Flashcards in Knowledge to date Deck (117)
Name 5 sources of finance?
Overdraft, Trade Credit, Retained profit in the form of cash reserves, Mortgage, Bank Loan, Selling Shares
What is meant by unlimited liability?
If the business goes Bankrupt then any money awed to suppliers or the bank can be recovered through repossession of owners personal assets. This will only happen if the company does not have enough assets to cover the amounts owing
Explain why a loan might not be appropriate for a business with unlimited liability
This will add further risk to the owners as it places pressure on the business to make regular payments which reduces cash reserves meaning that they may lack sufficient current assets to pay current liabilities risking liquidation which might then risk personal possessions.
Explain how having unlimited liability impacts a business' ability to gain credit from suppliers
If a business has unlimited liability it could work in their favour for getting credit from suppliers as the supplier will have the added security of collateral if the credit is not repaid. The supplier will know that they can recover any debt from the owners personal assets
Why might banks be reluctant to provide a loan to a business with limited liability?
As if the business lacks sufficient assets to cover the cost of the loan then the bank will lose that capital as they can't recover it from the owner's personal possessions
Explain the difference between an overdraft and a bank loan
An overdraft has a higher interest rate but is more flexible as the business can choose when they pay it off and by how much they pay off. However the bank can remove the overdraft at any time and ask the business for the amount owing. With a loan the repayments are fixed and the business must make regular monthly payments.
What is the difference when a business uses share capital as a source of finance compared to using a venture capitalist?
A business needs to be a limited company to sell shares and will usually sell a small proportion of the business in one issue compared with raising money through a VC which involves giving up a significant part of the business (sometimes as much as 50%) in exchange for capital and advice/ experience. When a business issues shares the shareholders (particularly for a PLC) will probably have limited involvement in the business
Explain why using retained profit as a source of finance may not be a favourable option for a PLC
If the business uses retained profit as a source of finance then the businesses share price may fall as it may mean that they reduce dividend payments which makes investing in the business (buying shares) less popular reducing demand for the shares and therefore reducing share price
Explain how a business' legal structure can have an impact on the source of finance a business chooses to use
If a business is a limited company they can issue shares and will attract more investors than a partnership and sole trader due to the reduced risk gained through limited liability status. Where as Partnerships and sole traders cannot sell shares and will struggle to attract investment due the unlimited liability status. Therefore they are more reliant on venture capitalists and loans.
Identify three short term sources of finance
Overdraft, Trade Credit, Retained profit in the form of cash reserves
Identify three long term sources of finance
Mortgage, Bank Loan, Selling Shares
What is meant by working capital and why is it important when choosing a source of finance?
Working capital is the value of current assets that are left over after the current liabilities have been paid. If a business has high working capital it shows that it is at low risk of having cash flow problems and is therefore able to safely take out a loan as it is likely to keep up with loan repayments as it is likely to have sufficient cash in reserves. This reduced risk is recognised by banks and shareholders meaning they are willing to provide the capital. A low risk business will usually get a lower rate of interest on loans and be able to sell shares at a higher price.
Why might a bank be more reluctant to lend money to a new restaurant than they are to other new businesses?
A restaurant is likely to provide luxury goods meaning that they are income elastic which means that sales could significantly fall if incomes fall due to changes in the economy. Therefore they are venerable to economic changes adding to the risk for the bank. If the country goes into a recession the business may struggle to pay the loan back.
Why might an overdraft be an appropriate source of finance for a new business?
A new business will not have past sales data and will have limited experience in the market. Therefore it will be difficult to predict sales. Therefore it will be difficult to predict cash outflows like wages and cost of raw materials. Therefore they need flexible finance that they can use as and when required rather than committing to regular monthly repayments
Why may a sales boom lead to the business going bankrupt?
To gain the sales boom the business may have overinvested into fixed assets such as vehicles and equipment causing significant cash outflows resulting in negative net cash flow making it difficult to keep up with payments to suppliers and banks. This may lead to the business being forced to sell fixed assets to the point that it can no longer function.
Why might it be argued that a business should not keep large sums of cash?
There is an opportunity cost of keeping large sums of cash as this means the business it not fully utilising their capital as it could be making a greater return if invested in fixed assets. As the fixed assets such as a store or equipment could be increasing sales due to increased capacity. Or the capital could be invested in advertising or training of staff which would also increase sales - explain how
Where can a new business go for capital if the bank says no and they don’t have any friends, family or savings?
venture capitalist - but the VA will know the high risk nature of a business like this and will want high returns so will request a large share of the business
Why might a business be reluctant to take out an overdraft?
As there are significantly high interest payments. It can also be taken off them at a short notice which may mean the business will have to sell fixed assets in order to repay it
Why might a business choose to buy equipment rather than lease it?
This will be better for long term cash flow as there will be will not be regular cash outflows
Why might a business source finance using debt rather than equity?
So the business doesn't have to give up shares so they can maintain complete control over the objectives of the organisation rather than having to consider potentially short term goals of shareholders
What is meant by collateral and why is it important to a business?
Collateral is when a business places a fixed asset down as security for a loan. This says to the bank that if the loan is not paid they have legal ownership of the asset
Why might suppliers refuse to give credit to a small company?
A small organisation might have few fixed assets therefore if they struggle to pay the supplier there is a risk that the supplier will not receive payment for the goods as there will be limited fixed assets that the business can sell to repay the debt
Why do some companies pay dividend rather than keeping large amounts of retained profits?
When a business pays dividend it makes investments in the company more attractive to shareholders as they will gain an increased return on their investment. This will increase the demand for shares leading to an increase in share price. This will benefit the business as it will mean they can generate more capital from selling shares if they issue new shares leading to further expansion.
I have a high interest rate and can be reduced or taken away with very little notice. What source of finance am I?
Using this source of finance may have an opportunity cost
Cash reserves or retained profit
I have to be secured against an asset
I give up a percentage of ownership in return for investment and advice.
Using the internet I can attract a significant number of investors for small businesses
Explain why a business plan might be needed to secure finance for a new business
The business plan, if backed up by effective and reliable research (e.g. with large sample sizes and not prone to bias) the business plan can show the bank how the loan will be invested and how the business plans to repay the loan. The key section is the finance section that will show the cash flow forecast and if the closing balance can remain largely positive when paying off the loan then it is likely that the bank will view the lender as a lower risk. The business plan could be so convincing (especially if based on creditable research) that the bank may reduce the interest on the loan.