3.5.3 Making financial decisions: sources of finance

Question 1

Why do businesses need a source of finance?

Answer 1

Businesses need finance to buy fixed assets, like factories, offices and machinery.
rinance is also needed to pay day-to-day costs. like wages and bills. so that the business can survive.

Question 2

When choosing a source of finance, a business must consider what? Give examples and reasons.

Answer 2

• The legal structure of the business - limited companies can sell shares, but this isn’t an option for sole traders.
• The amount of money required - the larger the amount, the less likely it is that internal finance can be raised.
• The level of risk involved - a risky business is less likely to find a loan, although venture capital is an option.
  *If short-term or long-term finance is needed - it depends on how long it will take the business to repay it.

Question 3

What is an example of internal sources of finance?

Answer 3

Retained profit

Question 4

What are examples of external sources of finance? Also give the length of time they’re suitable for.

Answer 4

• Overdrafts (short term)
• Debt factoring (short term)
• Bank loans (long term)
• Share capital (long term)
• Venture capital (long term)

Question 5

What is retained profit?

Answer 5

Profit can be retained and built up over the vears for later investment.
This can work in the short and long term.

Question 6

What is the main benefits of retained profits

Answer 6

The main benefit of using profit for investment is that the business doesn’t have to pay interest on the money.
* Cheap (though not free) - The “cost of capital” of retained profits is the opportunity cost for shareholders of leaving profits in the business
* Very flexible - (Management control how they are reinvested and Shareholders control the proportion retained)
* Do not dilute the ownership of the company

Question 7

What are disadvantages of retained profit?

Answer 7

Shareholders may object to this method as they may wish to receive the profits as dividends
Also. retaining profits may cause the business to miss out on investment opportunities
High profits and cash flows would suggest the business could afford debt (higher gearing)
Not all businesses can use this method - they may not be making enough profit

Question 8

What are overdrafts?

Answer 8

Overdrafts are where a bank lets a business have a negative amount of money in its bank account.

Question 9

What are advantages of overdrafts?

Answer 9

Relatively easy to arrange
Flexible - use as much cash flow requires
Interest - only paid on the amount borrowed under the facility
Not secured on assets of business

Question 10

What are disadvantages of overdrafts?

Answer 10

Can be withdrawn at short notice
Interest charge varies with changes in interest rate
Higher interest rate than a bank loan
Fixed charge for using overdraft, therefore unsuitable in the long term.

Question 11

What is debt factoring?

Answer 11

Debt factoring is when banks and other financial institutions take unpaid invoices off the hands of the business, and give them an instant cash payment (of less than 100% of the value of the invoice)

Question 12

What are debt factoring’s advantages?

Answer 12

• Receivables (amounts owed by customers) are turned into cash quickly!
• Business can focus on selling rather than collecting debts
• The facility is practically limitless and therefore suits a fast-growing business.
• There is no security required – unlike a loan or overdraft.

Question 13

What are debt factoring’s disadvantages?

Answer 13

• Quite a high cost – the charge made by the factoring company, typically around 3%.
• Customers may feel their relationship with the business has changed

Question 14

What are bank loans?

Answer 14

1) Bank loans are an external source of finance. Businesses can borrow a fixed amount of money and pay it back over a fixed period of time with interest - the amount they have to pay back depends on the interest rate and the length of time the loan is for.

Question 15

What are advantages of bank loans?

Answer 15

Greater certainty of funding, provided terms of loan complied with
Lower interest rate than a bank overdraft
Appropriate method of financing fixed assets
No business assets owned by the bank

Question 16

What are disadvantages of bank loans?

Answer 16

1) They can be difficult to arrange because a bank will only lend a business money if they think they are going to get it back.
If the business doesn’t own any property or other assets that can be used for security, they might not be able to get a loan.
2) Keeping up with the repayments can be difficult if cash isn’t coming into the business quickly enough. The business might lose whatever the loan is secured on (e.g. their home) - the bank can sell it to get their money back.
3) The business might have to pay a charge if they decide to pay the loan back early.

Question 17

What is ordinary share capital?

Answer 17

Private and public limited companies can be financed in the long-term using ordinary share capital - money raised by selling shares in the business

Question 18

What are advantages of share capital?

Answer 18

less risk (dont have to make regular payments)
no interest
investors offer advice and have contacts
makes the brand more known
more flexible and gives control

Question 19

What are disadvantages of share capital?

Answer 19

giving away control
you can get taken over if too many shares are given away

Question 20

What is venture capital? Explain what venture capitalists are.

Answer 20

Venture capital is funding in the form of share or loan capital that is invested in a business that is thought to be high risk. Venture capitalists are professional investors who invest in businesses they think have the potential to be successful.

Question 21

What are advantages of venture capital?

Answer 21

Substantial Funding
Open To Risk
Hands-on Support
No Repayments
Networking Opportunities
Quicker Growth

Question 22

What is a disadvantage of venture capital?

Answer 22

Applying for funding is a long process