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Learning Aim D

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The source of finance is where this money
comes from. What the money will be used for will determine which source is the
most suitable. For example, you might look for a long-term bank loan or mortgage to
fund capital expenditure such as buying a factory, but this would not be appropriate
for replenishing stock. Sources of finance can be short term or long term. Short term
means they have to be paid back in one year, and long term means in a period of time greater than one year

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Internal Sources of Finance

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Internal sources are funds generated within the business itself and do not involve borrowing from external institutions. The most common internal sources include:

Retained Profits

This refers to profits that the business has retained instead of distributing them to shareholders as dividends. The business can use this profit for reinvestment.

Advantages:

– No interest charges.
– No loss of ownership.
– Available immediately.

Disadvantages:

– Limited availability.
– May cause shareholder dissatisfaction due to reduced dividend payouts.

Net Current Assets

Net current assets are the difference between current assets and current liabilities. A positive figure can be used to finance day-to-day operations.

Advantages:

– Quick way to raise finance.
– Encourages efficient cash flow management.

Disadvantages:

– Short credit terms can damage customer relationships.
– Holding less stock may affect availability.

Sale of Assets

A business can sell physical assets, such as property or machinery, to generate immediate cash.

Advantages:

– No interest or borrowing involved.
– Good for liquidating unused assets.

Disadvantages:

– May not receive the full value of the asset.
– Could increase costs if the asset is needed again and must be leased back.

External Sources

External sources of finance involve funds obtained from outside the business, often through borrowing or investment. Key external sources include:

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Owner’s Capital

Personal funds invested by the owner, which does not involve borrowing from external institutions.

Advantages:

– No interest charges or repayment schedules.
– No loss of ownership or control.

Disadvantages:

– Limited to the owner’s personal resources.
– Puts the owner’s personal assets at risk.

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Loans

Bank loans are a common external finance option, where the business borrows a fixed amount and repays it with interest over time.

Advantages:

– Fixed repayments help with budgeting.
– No loss of ownership or control.

Disadvantages:

– Interest must be paid.
– Often secured against assets, which may be seized if the loan is not repaid.

Crowdfunding

This involves raising small amounts of money from a large number of people, typically via an online platform.

Advantages:

– No interest payments.
– Gauges public interest in the business.

Disadvantages:

– Partial loss of ownership.
– May not reach the funding target.

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Venture Capital

Venture capitalists provide funds in exchange for equity or an ownership stake in the business.

Advantages:

– Provides substantial funding and expert advice.
– Suitable for businesses with growth potential.

Disadvantages:

– Loss of ownership and control.
– Potential for conflict over the direction of the business.

Hire Purchase and Leasing

These allow businesses to acquire assets by spreading payments over time.

Advantages:

– Spreads the cost of expensive assets.
– Maintenance is often the responsibility of the leasing company.

Disadvantages:

– May cost more than outright purchase.
– The business does not own the asset until all payments are made (hire purchase) or may never own the asset (leasing).

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Trade Credit

Trade credit allows businesses to obtain goods and services and pay for them later.

Advantages:
– Improves cash flow as payment is delayed.
– Allows a business to sell goods before paying for them.
Disadvantages:
– Discounts for early payment may be forfeited.
– Delays in payment can damage relationships with suppliers.

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When to Use Different Sources of Finance

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Each source of finance is suited to different business needs:

Short-Term Finance: For working capital and day-to-day operations, businesses may use trade credit or short-term loans.

Long-Term Finance: For capital-intensive projects like expansion or purchasing property, businesses may prefer mortgages, venture capital, or issuing shares.

By understanding the advantages and disadvantages of each source, businesses can make informed decisions to align their financial needs with appropriate funding options.

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Exam Style Questions

Analyse the potential impact of using venture capital as a source of finance on a small business.

Venture capital (VC) can significantly impact a small business in various ways:

Growth Opportunities: VC provides access to substantial funds, which would enable Bella’s Beans Bags to grow faster than through organic growth or smaller loans. This is particularly beneficial for businesses with high growth potential and the company is struggling to meet demand.
Expertise and Networking: Venture capitalists often bring valuable business expertise and industry contacts. Arabella is looking for help. They can provide strategic guidance, introduce new partnerships, and help with scaling the business.
Ownership Dilution: The major downside of venture capital is that it usually involves giving away equity, which dilutes the ownership of the original owners. This could reduce the control the owners have over the business.
Pressure for High Returns: Venture capitalists typically expect high returns on their investments within a set time frame. It is debatable whether a bean bag business is high growth. This may result in pressure on the business to prioritise short-term profitability over long-term sustainability.
Exit Strategy: Venture capitalists often require an exit plan, such as an acquisition or IPO, which might not align with the long-term vision of the original business owners.

Debt Factoring

Debt factoring involves selling accounts receivables (unpaid customer invoices) to a factoring company. The factor provides an upfront payment, typically around 80% of the invoice value, and takes responsibility for collecting the debt. Once the customer pays, the factor releases the remaining balance minus their fee, usually a percentage of the invoice value. This improves Connor’s cash flow as he gains access to immediate funds.

However, the fees involved in factoring reduce the overall profit margin, and Connor may lose some control over customer relationships as the factoring company handles debt collection. This could impact customer satisfaction and the business’s reputation if the factor handles the process poorly.

Invoice Discounting

Invoice discounting, on the other hand, allows businesses to borrow against their unpaid invoices while retaining control over their collections. The discounting company advances a percentage of the invoice value, and once the customer pays, the remaining balance is returned after deducting fees.

Invoice discounting provides similar cash flow improvements to debt factoring but allows Connor to maintain control over customer interactions. This method tends to be less intrusive than factoring, making it a more favorable option if maintaining good customer relationships is a priority.

Cash Flow Improvement

Both early payment discounting and debt factoring significantly improve cash flow. Debt factoring provides immediate funds through the sale of invoices, while invoice discounting allows borrowing against receivables. Improved liquidity ensures Connor can meet short-term obligations such as supplier payments and wages, allowing the business to function smoothly.

Cost Considerations

Both methods come at a cost. Early payment discounting reduces the amount of cash received as discounts are offered to encourage early payments. Debt factoring involves factoring fees that reduce overall profitability. Connor needs to carefully assess these costs to ensure they don’t outweigh the benefits of improved liquidity.

Risks

Debt factoring carries the risk of losing control over customer relationships as the factor handles collections. This could lead to dissatisfaction if customers are unhappy with the process. Invoice discounting, while more discrete, still involves fees that can erode profits.

Long-Term Impact

Over time, both methods could lead to increased profitability if Connor uses the improved cash flow to invest in business growth. However, consistently offering early payment discounts could set an expectation among customers, potentially harming long-term revenue.

Conclusion

In conclusion, debt factoring offers immediate and substantial improvements to cash flow at the cost of control over customer relationships, while invoice discounting provides a lower-cost, customer-friendly alternative. A balanced approach, using both methods selectively, could offer Connor the best solution to improve cash flow without excessively increasing costs or damaging customer relationships.

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