Sources of finance
From WikiTextbook
A new business is likely to be financed by a mixture of the owners’ funds and loans. Once the business has opened there are a number of different places it can get money from. It could choose to use retained profits or if it has shareholders it could issue new shares. These are just two of the sources of finance we will look at in this module. A new business is unlikely to start as a limited company so is not likely to issue shares. The sources of finance we will look at are:
• owners’ funds;
• profits;
• loans and overdrafts;
• trade credit
• government grants;
• hiring and leasing;
• issuing shares;
• selling assets;
• venture capital.
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Owners’ Funds
This is the money that is put into the business by the owners. When some businesses are first opened owners will provide money to pay for the set up costs. If the owners don’t have enough money to pay for the start up costs other sources of finance will have to be obtained. Owners may also use their own money to pay for the initial running costs of the new business. Again, if the owners don’t have enough money other sources of finance should be obtained to pay for the running costs of the business.
When owners use their own funds they should consider what else that money could be used for, for example, if the money could be put in a bank account that would earn more than the business, it would be sensible for the owners to put the money into the bank rather than the business.
Profits
As we have seen from the balance sheet many businesses will use previously earned profit as a source of funds. When profit is used by the business, rather than being given to its owners, it is called retained profit. Over 60% of all investments made by businesses are funded by retained profit. This is a relatively cheap source of finance as the business does not have to pay anybody for borrowing money. The only cost of using retained profit is the interest that could be earned by placing the money in the bank.
Loans
There are many different types of loan that a business could take out. When taking out a loan the business must pay back the money borrowed plus interest at regular periods over an agreed period of time. Loans are offered for various periods of time at different interest rates, for example, the loan could be repaid over a period of 1 to 25 years. The interest rate the business has to pay could either be fixed or variable. If the interest rate is variable the amount the business has to repay might change if the Bank of England changes its interest rates. If the interest rate is fixed it will not change during the period of repayment.
Some banks will ask for collateral on the loan, this is a form of security if the business is unable to repay the loan. Collateral can be sold to repay any money the business has not paid back if it is unable to repay the loan.
Overdrafts
If the business runs out of money its bank may agree to it having an overdraft. The overdraft means the business is allowed to have a negative figure in its bank account. The bank charges a high interest rate for the overdraft, but it is beneficial to the business because it is flexible and the business only has to borrow what it needs. The overdraft should only be used as a short term solution.
Trade Credit
The business can obtain goods and services from other businesses without having to pay for them at the time. It is common to have one or two months of interest free trade credit.
Grants
Business can obtain grants from a number of different sources including the Government, the European Union and the Princes Trust. Business can receive grants for locating in areas where there are high levels of unemployment and relative poverty, examples are:
• The Government’s Department for Trade and Industry (DTI) – the size of the grants that the DTI will give is linked to the number of jobs that will be created or safeguarded.
• The Rural Development Commission (RDC) – will provide grants for businesses with between 5 and 50 employees in manufacturing, service, tourism and some forms of retailing.
• The European Regional Development Fund (ERDF) – The European Union provides assistance for areas of relative poverty. The European Regional Development Fund (ERDF) offers garnts and cheap loans to help build essential infrastructure, e.g., railways and roads.
The Prince’s Trust offers grants to young people who are setting up in business.
Hiring
Hire purchase is often used to buy equipment. If, for example, a business wishes to buy a plasma screen television: the finance house would pay the supplier for the plasma screen television and it would then delivered to the business. The business then pays the finance house for the plasma screen television in installments over a period of time. The business will not legally own the plasma screen television until the final installment is paid. The interest rate the finance house charges are usually higher than a bank’s.
Leasing
If a business wants a delivery lorry it could choose to lease it. A lease means that the business is simply renting the lorry for an agreed period of time. The business will never own the lorry, but some leases give the business the option of buying the lorry after the lease period. Many leasing contracts now include maintenance contracts with them, this means the lorry will be maintained and repaired as part of the agreement.
Issuing Shares
Private and public limited companies are allowed to sell shares. Most shares sold are ordinary shares which entitles the shareholder to receive a share of the business’s profits, this is called a dividend. The dividend will vary from year to year depending on the amount of profit the business owns. Dividends will also fall if the business decides to use retained profit as a source of finance.
Some limited companies also offer preference shares. These shares agree to pay the shareholder a fixed dividend each year which does not change with the level of profit.
Selling Assets
A business can sell off assets that it already owns in order to raise cash. Sometimes a business will be forced to sell their assets if it can’t get finance from any other source.
Venture Capital
This is money that is invested in the business by venture capitalists. These funds are provided by investors who believe the business has potential to make profits in the future. Venture capitalists will often invest in businesses that others feel are too risky. In return for investing money the venture capitalists will often be given a share of the business.
