Theme 2.1.1 & 2.1.2 - Internal and External finance

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Note by sophie terry, updated more than 1 year ago
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A-Level Business Studies (Theme 2) Note on Theme 2.1.1 & 2.1.2 - Internal and External finance , created by sophie terry on 06/17/2017.

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INTERNAL & EXTERNAL FINANCE Sources of finance: (where to get money from) Family & friends Banks  Peer-to-peer funding Business angels Crowd funding Other businesses   Methods of finance: (what type of finance is available) Loans Share capital Venture capital Overdrafts Leasing Trade credit Grants      

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Reasons for raising finance: To start up a company - A business would seek out a loan through a business plan, or they would ask their friends and family for financial support.  To pay back debts. For example; paying back suppliers. To expand: A business may apply for a long-term finance such as ; a loan. To buy stock - A business may ask a supplier for trade credit. This could be for 30, 60, or 90 days. 

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Friends & Family Private limited companies (Ltd.) are able to raise finance by selling shares to their friends and family.  A sole trader or partnership may also find that their family wants to contribute to the business. Their reasons may be for personal interest, a share of the profits or maybe for the possibility of an interest free loan amongst the family.  The advantages of using friends and family as a source of finance, is that the owner may still be able to keep control of the business. Plus, they may be better able to trust their business investors, in comparison to complete strangers.  The disadvantage of using friends and family for sources of finance, is that it may cause tension or conflict if the finance is not repaid, or if the business does not prosper / grow.

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Owner's capital: This is also known as an owner's equity.  Sole trader start-up capital. It shows how much stake the owner has in the business. It represents the net assets of the company.  The owner may have used savings or a redundancy payout to start up the business, which is still owed back to the owner. 

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Retained Profits. After a year or two or trading, a business may have some leftover profits that they are able to re-invest back into the business to help it grow.  A good business should continually re-invest in new staff, new equipment, stock, their premises or their vehicles.  However, if the business is in its first year of trading it will NOT have any retained profits to use. An advantage of retained profits is there is no interest to pay when using it. Although once it has been used, it is gone. 

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Sale of assets.  A business can raise finance by selling items they already own.  For example this could include:  Machinery Land Premises Vehicles Once the business sells that particular asset, it will no longer have the benefits of that assets and it will not be shown on the balance sheet. As a result, the business may look less attractive to investors.    

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Banks Banks may lend a loan to businesses to help them start -up or grow. They may also offer them financial advice or an overdraft to help when they have cash-flow problems. Banks also have connections with other businesses who may be able to help or contribute.  Banks are also a trustworthy source of finance as they must honour their promises. They also provide online banking and easy accessibility for businesses to track their finances.

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Peer - to - peer funding. Also known as lending, it can be abbreviated to 'P2PL'. This type of method for raising finance offers high rates to savers who are willing to lend their money to start-up businesses, as well as, other individual borrowers.  They also offer lower rates to borrowers than traditional banks, making it easier for businesses to pay back their debts.   

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(Debt) Factoring: Where a business raises cash by selling off their debts to a finance company. The finance company then pays around 90% of the debt value in cash, before collecting the debt themselves. The reason for this may be so that businesses can receive cash straight away, rather than waiting 28 days to be paid the full amount.   

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Business Angels Angel investing is an equity finance (sale of an ownership interest) An angel investor uses their own personal, disposable finance and makes their own decision about making the investment.  The angel investors would normally take shares in the business in return for providing the equity finance.  Alongside having financial support, business angels also offer their experience and knowledge to help the company flourish. Angel investors look to have a return on their investment over a period of 3-8 years.  They can either invest on their own or with a group of people.  Angel investors either actively take on a role on the board, or they actively support the business. They may also act quietly as part of a group with a lead angel taking the role above on their behalf.

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Crowdfunding: A large number of people fund a project via the internet. The each individually make small investments. There are 3 ways to fund: Donate - No money back. Receive rewards like tickets or a newsletter.  Lend - Get money back with interest & the satisfaction of contributing the success of a small business. Invest - They can invest in the business in exchange for equity or shares, which may increase in value.

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METHODS OF FINANCE: Bank loans Loans  Overdraft Raising share capital Ordinary share capital Venture Lease Trade credit Government grants

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Bank loan: Banks will lend to small businesses but they may not lend them money when they first start-up. This because there is no track record or history of them making money. Some notes on bank loans: The loans are quick to set up. They are affected by interest rates. (High I.R = High cost of borrowing) A bank will ask for a collateral on a loan, so that if the loan is not paid, the asset promised can be seized.  They will ask for a business plan to see how the loan will be repaid. Loan repayments are made each month.  Borrowing from banks is more difficult because of the 2008 banking crisis. (The financial system collapsed globally).

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Overdraft: In some cases, a business may need extra money to help them see through the month until the next. An overdraft tends to be short term, with smaller amounts of money being loaned. It is often organised by the bank.  There are very high charges and interest rates for an overdraft.  A business can have an arranged overdraft, however if they go over the set amount then it will be classed as "unauthorised", thus the business will be charged heavily.  This financing method is a very expensive source.  The bank can remove the option of an overdraft at any time, so it's important that a business does not continually rely on an overdraft the fund their business.

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Raising share capital through limited companies: Private Limited Company: The shares in the business are offered only to chosen people. This may just be friends and family. These people will then invest money into the business, seeking a return for a share in the profits, as well as, other benefits. Public Limited Company: Members of the public can buy shares in the business, in return for a share in the profits, as well as, other benefits.

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Raising ordinary share capital: In a plc (public limited company) aka one that has been floated on the stock market, can raise more finance to expand by having an ordinary share capital. This method of raising finance is external and long-term, which would only apply to a large business with 'plc' after its name.  (Floating on the stock market means the shares are open for the public to buy).

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Venture Capital This method is also known as a private equity finance.  The venture capitalists will invest large sums of money into a business, seeking a return in shares from the company.  For a small, regional business the VCs may invest at least £50,000. However, for larger businesses this may rise into millions of pounds. Venture capitalists look for a high rate of return, within a specific time period.  They also look for a strong business plan, a dependable management and a great track record before investing into the company. As a result, this makes it difficult for start-up firms to attract Venture Capitalists.

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Lease The purpose of a lease is so that if a business decides that they need more vehicles or equipment, then it can be updated regularly. However, the firm will never own the equipment, instead they will just rent it out until they decide to change it when it starts to wear out.  Some examples may be vans or gym equipment. 

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Trade credit: When a business trades with another, they may need to "buy" goods with a trade credit. This means that the seller or supplier gives the buyer up to 30, 60 or 90 days to pay them back. Because of this, the buyer has time to sell the goods in their own business, before paying the sellers / suppliers back.  If the business decides to purchase the goods with cash, the wholesaler may then decide to give the buyer / business a discount. In short, trade credit can be defined as "buy now, pay later". 

ADVANTAGES: A business can retain cash for more immediate needs. I.e. paying off other debts or purchasing other supplies and equipment for the business. The business can also earn profit before having to repay the credit back. 

DISADVANTAGES: The business may lose out on an opportunity for discounts if they are not paying cash. 

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Government grants:  

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