All businesses need finance. There are a number of funding sources used by organisations.
Why business needs finance
Finance refers to sources of money for a business. Firms need finance to:
- Start up a business, eg pay for premises, new equipment and advertising.
- Run the business, eg having enough cash to pay staff wages and suppliers on time.
- Expand the business, eg having funds to pay for a new branch in a different city or country.
New businesses find it difficult to raise finance because they usually have just a few customers and many competitors. Lenders are put off by the risk that the start-up may fail. If that happens, the owners may be unable to repay borrowed money.
Sources of finance
Some sources of finance are short term and must be paid back within a year. Other sources of finance are long term and can be paid back over many years.
Internal sources of finance are funds found inside the business. For example, profits can be kept back to finance expansion. Alternatively the business can sell assets (items it owns) that are no longer really needed to free up cash.
External sources of finance are found outside the business, eg from creditors or banks.
This video explains about sources of finance
Short-term sources of external finance
Sources of external finance to cover the short term include:
- An overdraft facility, where a bank allows a firm to take out more money than it has in its bank account.
- Trade credits, where suppliers deliver goods now and are willing to wait for a number of days before payment.
- Factoring, where firms sell their invoices to a factor such as a bank. They do this for some cash right away, rather than waiting 28 days to be paid the full amount.
Long-term sources of external finance
Sources of external finance to cover the long term include:
- Owners who invest money in the business. For sole traders and partners this can be their savings. For companies, the funding invested by shareholders is called share capital. Limited companies can issue shares and shareholders receive dividends. Shares can be Preference shares (fixed % dividend) or Ordinary shares (risk capital / equity)
- Loans from a bank or from family and friends.
- Debentures are loans made to a company. These long term loans are at an agreed fixed % of interest repayable on a stated date. Up to 25 years.
- A mortgage, which is a special type of loan for buying property where monthly payments are spread over a number of years.
- Hire purchase or leasing, where monthly payments are made for use of equipment such as a car. Leased equipment is rented and not owned by the firm. Hired equipment is owned by the firm after the final payment.
- Grants from charities or the government to help businesses get started, especially in areas of high unemployment.
Creditors and debtors
A creditor is an individual or business that has lent funds to a business and is owed money. A debtor is an individual or business who has borrowed funds from a business and so owes it money.
There is a cost in borrowing funds. Money borrowed from creditors is paid back over time, usually with an additional payment of interest. Interest is the cost of borrowing and the reward for lending.
Creditors often ask for security before lending funds. This means sole traders and partners may have to offer their own house as a guarantee that monies will be repaid. A company can offer assets, eg offices as collateral.
The type of finance chosen depends on the type of business. Start ups and small firms are considered very high risk and find it difficult to raise external finance. The only source of funds might be the owner's own savings, retained profits and borrowing from friends. Companies can issue extra shares to raise large amounts of capital in a rights issue.
Choosing the right source of funding
- Businesses need to consider a number of factors when deciding what sources of finance to use
- External sources of finance are more expensive as you need to pay interest
- To use retained profits you need to get agreement from shareholders
- The source of finance chosen also depends on the time period and what you need the finance for
This video looks at the best source of finance and how to deal with exam questions