AS Economics and BusinessSources of finance

Unit 1

By Mrs Hilton for revisionstation

Lesson objectives

• To be able to discuss all the relevant sources of finance for a business

• To be able to answer a past paper question on sources of finance

Starter

• Where do you think a business gets its money from?

• (BTW)This is the last day you will ever use the word money from now on you must be more specific....

Trade credit

• When one business trades with another they will sometimes need to “buy” goods with trade credit

• The seller gives the buyer 30, 60, 90 days to pay

• The buyer then has time to sell the goods in their own shop before they have to pay for them

• The wholesaler may give the buyer a discount when they use cash instead

Buy Now pay later

Venture capitalVenture capital is also known as private equity finance. Venture capitalists (VCs) will invest large sums of money in a business in return for shares in the company.

Typically, VCs will invest at least £50 000 in a small regional business although this can rise into millions of pounds.

The VC will look for a high rate of return in a specific time period.

They look for a strong business plan, sound management and a proven track record, making it difficult for start-up firms.

• http://www.investopedia.com/video/play/venture-capital/

• http://www.bbc.co.uk/programmes/b006vq92

Bank - Loan

• Loaning money from a bank is like “renting” the money

• Banks will lend to small business but may not lend when they first start-up as there is no track record or history of them making money.

• Loans are quick to set up • Loans are affected by interest rates – if they go

up the cost of borrowing will go up too and the business may have to pay more interest back to the bank

A bank will want to see a business plan so they know how their money will be paid back.

A bank will charge interest on the loan

A bank will ask for security or collateral on a loan this may be a house or another asset that can be seized if the loan is not paid back

Overdraft

• Some months a business may need extra cash to tide it over until a better month. A loan is over many years so is not suitable.

• An overdraft may be organised by the bank which is short term lending of smaller amounts of money

• Very high charges and interest rates for an overdraft• Once its arranged (say £2,000) on an account a business can dip

into it or pay it back as they see fit• If the business goes over this amount the overdraft will be

“unauthorised” and the business will be charged heavily• Very expensive source of finance

In the graph in Jan and Feb the business would need to borrow from an overdraft until there was

an income in March

Sale of assets• A business can raise finance by

selling items that they already own.

• This could be:

Machinery Land Premises Vehicles

The business that sells the asset will no longer have the benefit of that asset and it will not appear on the balance sheet of the company – meaning the business will look less attractive to investors

Internal source of finance

Retained profits

• After a year or more of trading a business may have some profits that they are able to re-invest into the business to help it grow.

• A well run business should continually re-invest in new staff / equipment / stock/ premises / vehicles etc

• If a business is in its first year of trading it will NOT have any retained profits – as it will not have made any to retain.

• The advantage is there is no interest to pay.

• The disadvantage is once it is used it has gone. This is an internal source of finance.

Internal source of finance

Ordinary share capital

• In a public limited company (one that has been floated on the stock market) they can raise more finance to expand by having an ordinary share issue.

• This is an external and long term method of finance but would only apply to a large business with a plc after its name.

Lease• As a business grows it may decide that it

needs some more vehicles or equipment.• They may decide to lease so that the

equipment can be updated regularly.• They will NEVER own the equipment but will

get the option to change it when it wears out. • Examples are photocopiers and vans

Hire purchase• A business may wish to expand

and may need a vehicle or some equipment in order to grow.

• Some business machinery is very expensive – so they may decide to use HP

• The business will pay for the equipment over a fixed amount of time (say 5 or 10 years) and at the end the equipment is theirs to keep.

• This will be cheaper method than a bank loan plus the business will know what their fixed costs are each month as the amount they have to pay back will not change.

Friends and family• Private limited companies are

able to raise finance by selling shares to friends and family.

• A sole trader or partnership may also find that their family may want to contribute to the business. This may be for interest, a share of the profits or maybe even an interest free loan amongst family.

• The benefit of this is the owner may still keep control of the business and may be better able to trust their business investors.

• Downside is that it may cause tension and problems if the finance is not repaid or the business does not flourish.

• Cake boss:• https://www.youtube.com/wa

tch?v=SEuJfekCh0w

Internal source of finance

Reasons for raising finance

• To pay debts (consolidation) - loan• To help a business over a slow trading

period - overdraft• To expand – needs long term finance such

as VC / Loan• To grow and merge with another business –

again long term external finance such as loan or VC

• To start-up – loan / friends and family• To buy stock – trade credit

Sample question 1

• Facebook began as a social networking site for university students in the USA and was reported to be worth in excess of $2,000 million in September 2007.

• Which of the following is the most likely source of the $500,000 start-up capital

• for Facebook owner Mark Zuckerberg?• A A Commercial Bank• B Debenture Company• C Venture Capitalist• D Trade Creditor

Answer question 1

• Answer Option c venture capital• Describes what is meant by start-up capital or debenture

capitalist or trade credit (1 mark)• - A commercial bank or debenture company is not likely to

lend that amount of money to a university• student (1 mark) given the risk involved (1 mark) as he is

not likely to maintain the re-payments (1 mark)• - Trade credit is a source/method of providing short term

capital (1 mark) to customers who have been trading with you for a while which would not be the case (1 mark) and for smaller sums, not $500,000 (1 mark)

• - Venture capitalist implies high risk (1 mark) and potentially high returns (1 mark) which this business would have been (1 mark)

Sample question 2

• Small businesses, such as Cheeky Cheesecake Ltd of Cheltenham, might source their finance for the expansion of their premises through external methods.

• Which one of the following might be the most appropriate external method of financing the expansion of Cheeky Cheesecake’s business premises?

• A Trade credit• B Venture capital• C Sale of assets• D An overdraft

Answer question 2

• Answer option B venture capital• - A limited company has limited liability (1 mark)• - Profitable means that revenues exceed costs (1 mark)• - External finance is obtained from a source outside the• business (1 mark)• - Expansion usually requires long term financing (1 mark)• - Which in this case comes from an investor – venture• capitalist (1 mark)• - Trade credit and overdrafts are short-term methods of• finance (1 mark)

Sample question 3 (from part 2 of the paper)

[8]

Answer question 3

Sample question 4 (from part 2 of the paper)

• Marie could have approached members of her own family for the £50,000 start-up capital, but chose not to do so. Evaluate Marie’s decision. [8]

Answer question 4