Sources of Finance

Harshad Karia
Mind Map by , created about 6 years ago

A-Levels Accounting A2 Unit 3 (1 Sources of Finance) Mind Map on Sources of Finance, created by Harshad Karia on 09/04/2013.

Harshad Karia
Created by Harshad Karia about 6 years ago
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1 Factors To Consider When Applying Fore Fiance
1.1 Purpose - Identify the purpose for which the financing is required, Purchase of assets?, Day-to-day trading purposes as indicated on cash budget? You will need some form of loan or mortgage for asset purchase and an overdraft for day-to-day requirements (working capital)
1.2 Amount - Important to work out exactly how much you will need to borrow. This is straight forward when it comes to a loan for asset purchase; an overdraft requirement can be worked out from a cash budget.
1.3 Repayment - Important to work out accurately the period over which the finance is needed and from this to draw up a schedule for the repayments that will be needed. Most loans are paid by regular instalments of the amount borrowed, plus intrest, but some may require payment in full at the end of the period. As cash budget will not always show a fixed bank balance, and sometimes may be negative, it may be repaid from time-to-time when cash flow into the business is positive.
1.4 Interest - This is the charge applied to the loan and overdraft, where the business is charged for these services. Interest is often expressed as an annual rate, E.g. 5% p.a., and is a useful guide for comparing the cost to the business of raising different forms of finance. E.g. bank loan being 5% p.a whereas a loan from a partner (internal financing) may only be 3% p.a, in which case the partner's loan is the better (cheaper) choice.
1.5 Security - Business fiance from a bank will inevitably involved the business or business owners having to put down security for the borrowing. This security might comprise the business assets (eg the business premises) or the homes of the owners/directors. This means if the business fails and the finance has to be repaid to the bank, the business assets or homes of the owners/directors may have to be sold to repay the borrowings.
2 Different Sources Of Finance
2.1 Bank Overdraft
2.1.1 Features • Flexible arrangement with a bank which allows a customer to borrow money on a current account up to a certain limit. An overdraft is used to cover the day-to-day working capital requirements of a business. • Interest is paid – normally at a variable rate in line with market rates • An overdraft limit is normally reviewed with the business every year • An overdraft is repayable on demand if the bank wants the borrowing repaid • Security will be required from the business or business owners to safeguard the borrowing Advantages • Bank overdraft is very flexible: business can borrow and repay whenever it likes • Overdraft can be economical to operate: interest is only payable when the business borrows, and is charged only the borrowed amount Dis-advantages • Interest rates for banks overdrafts can be higher that bank loan rates. • If this business gets into financial difficulties the bank can ask for immediate repayment of an overdraft • Security, including possibly the house of the business owner, is required for an overdraft
2.2 Bank Loan
2.2.1 Features • Finance provided by the banks for a specific purpose, E.g. purchase of an asset. Loans can range from £1,000 to £100,000 • Interest is paid, either at a rate fixed at the beginning of the loan, or at variable rate in line with markets rates during the lifetime of the loan • Loan is for a set time period, normally between 2 and 30 years • Normally paid in regular instalments, but this may be varied, as there may be a 1 year wait before payments are required. Some loans can also be repaid in full at the end of the loan period rather than by instalments • Security, either the assets being purchased or the property of the business owner(s), is required for a bank loan Advantages • Easy to budget for because the timing and the amount of the repayments is known • There may be flexibility in the repayment schedule, for example arranging to delay the early repayments (a repayment holiday) • Favourable interest rates can be negotiated, often at a lower rate than an overdraft Dis-advantages • Long-term financial commitment which will need to be serviced • Security, including possibly the house of the business owner, is needed.
2.3 Bank Commercial Mortgage
2.3.1 Features • A mortgage is an arrangement in which a property is used as security for borrowing. If the borrower defaults on the loan, the lender can sell the property to obtain the funds. Amounts can range from £25,000 to £500,000. • Banks can provide finance for the purchase of commercial property, normally up to 70% of its market value. In principle a mortgage is basically the same for a business as it is for a house buyer • Interest is paid, either at a rate fixed at the beginning of the mortgage, or at a variable rate in line with market rates during the lifetime of the mortgage • For a set time period, normally up to 25 years Advantages • A mortgage is easy to budget for because the timing and the amount of the repayment is known • If a fixed rate mortgage is taken when rates are relatively low, the cost of borrowing is also relatively low Dis-advantage • Long-term financial commitment which will need to be serviced, it also involves the putting down of security
2.4 Limited company ordinary shares
2.4.1 Features • When a limited company starts up for the first time, or expands its operations, it obtains finance by issuing ordinary shares to its owners and other investors who become its shareholders • Shares are issued in return for payment of fixed amount per share and become the capital of the company • In return for investment in company ordinary shares the shareholders receive regular dividend payments, paid out of the profits of the company • Shares of public limited company companies (PLCs) can be bought on the Stock Exchange but the majority of limited companies are private limited companies (LTD’s), often started by sole trader or family businesses. Their shares are not for public sale • If a limited company wishes to raise finance by issuing more shares, it can do so either by issuing them to the existing owners and shareholders or by applying to a private equity firm for an issue to outside investors. These investors will provide the finance, but will want an element of contr Advantage • Making a share issue can potentially raise more finance than a sole trader or partnership because outside investors are able to buy shares in the company • Making a share issue can also attract new management with valuable skills and expertise • Dividends on most ordinary shares vary according to the level of profits; therefore the cost of the finance is effectively variable and will not be such a burden if the business profits are lower Dis-advantage • If outside investors buy into the company by acquiring ordinary shares, they will have an element of control over the company which could prove disruptive for the existing management • With most shares, the finance is never ‘paid off’ as it is with a fixed term loan or overdraft because there will always be the need to pay dividends • If the company ‘goes bust’ the ordinary shareholders are normally the last people to get their money back – in fact they rarely get anything at all
2.5 Limited company preference shares
2.5.1 Features • Most shares issued by a company is ordinary shares. Preference shares have preference over ordinary shares because they have priority claim on the profits ahead of the other shareholders • Preference shares are often quoted as having a fixed percentage rate dividends, E.g. 3% Preference shares Advantages • Preference shareholders are unable to vote at shareholder meetings and so are unable to take part in the running of the business • Preference dividends are normally at a fixed percentage rate – this makes budgeting easier for the company Dis-advantage • If the profitability of the company is low ordinary shareholders (in many cases these are the company owners) may lose out completely on their dividends because preference shareholders have to be paid first.
2.6 Debenture Stock
2.6.1 Features • Debenture stock is a fixed interest, fixed repayment date investment issued by a limited company which represents debt owed by that company • Debenture stock only relates to loans made to the company and does not give any rights of ownership of the company in the way that ordinary shares and preference shares do. Its sometimes secured on the company’s assets • Debenture stock of larger companies can be traded on the stock markets • Debenture holders may require to have company assets charged as security Advantages • Debenture stock holders are unable to vote at shareholder meetings and so are unable to take part in the running of the company • Interest is paid at a fixed percentage rate – this makes budgeting easier for the company Dis-advantages • If the company does not make a profit, the interest (which ranks ahead of dividends) will always have to be paid at the fixed rate on the due date • Debenture stock sometimes gives holders better rights than ordinary shareholders to obtain repayment if the company ‘goes bust’
3 Where Will The Fiance Come From?
3.1 Internal
3.1.1 Funds provided by the owners Capital from savings or loans from members of the family who want to help and possibly recieve some return on their investment Main Drawbacks Money is not always available when required, there may not be any money available to invest
3.1.2 Funds generated from the profits of the business Purchase of new computer from cash generated Main Drawbacks The company could be in loss
3.2 External
3.2.1 Banks- Loans, Overdafts & Mortgages Main High Street banks have a range of different services for business, from day-to-day trading to loans for purchase of assets
3.2.2 Private Equity Capital If a Private Limited Co. needs externasl finance, it can apply for funds from a 'Private Equity' Company. The private Equity Co. will provide finance for a percentage of the shares of the business and an active role in helping to run the business. This is a very long-term commitment, but can be very advantageous for a new business which receives expertise as well as money from the investing company. (Public limited companies receive similar assistance from 'venture capital' companies such as 3I (Investors in Industry))
3.2.3 Business Angels They are wealthy individuals - often entrepreneurs or retired executives - who invest their own money. They provide finance and in return take a percentage stake in the business and help to run it.
3.3 Forming a limited Company to obtain additional finance
3.3.1 Banks and business angels provide finance for all forms of business: sloe trader, partnerships and limited companies. However Private equity and venture capital companies provide finance specifically for limited companies. This is because the investing comapany would want a percentage of shares, profits and an element of control in return for the finance provided. Each propersition is judged very much in terms of investment potential and profit. Limited Comapnies and "sole traders & partnerships" have the same sources of finance except limited companies also have "private equity & venture capital"

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