some notes on finance

7/29/2019 some notes on finance

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QUESTION

Briefly discuss the following forms of financing small firms

and their pros and cons:

1. Leasing

2. Hire Purchase

3. Factoring

4. Trade/Suppliers credit


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1. Leasing:

A lease is an agreement between two parties, the "lessor" and the

"lessee". The lessor owns a capital asset, but allows the lessee touse it. The lessee makes payments under the terms of the lease to

the lessor, for a specified period of time.

Leasing is, therefore, a form of rental. Leased assets have usually

been plant and machinery, cars and commercial vehicles, but

might also be computers and office equipment. There are two

basic forms of lease: "operating leases" and "finance leases".


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Types of leasing

Operating leases

Operating leases are rental agreements between the lessor andthe lessee whereby:

a) the lessor supplies the equipment to the lessee

b) the lessor is responsible for servicing and maintaining the

leased equipment

c) the period of the lease is fairly short, less than the economic

life of the asset, so that at the end of the lease agreement, the

lessor can either ;

i) lease the equipment to someone else, and obtain a good rent forit, or

ii)ii) sell the equipment secondhand.

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Finance leases

Finance leases are lease agreements between the user of the

leased asset (the lessee) and a provider of finance (the lessor)for most, or all, of the asset's expected useful life.

Suppose that a company decides to obtain a company car and

finance the acquisition by means of a finance lease. A cardealer will supply the car. A finance house will agree to act as

lessor in a finance leasing arrangement, and so will purchase

the car from the dealer and lease it to the company. The

company will take possession of the car from the car dealer,

and make regular payments (monthly, quarterly, six monthly or

annually) to the finance house under the terms of the lease.

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Advantages of Leasing

For businesses, leasing property may have significant financialbenefits:

No Large Outlay

The biggest advantage of leasing equipment is that the cost

is spread over a number of years; there is no need for afirm to pay the entire amount upfront. This can

significantly help maintain cash flow, which is critical to

all businesses. Poor cash flow is the main cause of small

business failures, and leasing can help a firm to keep itunder better control. Leasing can also allow a firm to use

better equipment (e.g. A more efficient / faster / more

accurate product) that would be too expensive to buy

outright


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Security

When you lease a product, it is still owned by the leasing

company, meaning that they have better security on yourfinance. This means you are unlikely to need any further

security to be able to start a leasing contract, and therefore

you have a much better chance of acceptance (passing the

cre.dit check) than with other forms of finance.

Tax Advantages

Lease rentals are considered as an operating cost, which

means that it is often possible to deduct them from taxable

profits (as a trading expense). However, you should always

check that the equipment you are buying is eligible before

agreeing to a contract.


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If a business pays no or minimal taxes, then some leasing

companies will claim the capital allowance on its behalf,

and lower the leasing costs accordingly.

Budgeting

As a lease agreement is almost always a fixed contract, it is

relatively easy to budget and forecast with. The amount canbe worked intobusinesses budget much more easily than an

irregularly occurring lump sum; allowing a firm to keep a

much better control over current and future cash flow. In the

event that a firm need an item replacing quickly, it can do so

with a relatively minor monthly adjustment to the budget,

instead of a lump sum that could seriously damage cash

flow.

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Disadvantages

No Ownership

The main disadvantage of leasing is that you never own

the product. It remains the property of the leasing companyduring and after the lease. The only exception being if you

arrange for it to be sold to another company or person, in

which case the leasing company would receive the money

and a percentage would be passed back to you (dependingon the amount, product type, age, and which leasing

company you use).

As you do not own the product, you are unable to sell it in

the event it is no longer needed, and you cannot upgrade

to a newer or better product without either paying off theremaining contract, or paying a large fee to cancel the

contract. You also need to carry on paying a smaller lease

cost, even after the cost of the equipment has been fully

covered.


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Maintenance

Although a business do not own the equipment that it

leases, it is still responsible for its maintenance and repair.Unless it has specifically trained employees to fix the

equipment, then this could prove very costly in the event of

a serious fault.

Some leasing companies will allow a firm to cover themaintenance and repair costs for an extra sum (which is

added to the monthly leasing cost). This will increase

businesses monthly payments, but may save a firm money

in the long run; particularly with manual or highly technicalproducts that may go wrong frequently, and may cause

severe disruption if out of action. Cover is normally

through the leasing company itself, or through a separate

insurance policy.


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Difficult to terminate the lease

If circumstances dictate that a business must change its

operations significantly, it may be expensive or otherwise

difficult to terminate a lease before the end of the term. Insome cases, a business may be able to sublet property no

longer required, but this may not recoup the costs of the

original lease, and, in any event, usually requires the

consent of the original lessor. Tactical legal considerations

usually make it expedient for lessees to default on their

leases. The loss of book value is small and any litigation

can usually be settled on advantageous terms. This is an

improvement on the position for those companies owning

their own property. Although it can be easier for abusiness to sell property if it has the time, forced sales

frequently realise lower prices and can seriously affect

book value.


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Negotiation powers

If the business is successful, lessors may demand higherrental payments when leases come up for renewal. If the

value of the business is tied to the use of that particular

property, the lessor has a significant advantage over the

lessee in negotiations


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2. Hire Purchase

Hire purchase is a form of installment credit. Hire purchase is

similar to leasing, with the exception that ownership of thegoods passes to the hire purchase customer on payment of the

final credit installment, whereas a lessee never becomes the

owner of the goods.

Hire purchase agreements usually involve a finance house.

i) The supplier sells the goods to the finance house.

ii) The supplier delivers the goods to the customer who will

eventually purchase them.

iii) The hire purchase arrangement exists between the financehouse and the customer.


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The finance house will always insist that the hirer should pay a

deposit towards the purchase price. The size of the deposit will

depend on the finance company's policy and its assessment ofthe hirer. This is in contrast to a finance lease, where the lessee

might not be required to make any large initial payment.

An industrial or commercial business can use hire purchase asa source of finance. With industrial hire purchase, a business

customer obtains hire purchase finance from a finance house in

order to purchase the fixed asset. Goods bought by businesses

on hire purchase include company vehicles, plant and

machinery, office equipment and farming machinery.

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Advantages of Hire Purchase Agreements

Spread the cost of financeWhilst choosing to pay in cash is preferable, this might not be

possible for firms with a tight budget. A hire purchase

agreement allows a firm to make monthly repayments over a

pre-specified period of time

Interest-free credit

Some merchants offer customers the opportunity to pay for

goods and services on interest-free credit.

Higher acceptance ratesThe rate of acceptance on hire purchase agreements is higher

than other forms of unsecured borrowing because the lenders

have collateral.


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Sales

A hire purchase agreement allows firms to purchase items

when they are not in a position to pay in cash. The discounts

secured will save some firms money.

Disadvantages

Personal debtA hire purchase agreement is yet another form of business

debt. It is a monthly repayment commitment that needs to be

paid each month.

Final payment

A firm does not have legitimate title to the goods until the final

monthly repayment has been made

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Bad credit

All hire purchase agreements will involve a credit check.

Firms that have a bad credit rating will either be turned down

or will be asked to pay a high interest rate.

Creditor harassment

Opting to buy on credit can create money problems should a

firm experience a change of business circumstances.

Repossession rights

A seller is entitled to take back' any goods when less than athird of the amount has been paid back. Should more than a

third of the amount have been paid back, the seller will need a

court order or for the buyer to return the item voluntarily.

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3. Factoring

Factoring is a financial transaction whereby a business sells its

accounts receivable (money owed to the firm by clients, i.e. credit

invoices) to a third party, called a factor, at a discount in exchange

for immediate money with which to finance continued business.

Most businesses extend credit to their customers and extending

credit requires finance. Unless a business has the cash flow to

support the difference in timing between the cash it collects and thecash it has to pay out, it can be in trouble. As a result additional

financing is required. Although factoring is not appropriate for

every SME, but in certain particular circumstances, where bank

financing is not available, or the owner wishes to avoid guarantees,collateral and lengthy loan procedures, and the business generates a

return that is higher than the cost of capital, factoring is a viable

option worthy of some consideration.


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Advantages

Speed

Factoring allows a firm to capitalize in its invoices with a

minimum of delay. A firm can get up to 85% of the invoice

within 24 hours, helping to maintain a good working cash

flow rather than requiring you to wait 30/60 days for a

customer to pay (If they pay on time!).

This is particularly useful if a firm get a large order that

requires it to spend on stock and production costs before it

get paid; factoring allows a firm to accept the order withmuch less risk to its cash flow.


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Cost

Factoring an invoice is cheaper than using credit cards,

overdrafts and many other forms of finance. Factoring also

gives a fee set fees, whereas credit cards and overdrafts costs

can build up if a firm keep using them and not paying them

off in full.

Time Saving

Rather than having to chase debts, factoring usually means

the invoice finance company will collect the money

themselves; saving a firm time and effort that it can use tobenefit its business in other areas.

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Security

Factoring does not require a firm to risk its business assets as

security on the finance, as the money is secured on the sales afirm has already made. Bearing in mind though that some

factoring companies will not want to factor risky invoices; as

they carry the risk rather than a firm.

Funding matches your business

As business grows and increases sales, so can it increase the

amount of funding available through factoring. Having

funding that expands as a firm grow is extremely useful;particularly as many businesses fail because expanding sales

use up their cash flow.

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Suitable for businesses of all sizes

One big advantage of factoring is that it is potentially

suitable for businesses of all sizes; especially now there areinvoice finance firms that are targeted at small businesses

and their needs.

Disadvantages:

Reputation

Some less reputable invoice finance companies can damage

firms customer relations by being too aggressive in

collecting factored invoices. However, a firm can avoid thisproblem by choosing a well known and reputable firm.

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Control

Factoring reduces the control firms have over their debts, as

the invoice finance company collects them for a firm.

However, this also means less work on firms part.

4. Trade credit

Trade credit is the credit extended to a firm by suppliers who letit buy now and pay later. Any time a firm take delivery of

materials, equipment or other valuables without paying cash on

the spot, they are using trade credit.

Many suppliers may require the first order to be paid by credit

card or by cash/check on delivery until the business has been

deemed credit worthy. Once it is established that a business can

pay its bills on time, it is possible to negotiate trade credit and

terms with suppliers.

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Types of Trade Terms

Two of the most common types of trade credit terms are the

Net 30 and Net 10 accounts. These net terms specify payment

is expected to be made in full 30(net 30) or 10(net 10) days

after the goods are delivered to the retailer.

Some vendors offer cash discounts and the retailer may notice

the notation "1/10, Net 30" on their invoice. This refers to a

1% discount to the retailer if payment is received within 10

days of the delivery of goods, and full payment is expected

within 30 days.

If an invoice is $5000 and "1/10 Net 30" is noted, the retailer

can take a 1% discount ($5000 x .01 = $50) and make a

payment of $4950 within 10 days.


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Advantages of Trade Credit

More SalesFrom the perspective of the creditor, or supplier, trade credit

should induce more sales over time by allowing customers to

make purchases without immediate cash. This flexibility in

purchasing methods also encourages customers to makelarger purchases when prices are right than they might if they

had to pay cash upfront.

Along with higher sales volume, trade credit often producesinterest fees and late payment fees for creditors, which

increases revenue.

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No Cash

From the resellers perspective, the ability to buy on creditmakes it possible to buy needed inventory even when cash

balances are low. Having cash to pay off long-term debt and

other more urgent and immediate expenses is critical. The

ability to delay cash requirements for supplies and inventoryhelps preserve cash for these purposes.

Buyers may want to ramp up the volume of purchases at a time

when demand is higher, and a trade account makes it morefeasible to do so.

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Bad Debt

The potential risk to the supplier when offering trade creditis bad debt. If buyers do not pay off their debt, and in a

timely manner, it has negative cash effects on the supplier.

Companies eventually have to write off unpaid accounts asbad debt, which lowers their profits. Accounts that remain

unpaid for a long period of time still have negative effects,

though. This means the supplier has to wait to collect cash

which it needs to pay its own bills.

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High Costs

If buyers are not careful in the way they use trade credit, theycan end up paying much higher costs for inventory. Many

companies offer a 2-percent discount if you pay within 10

days, but payments received after 30 days usually include late-

payment fees and interest that begins accruing.

In its overview of trade credit, "Entrepreneur" notes that

purchases on account can cost between 12 to 24 percent extra

in interest fees if the business does not pay within the typical30-day net payment term.

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Documents

some notes on finance