracting enough crowdfunding capital

Question 16

What are investors often attracted by?

Answer 16

Incentives such as samples or early access to products

Question 17

It may be possible for a business to access finance via a joint venture with another business, such as a key customer or supplier, what is a joint venture?

Answer 17

A contractual agreement between 2 or more firms to combine their resources and expertise to achieve a particular goal

Question 18

What are the advantages and disadvantages of finance from other businesses?

Answer 18

Advantages:
May provide access to business processes and market knowledge alongside finance

Can access large amounts of finance

Disadvantages:
Profits need to be shared between businesses

Decisions will usually need to be agreed by all businesses

Question 19

What are the methods of external finance?

Answer 19

• loans
• share capital
• venture capital
• overdrafts
• leasing
• trade credit
• grants

Question 20

What are loans and what are the benefits and drawbacks?

Answer 20

A loan is a sum of money that is borrowed and repaid (with interest) over a determined period of time

Bank loams are usually unsecured meaning no asset or collateral is required to gain access to the loan

Benefits:
Interest rates are fixed for the term of the loan

Repayments are made in equal instalments, helping budgeting

Businesses can purchase expensive equipment or property without the need for large amounts of capital

Control over decision-making is retained within the business
With debentures, interest is fixed, aiding budgeting

Drawbacks:
Interest rates depend on the businesses credit rating

Non-current liabilities are increased in the balance sheet

With a mortgage, missed payments may lead to property being repossessed

Failure to repay debentures may deter investors in the future

Question 21

What is a debenture?

Answer 21

A long-term agreement between a business ad a lender to repay a specific amount (with a fixed rate of interest) by a certain date

Debenture holders are creditors (a business or individual to whom a business owes money) rather than owners of a business and do not hold voting rights

Question 22

What is an overdraft and what are the benefits and drawbacks?

Answer 22

An overdraft is an arrangement where business current account holders can spend more money than is in their account

A limit is agreed and interested is charged ONLY when a business goes over the limit

Benefits:
A short-term source of finance that offers significant flexibility and aids cash flow

Drawbacks:
An overdraft may be ‘called in’ if the bank is concerned about a business’s ability to repay what it owes, meaning they have to pay it all back immediately.

Question 23

What is share capital and what are the benefits and drawbacks?

Answer 23

Share capital is finance raised from the sale of shares in a limited company

Shareholders are the owners of shares and they are entitled to a share of the company’s profit when dividends are declared

Benefits:
No need to make regular payments
Lower risk of bankruptcy

Disadvantages:
Issuing shares mean the company founders are giving up some control. (Shareholders can become diluted)

Question 24

What is venture capital and what are the benefits and drawbacks?

Answer 24

Venture capital is funds provided by specialist investors in small to medium-sized businesses that have significant potential for growth e.g. in the tech sector

Benefits:
Businesses that may have been refused finance from other sources may be able to attract investment from less risk-averse venture capitalists

Drawbacks:
Venture capitalists usually require a stake in the business in return for finance and often expect to exert some control over the business

Question 25

What is leasing and what are the benefits and drawbacks?

Answer 25

Leasing is where an asset such as a piece of machinery or vehicle is used by a business in return for regular payments E.g. office equipment such as a photocopier Benefits: The business does not own the asset during the period of the lease and so is not responsible for maintenance or repair costs Drawbacks: Leasing is usually more expensive in the long run than buying an asset

Question 26

What is trade credit and what are the benefits and drawbacks?

Answer 26

Trade credit is an agreement made with suppliers to buy raw materials, components and stock which are paid for at a later date, typically 30 to 90 days later, this allows a business to improve their cash flow Benefits: Trade credit is usually interest free Drawbacks: Discounts for early payment will not be available If businesses fail to repay in time it will damage their relationship with their suppliers

Question 27

What are grants and what are the benefits and drawbacks?

Answer 27

Grants are money given to a business by the government, grants are usually offered to businesses that meet a specific criteria E.g. grants may be available for businesses that create jobs or improve infrastructure in a region Benefits: Grants DO NOT need to be repaid Drawbacks: The business MUST use the finance for its intended purpose

Question 28

What types of businesses have an unlimited liability?

Answer 28

Sole traders Partnerships

Question 29

What types of businesses have a limited liability?

Answer 29

Private limited companies Public limited companies Franchises

Question 30

What are the characteristics of an unlimited liability?

Answer 30

Sole proprietors and partnership owners are fully responsible for all debts owed by the business Owners are also legally responsible for any unlawful acts committed by those connected to the business

Question 31

What are the characteristics of a limited liability?

Answer 31

Owners (shareholders) of private limited companies and public limited companies can only lose the original amount they invested in the business if it fails Shareholders are not responsible for business debts In most cases, the shareholders cannot be held responsible for unlawful acts committed by those connected with the business

Question 32

Why are debentures, retained profit, share capital, venture capitalists and business angels not viable for a company with an unlimited liability?

Answer 32

Because they don’t want to risk their personal assets.

Question 33

What are the factors affecting the choice of finance?

Answer 33

WHY IS FINANCE NEEDED?: Capital expenditure on buildings and expensive equipment will usually require a longer-term method of finance, such as a mortgage or share issue Revenue expenditure (e.g. purchasing raw materials or paying business rates) is more likely to be funded through a short-term method such as trade credit or overdraft FOR HOW LONG AND HOW QUICKLY IS THE FINANCE NEEDED?: For quick, short-term finance, businesses may use methods such as overdrafts, trade credit, short-term loans or leasing If a business needs access to finance over the longer term, methods such as a share issue, debentures, mortgages or grants may be more suitable WHO WILL LEND TO THE BUSINESS?: Start-ups or struggling businesses may find their choice of finance limited and will often pay much more to access it than more established, stable businesses Businesses that present more of a risk to lenders may choose to raise finance through venture capitalists, business angels or crowdfunding Unlimited liability businesses, as well as businesses that own few assets, often struggle to raise finance as they’re seen as risky HOW MUCH WILL IT COST, AND HOW EASY IS IT TO ACCESS THE FINANCE?: Methods of finance that attract interest, e.g. loans, mortgages and overdrafts, are less affordable for businesses when interest rates are high Interest-free methods of finance are usually more complex to access, e.g. share issues and grants WHAT IS THE LEGAL STATUS OF THE BUSINESS?: Unlimited liability businesses often struggle to raise finance They may be small, own few business assets (e.g. to use as collateral) or have a limited trading record Lenders (e.g. banks) prefer to lend to more established businesses that own assets Investors prefer to invest in limited companies as they are often able to obtain a share in the business

Question 34

What is a business plan?

Answer 34

A document produced by the owner at start-up, which provides forecasts of items such as sales, costs and cash flow

Question 35

What is the main aim of producing a business plan?

Answer 35

To reduce the risk associated with starting a new business. Producing a business plan forces the owner to think about every aspect of the business before they start which should reduce the risk of failure, It shows potential lenders or investors that the business has done their research

Question 36

What is a cash flow forecast?

Answer 36

A prediction of the anticipated cash inflows and cash outflows, typically for a 6 or 12 month period A detailed business plan should include a cash flow forecast that allows the business owners to identify its financial needs

Question 37

How is net cash flow calculated?

Answer 37

By subtracting total outflows from total inflows

Question 38

How is the opening balance calculated?

Answer 38

The closing balance of the previous month or period of time given

Question 39

How is the closing balance calculated?

Answer 39

Adding the net cash flow to the opening balance

Question 40

What are the advantages and disadvantages of cash flow forecasts?

Answer 40

Advantages: Cash flow forecasts can support an application for a loan and are an integral part of the business plan They can help identify where the business may experience cash shortfalls or cash surpluses so that plans can be made to manage these periods (e.g. arranging an overdraft) Cash flow forecasts aid planning and help a business avoid costly mistakes Disadvantages: Forecasts are usually based on estimates and in reality, inflows and outflows may differ significantly from the estimates Cash flow forecasts require appropriate skills, insight, research and time to prepare and update adequately External factors that can impact inflows and outflows may not be reflected in the cash flow forecast