Sources of Finance Introduction All businesses need to raise finance to run a business.

There is a variety of sources that you need to be familiar with which include bank loans, overdrafts, sale of shares, government grants and personal savings. However: There are advantages and disadvantages of each type of finance Which method of raising finance will depend in turn on: o The project for which the finance is being used o Whether the finance is needed for the long term or the short term o Whether the firm calls upon the owners to provide the finance or whether the finance is to be borrowed from outside the business.

Sources of finance can be internal or external. The type of finance that is available to a privately owned business also depends on the type of business. All businesses fit into two, broad, categories: Non-incorporated firms. These are firms that are owned by individuals: Sole traders- are firms that are owned by a single individual. Legally, the business is not separate from the individual although the owner will keep their personal and business accounts separate. Partnerships these are firms that are like sole traders but ownership is shared by up to 20 individuals who share ownership, the responsibility for raising finance and entitlement to a share of the profits. Incorporated firms. These are firms that are owned by individuals in the form of shares but the firm is a legal entity in its own right. This means that if a firm owned by shareholders goes bankrupt then the shareholders, as they are separate to the business, do not go bankrupt personally although they might lose the value of their shares. This is known as limited liability. The types of incorporated firms are: Private limited company (ltd) These tend to be small firms that are locally based. Shares can only be sold privately by invitation from the board of directors. This enables the firm to control who can own shares in the business. Hence, this is a popular form for family run businesses. Public limited company (PLC) These tend to be the large firms that are listed on the stock exchange. Anyone can buy or sell shares in a PLC. This enables the firm to raise large scale finance although the risk is that PLCs can be taken over by other companies. Co-operatives these tend to be democratically run firms owned by workers or customers. Each person only has one vote in electing the directors however many shares they own.

Types of raising finance The form of finance open to business falls into two categories: Internal sources and External sources. Internal sources For a sole trader or partnership these will include savings, retained profits and the sale of assets. These are long term in so far as this money is usually only available on a one off basis eg life time savings. So therefore there must be a long term benefit such as new buildings or machinery. New partners can also be brought into the business although this will dilute ownership ie the existing owner(s) will lose some ownership and control. For a sole trader or partnership these will also include sale of stock. This is short term in that sale of goods already produced should provide a stream of finance that can be used to pay wages and buy more supplies. For a company these will include sale of shares and sale of assets. The directors can issue new shares in a business. This will dilute ownership. These are long term sources used for expanding the business. For a company these will also include sale of stock for the short term. External Sources For a sole trader or partnership these will include bank loans, secured loans (mortgages), leasing, venture capital and government grants. These are long term and are used for expanding the business through the purchase of assets. Loans from banks incur interest charges and can be expensive. However, this may be offset by the additional profits that this finance generates. Loans have the advantage that you are ownership of the business is not being diluted (the owners retain control). However, banks can place conditions on loans and often require to see the business plan, cash flow and break-even forecasts. Secured loans carry a lower rate of interest because they carry less risk for the lender. The most common form of a secured loan is a mortgage ie finance is lent on condition that if it is not paid property assigned to the loan can be re-possessed. Because the loan is secured it carries a lower rate of interest. Mortgages are common for small businesses because they carry more risk and find raising finance harder otherwise. Leasing is a form of finance similar to rent whereby land or equipment is loan for a contracted period of time usually a number of years. Sale and lease back is where land and equipment is sold and then rented back.

Government grants are awards from the government aimed at encouraging enterprise and employment opportunities. They are usually available to firms that set up or expand in areas of deprivation and high unemployment. The advantage is that the finance is free. However, such grants can be difficult to obtain as firms have to prove that they are going to be successful and they are able to expand and employ more people than they otherwise would have done. Bidding for grants can be complex. For a sole trader or partnership external sources of finance also include overdraft, trade credit, short term loans and debt factoring. These are short term and are used for paying overtime wages, bills and supplies. An overdraft is an arrangement with a bank whereby a firm can spend more cash than it holds in the bank up to an agreed limit. Interest is very high so this is a short term method. The advantage is that it is flexible. Trade credit is an agreed delay in paying for supplies. 3 months after delivery is a standard period of time before a supplier has to be paid. This enables the firm to have time to sell the goods in turn to be able to pay the supplier. A discount for immediate payment is often sacrificed (usually around 2.5%) Short term loans These are similar to bank loans but operate on a short term basis usually a year. Debt factoring This is the sale of debts. If firms struggle to obtained money owed to them from their customers then they might sell the debt to a debt factoring company. For example, if a group of customers owes a firm 10,000 then the firm will now sell this debt on to a debt factoring company for say 8000, sacrificing 2000 of the money owed to them but at least recovering most of their debt. The debtors will now owe between them the full 10,000 to the debt factoring company who will be much more experienced at collecting debt and taking people to court. For a company external sources of finance include government grants, bank loans, debentures (public limited companies only) and venture capital. These are long term sources of finance. Debentures are a means by which a public limited company can borrow finance from the general public through the stock exchange. They are similar to shares in that certificates are issues stating the amount of money each debenture is worth. A fixed rate of interest is paid on debentures which have a limited life before they are cashed in. They are a cheap source of finance. Venture capital is finance lent to companies who are innovative and taking risks in new products and new markets. They are risky and so carry high rates of interests. Venture capital firms also require a say in the business to ensure success. For a company external sources also include trade credit, short term loans and debt factoring.

Sources of Finance Summary Long Term Unincorporated firms (sole traders, partnerships) Incorporated firms (private limited companies, public limited companies, cooperatives Share capital Sale of assets Short term Unincorporated firms (sole traders, partnerships) Incorporated firms (private limited companies, public limited companies, cooperatives sale of stock

Internal Sources

Savings Retained Profits Sale of assets

sale of stock

External sources

Long term bank loans Secured loans (eg mortgages) Government grants Leasing venture capital

Government grants Bank Loans Debentures (plcs only) venture capital (short term only)

Overdraft Trade credit short term loans debt factoring

Trade credit short term loans debt factoring

You need to be aware of the advantages and disadvantages of each type of finance source and the circumstances in which each would be used.