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SOURCES OF FINANCE - Philip Boulton

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					SOURCES OF FINANCE

IB BUSINESS & MANAGEMENT
 A Course Companion (2009)
   P146-157 (Clark Edition)
                                            2
        SOURCES OF FINANCE
• All businesses require funding for their
  activities.
• For example – a loan to purchase a new
  computer system or a bank overdraft to pay
  suppliers before the receipt of customers
  cash.
• Just like people, organizations require a
  variety of funding for a range of purposes.
         Factors to consider when                  3
             choosing finance:
• A business should match the source of finance to
  its specific use – in practice this means that a
  business should secure long-term sources of
  finance for long term uses or needs and for more
  short term finance immediate needs.
• The cost of the source.
• The organization’s objectives.
• The flexibility and availability of the finance, for
  example, how easy it is to switch from one form
  of funding to another, or whether a particular
  form of finance is available for a new business
  with no trading record.
        Factors to consider when             4
            choosing finance:
• The impact the new funding would have on
  the organizations current financial structure,
  for example, its balance sheet.
• The state of the external environment, for
  example the economy and consumer trends.
• The type of business structure it is, for
  example a sole trader or partnership can raise
  funds from the stock market.
                                                5
 INTERNAL SOURCES OF FINANCE
There are several sources of internal finance
for the business including:
• Retained Profit
• The Sales of Assets
• Utilizing working capital more
  effectively
• Depreciation
   INTERNAL SOURCES OF FINANCE 6
          Retained Profit
• This is one of the most important sources of
  business finance.
• It represents the profits generated from sales
  after interest payments to lenders, taxes to
  the government and payments to
  shareholders in the form of dividends.
• The remaining profit is then retained or put
  back into the business and available for future
  spending by the organization.
   INTERNAL SOURCES OF FINANCE 7
          Retained Profit
Advantages of using Retained Profit
• The advantages of retained profit are that
  there are no associated borrowing costs and
  that businesses do not see a rise in debt levels
  (gearing).
• The owners control is not diluted and
  decisions are not vetted by lenders (banks)
   INTERNAL SOURCES OF FINANCE 8
          Retained Profit
The Disadvantage of using Retained Profit
• The disadvantages are that the owners may take
  out all the organization’s spare cash and there
  will be no buffer if the business suddenly needs
  cash or another market opportunity arises.
• Equally some businesses are more focused on
  investment decisions when borrowing money,
  but are more lax when using retained profits.
• There may no outsiders to be accountable to –
  especially small and family run businesses with
  no outside shareholders.
   INTERNAL SOURCES OF FINANCE 9
         The Sale of Assets
• Many large retail businesses that own lots of
  property have decided to sell off their property
  portfolio and raise fresh expansion capital or
  cash.
• Supermarkets and banks are examples. They see
  themselves as retailers not property developers.
• Companies may sell their assets to property
  development or pension companies and then
  lease then back for a fixed period of time and
  rent.
   INTERNAL SOURCES OF FINANCE 10
         The Sale of Assets
The Advantage of Selling Assets
• The main advantage is having no associated
  borrowing costs or debts.
Disadvantages of Selling Assets
• The business can only sell off the `family
  silver` once, so it needs to care what is sells
  and how wisely it uses its cash.
   INTERNAL SOURCES OF FINANCE 11
         The Sale of Assets
Sale and Leaseback Deals
• When setting up a sale and leaseback
  situation, it is imperative that the lease allows
  the business flexibility, for example, the new
  landlord wants to sell the site in 10 years time
  or up the rent above inflation.
• Will there be an adequate notice period in the
  contract?
   INTERNAL SOURCES OF FINANCE 12
   Utilizing Working Capital more effectively
• Working capital is money tied up in the
  business and used to finance its day to day
  needs, such as buying raw materials.
• All businesses have a working capital cycle
  that identifies how this money moves around
  the business
            Working Capital-                                 13
         Manufacturing Case Study
• The first part of the cycle starts with cash being spent on
  raw materials.
• These materials become our stock, so the cash is now tied
  up as unsold stock items.
• When the finished items of stock are finally sold to
  customers, (on credit) these customers owe us money.
• They in effect become the debtors of the business.
• When paid, the debtors cash is returned to the business
  and the cycle carries on in funding new stock or paying the
  expenses the business (eg: paying suppliers or reducing our
  bank deficit.
• If the business is making a profit some of this cash may be
  kept in the business as retained profit and not spent in the
  short term.
                                               14
 Reducing our Working Capital Needs
• A possible source of finance is squeezing or
  reducing our own working capital needs.
• Therefore the cash we need is more efficiently
  used.
• Eg: IF we minimize our stock levels we reduce
  the amount of money tied up in stock.
                                                              15
        Just in Time Production (JIT)
          Reducing Working Capital Needs
• In modern customer manufacturing the concept of
  producing just in time (JIT) and only to a specific order has
  grown dramatically.
• Eg: When a customers orders a bed or dining table they
  may in some cases have to be wait 2 to 4 weeks for
  delivery.
• This is because some items are not held in stock by the
  retailer or manufacturer – they are both minimizing their
  working capital needs and the amount of money tied up in
  the unsold stock.
• The consumer therefore pays upfront to the retailer and is
  effect funding the retailing and manufacturing of the
  product.
                                                 16
       Early Payments Incentives
       Reducing Working Capital Needs
• A business can ask its customers who
  purchase goods on credit to pay more
  promptly, by offering a financial incentive.
• Eg: A 5% discount for payment in 14 days and
  this helps to reduce the funding needs from
  the bank or shareholders.
                                                   17
    Delaying Payments to Creditors
       Reducing Working Capital Needs
• A business can slow down payment to it
  suppliers or creditors.
• Therefore a business can use resources for
  longer without having paid for them.
• Suppliers or creditors are being asked to fund
  more of our operation.
                                                     18
                 MRP & MRP2
        Reducing Working Capital Needs
• Better management of stock can be done
  internally and without always affecting delivery
  dates.
• Better MRP (Material Resource Planning) and
  MRP2 (Manufacturing Resource Planning)
  systems are making the ordering of stock
  materials more efficient.
• These systems reduce the time that stock is left
  unused and therefore reduce the amount of
  money tied up in stock.
                                               19
         The Advantages of
   Reducing Working Capital Needs
• The advantage of squeezing working capital as
  a source of finance is that you do not have to
  ask a bank or shareholders to give you more
  money and on terms that may be expensive.
                                              20
       The Disadvantages of
   Reducing Working Capital Needs
• The disadvantage is that suppliers and
  customers may not be happy waiting for
  money or paying upfront for goods, especially
  when competitors may be able to offer a
  better delivery schedule for customers or
  better payment terms to their suppliers.
• Caution has to be exercised and
  communication with these two stakeholders is
  paramount.
                                                    21
  INTERNAL SOURCES OF BUSINESS FINANCE
              Depreciation
• Depreciation is a reduction in value of our assets,
  which occurs naturally through wear and tear in
  the production process of a business.
• Measuring this fall in value over time is not
  always easy.
• There are two normal methods of calculating the
  level of asset depreciation:
 The Straight Line Method
 Reducing Balance Method.
 Straight Line Method of Depreciation
                   Example               22
• A machine costs $500,000 to
  purchase.
• Its useful life in our manufacturing
  business is 10 years.
• After that we may be able to sell it to
  a second hand dealer for $50,000.
  This is called the Residual Value.
Straight Line Method of Depreciation
               Example              23
Annual Depreciation Value =
(Original Cost of Item – Residual Value)
Useful Life of Asset in Years

$500,000 – 50,000
10                    = $45,000 depreciation
                        each year.
$50,000 – 4000   = 46000
5                   5    = $9200
Straight Line Method of Depreciation
                                                 24
• The straight line method is easy to calculate and
  it gives us the same depreciation amount for each
  year.
• However, the problem here is that with some
  assets, the drop in value is not constant, but is
  greater in the earlier years and less in the last
  years of ownership.
• Assets where this is more common are cars and
  vans, which lose a high amount of value once
  they are driven offer the car outlet where they
  are purchased (except in Venezuela!)
                                                25
      Reducing Balance Method of
             Depreciation
• The second method of depreciation – the
  reducing balance method, attempts to take
  account of this problem and weights the
  depreciation more heavily in the earlier years.
                                                     26
      How is depreciation a source of
                finance?
(1)   By recognizing that assets lose value and by
      attempting to identify how much each
      assets falls in value, it is possible to set
      aside cash year to replace each asset when
      it is no longer of use to us.

(2)   In many countries depreciation is a major
      tax deduction. Depreciation is recognized
      as an expense which we can claim to reduce
      our taxable income.
                                                 27
    Other Issues with Depreciation:
               Inflation
• A major disadvantage is that depreciation
  does not take into account the fall in
  purchasing power over time due to inflation.
                                                  28
   EXTERNAL SOURCES OF FINANCE
           (Long Term)
There are four main sources of external finance
in the long term:
• Share Capital
• Loan Capital
• Venture Capitalists
• Grants from Governments & other
  philanthropic organizations.
                                              29
   EXTERNAL SOURCES OF FINANCE
           Share Capital
• Share capital represents the monies that are
  put into a company by investors, who are then
  classified as shareholders.
• Note: Sole Traders and Partnerships don’t
  have shareholders and this is not a relevant
  source of finance for these organizations.
                                              30
   EXTERNAL SOURCES OF FINANCE
           Share Capital
• The original investment by the owners is often
  used to fund the purchase of the organizations
  initial assets and sometimes to fund the
  working capital needs of the business while
  other funding is organized.
• However, it is a long term source of finance
  and therefore should be used for long-term
  needs, such as purchasing machines or
  computer systems or acquiring businesses.
                                                    31
   EXTERNAL SOURCES OF FINANCE
           Share Capital
• When a business expands it can ask existing
  shareholders to put more money into the
  business and therefore new shares are issued in
  proportion to the size of the increase in the share
  capital.
• Note: When people buy and selling existing
  shares, usually via a stock exchange, this does not
  help the business with raising new capital, as it is
  simply swapping ownership between people.
                                                   32
       Advantages of Share Capital
         as a Source of Finance.
• The advantages with this sort of finance are there
  are no interest payments and so no drain on
  company profits.
• If existing shareholders increase their investment
  by buying more share in proportion to the
  current levels, there is no change in control.
• However, if new shares are bought by new
  investors that may dilute the control of the
  original shareholders.
                                                    33
    Disadvantages of Share Capital
        as a Source of Finance.
• The disadvantages are that shareholders may
  still expect rewards in the form of dividends,
  and this is paid for from profits.
• However, unlike the arrangement with loan
  capital, if the business does not make a profit
  and does not have a reserve of past profits, it
  cannot be compelled to pay a dividend.
                                                      34
             A Share Capital or
            Debt Capital Tradition
• In countries such as the UK, the amount of share
  capital used to fund business activities is rather
  low relative to debt capital.
• This makes UK companies vulnerable to interest
  rate rises, which can hit profits directly.
• In other countries, (eg: Japan & Germany) there
  is a tradition of investing in share capital and this
  makes for a more long term and perhaps more
  stable financial structure.
                                                            35
    EXTERNAL SOURCES OF FINANCE
         Debt or Loan Capital
• Funding provided by outside banks and lenders is
  generally referred to as debt or loan capital.
• It is usually provided for a fixed period of time, with
  repayments evenly spread out over the length of the
  loan.
• Interest is paid on the loan at regular intervals,
  although interest rate holidays (where the lender
  agrees not to take interest for a short period of time)
  can be negotiated if the business is struggling to fund
  the debt.
• Loan capital is provided for more than 1 year and so is
  a long term form of finance.
• Any loan shorter than 1 year is classified as current
  liabilities or debt.
                                                  36
  The Advantages of Loan Capital
• The advantage of this form of finance is that it
  is often easier to access and use for specific
  purposes like buying fixed assets, such as
  machines or property.
• Payment is spread out over the useful
  revenue-earning life of the asset.
• If the loan has a fixed interest rate, and
  interest rates rise in the future, the loan could
  be a very smart investment.
                                                             37
The Disadvantages of Loan Capital
• The disadvantages is that lenders have to be paid even
  if the business does not make a profit.
• Any default (not paying the loan on time) can lead to
  the lender controlling future decision making, in effect
  they call the shots.
• Equally if the loan is secured against an asset then the
  asset can be seized if payments are missed.
• If the loan has fixed interest rate, and interest rates fall,
  the business may find itself with a very undesirable
  loan, that is a burden on the business.
• However, large and very profitable organizations may
  be able to renegotiate terms with lenders.
                                                38
   EXTERNAL SOURCES OF FINANCE
        Venture Capitalists
• These are specialist bankers who are more
  prepared to share the risks of starting a new
  business enterprise than traditional banks.
• Venture capitalists invest in the share capital
  of the business and provide loan capital for
  the business.
• Venture capitalists only target companies with
  great expansion or growth potential.
                                                    39
Advantages of Venture Capitalists
• The advantages are that they often provide
  business help and contacts - perhaps for export
  drives or for identifying new technologies or
  partners.
• They sit as non-executive directors to protect
  their investments.
• They will ensure that there is a planned exit route
  for the investment in maybe five to seven years,
  often through a stock market floatation or via a
  trade sale.
                                                   40
 Disadvantages of Venture Capitalists
• The disadvantages are many for the existing
  shareholders as venture capitalists impose profit
  or sales targets.
• If the businesses they invest in fail to expand as
  planned the venture capitalists can automatically
  increase their equity stakes, often from that of a
  minority investor to being the controlling one.
• However, many organizations have used venture
  capital successfully and benefited from the
  business advice of their managers.
   EXTERNAL SOURCES OF FINANCE 41
        Grants from governments & other
           philanthropic organizations
• This is a growth area.
• Governments, successful entrepreneurs such as Bill
  Gates & large corporations keen on promoting their
  social responsibilities, are all increasingly seeking to
  help the smaller business sector with grants and soft
  loans.
• Soft loans are loans with more relaxed payment terms
  and lower than usual interest rates.
• While the sums may be small they can make a big
  difference to a projects viability.
• Often the problem is identifying what grants are
  actually available, although the internet has made the
  research easier.
                                                 42
   EXTERNAL SOURCES OF FINANCE
           (Short Term)
There are several types of short term finance:

• Bank Overdraft
• Trade Credit
• Factoring
• Leasing.
EXTERNAL SOURCES OF FINANCE (ST)
         Bank Overdraft        43
• Banks finance the short-term needs of businesses
  by providing short term monies called overdrafts.
• An overdraft is repayable on demand and should
  be used for short term funding needs, such as
  when a business is waiting for customers to pay,
  when it needs to pay suppliers upfront or when
  staff have to be paid.
• When business find they are expanding very
  quickly due to a successful sales drive they may
  well find their overdraft rising as they await
  receipts from customers.
EXTERNAL SOURCES OF FINANCE (ST)
 Disadvantages of a Bank Overdraft 44
• The disadvantage is that the cost of an overdraft will
  vary as interest rates change in the economy.
• This makes budgeting costs a little difficult.
• In some countries (eg UK) bank overdrafts can
  represent a very high proportion of total funding for a
  business. If the bank decides the business is struggling
  or that a recession is coming it may cut back the
  overdraft limit without much notice.
• This can lead to a business failing.
• Overdrafts are often secured on a personal guarantee
  from the owners and or the assets of the business.
EXTERNAL SOURCES OF FINANCE (ST)
  Advantages of a Bank Overdraft 45
• The advantages are that changes in overdraft
  limits can be increased quite easily and it is a
  flexible source of finance.
EXTERNAL SOURCES OF FINANCE (ST)
          Trade Credit         46
• Trade Credit is when a business gains
  extended time to pay its suppliers – perhaps
  30 or 60 days after the delivery of the
  suppliers goods.
• This means the business can in effect use its
  suppliers as a source of finance.
    EXTERNAL SOURCES OF FINANCE
     Factoring – Third Party Agency 47
• When working capital is tight or when a business is
  struggling to get paid by customers, it may consider
  using a third part agency to help.
• A factor agent is a company that buys the current
  unpaid invoices of a business at a discount of, say 25%.
• The factor agent pays that cash immediately to the
  business and hopes that it can recover more than 75%
  of the value of the debts in order to make it a profit.
• The better the quality of the customers a business has,
  the greater the percentage that the factor agent may
  be prepared to offer upfront.
   EXTERNAL SOURCES OF FINANCE
                               48
       Advantages of Factoring
• The advantage is that the business receives
  cash upfront and can use this money to fund
  expansion and working capital needs more
  generally.
• In addition, the administration cost to the
  business of chasing up its customers, is
  immediately removed.
    EXTERNAL SOURCES OF FINANCE
      Disadvantages of Factoring 49
• The disadvantage is that the business is really giving up
  some of its profit margin by doing this.
• For example, if the firm is making a 50% profit margin
  already, giving away 25% of the sales value may be
  acceptable, but not if the business is only making a
  small margin.
• Equally factoring will not help very small businesses
  and those with very marginal and local clients.
• Also remember that a factor agent ringing up your
  biggest customer and demanding immediate payment
  (otherwise the customer may be taken to court) could
  mean that you could lose vital sales in the future.
   EXTERNAL SOURCES OF FINANCE
                               50
             Leasing
• When purchasing assets such as new
  machines or vehicles it can be sometimes be
  useful to consider leasing as a source of
  finance.
• Many airlines lease purchase their aircraft.
• GE, a large US finance company, is one of the
  largest leasing businesses in the world.
• Equally leasing can be arranged with firm’s
  own bank.
   EXTERNAL SOURCES OF FINANCE
       Advantages of Leasing   51

• The advantages are that the business does not
  need to find a large initial lump sum to buy
  the equipment and can thus pay for the asset
  from its own revenue.
   EXTERNAL SOURCES OF FINANCE
      Disadvantages of Leasing 52

• The disadvantages are that the ownership of
  the asset does not pass to the business until
  the last payment has been made and the
  business will probably be paying a reasonably
  high level of interest.
         FINAL COMMENTS –
    EXTERNAL SOURCES OF FINANCE 53
• Using external financing brings in much needed
  funding for expansion, but it has its problems or costs.
• Gearing ratios, rises as loans become a larger share of
  the total capital of the business, also interest cover
  ratios may worsen, unless profit rises proportionally as
  well.
• Equally more long term debt will dilute the owners
  stake in the business and that of the lenders will rise,
  affecting to some extent business decision making.
• It is important to consider a variety of funding sources
  and not to become overly dependent on one.

				
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