Topic 3: Finance and Accounts 3.1 Sources of Finance Topic 3: Finance and Accounts

What is finance? The ability to access money in order to fund business activities. Many different business activities need finance. Can you name some?

Business Activities to Finance What is Capital? Can be Cash, Equipment, Buildings Startup Capital Money needed to start a business to: buy equipment, rent/buy a building, purchase inventory Working Capital Money needed to operate the day-to-day activities of the business: pay bills, pay employees, buy supplies Business Expansion Move to a larger location, hire more people, equipment upgrades; purchase other businesses

Business Activities to Finance Special Situations Decline in sales could leave company without enough cash; a customer could fail to pay his bill in time; unexpected repair expenses Research and Development Invest in new markets, create new products

Financing Expenditures Capital Expenditures Purchasing fixed assets that will last over one year (things that aren’t consumed in the day-to-day operation of the business) Buildings, machinery, or cars (What are ASSETS?) Revenue Expenditures Spending that occurs in order to produce your product or service Wages, inventory, supplies, utilities Financing these two different types of spending will be very different as the length of time for “pay back” is different.

Sources of Financing - Internal Internal Money Money raised by the business’s own assets or from the profits left over from the business. Personal funds (sole traders) Profits Retained by the business Sale of Assets Managing Working Capital

Internal Sources of Finance Personal Funds (sole traders) Usually owner’s savings Adds to the business risk of the entrepreneur to invest his personal savings. There is no interest to be paid to lending institution. The owner remains in control of the business.

Internal Sources of Finance Profits retained by the business Profit that is kept by the business after taxes and dividends are paid New companies or companies that experience a LOSS may not have access to this type of financing. This type of financing is permanent because it is not “paid back” Revenue $100,000 Expenses 30,000 Profit $ 70,000 Taxes @10% - 7,000 Dividends paid - 20,000 Profits Retained $ 43,000

Internal Sources of Finance Sale of Assets Companies can sell assets they no longer need or use to raise cash for financing. Example: A company owns 2 cars worth $10,000 each Total: $20,000 in Asset Value NOT Cash $20,000 Liquidate car asset to raise cash. $10,000 CASH $20,000

Internal Sources of Finance Managing Working Capital Working Capital = Current Assets – Current Liabilities - = I can use Working Capital to finance the purchase of equipment. Sale of assets – involve selling off long-term assets Reductions in working capital involve reducing current assets. This alters the ratios for a business and can limit the cash required to operate the business on a daily basis. - = -

Evaluation of Internal Financing No direct cost to the business Does not increase the debt of the company No risk of loss of control of the company to another party No shares are sold to others New or unprofitable companies have few assets to sell to raise cash Growth will be constrained by limited cash resources

Time to Finance – External Short-Term Financing One year or less Medium-Term Financing One to five years Long-Term Financing Over 5 years

Sources of Financing External – sources from OUTSIDE the business Short – Term External Money Bank Overdrafts Trade Credit Debt Factoring (Selling Receivables at a discount)

External Sources of Finance Bank Overdrafts Most Flexible types of financing Pre-arranged with a banking/lending institution Expensive with high interest rates Used on a day-to-day basis to cover the cash needs of a business Allows a business to spend more in their checking account than the actually have.

External Sources of Finance Trade Credit Delaying payment of your vendors Early payment discounts cannot be taken Suppliers may not be happy if you take to long to pay your bills What is “Trade” – buying from a supplier in your industry.

External Sources of Finance Debt Factoring Selling Accounts Receivable at a discount to a collector (What is Accounts Receivable? Money owed to you by your customers.) Money Owed You: Accounts Receivable: $10,000 You Sell to a Debt Collector for immediate cash: $ 7,000 Debt Collector Profits when debts are collected: $ 3,000 This is not BAD Debt Collection.

Sources of Financing External – sources from OUTSIDE the business Medium – Term External Money Hire Purchase Leasing Medium-term bank loans

External Sources of Finance Hire Purchase (A LOAN) Purchasing an asset over a period of time Example: buying a car, equipment using a loan Ownership Leasing A contract with a company to pay a fee but not actually acquire ownership of the item. Example: leasing a car, or equipment No Ownership Bank Loan A loan from a banking institution

Sources of Financing External – sources from OUTSIDE the business Long – Term External Money Sales of Shares of Stock Debentures Long-term bank loans

Sources of Financing External – sources from OUTSIDE the business Sell Shares of Stock Sell additional shares of stock to new investors “Go Public” – a private corporation selling stocks to new public investors through a stock exchange OR Rights Issue Existing shareholders have the right to purchase more stock at a discount in order to raise capital for the business. This does not introduce new owners.

Sources of Financing External – sources from OUTSIDE the business Debentures (Corporate Bonds) Bonds issued by a company to raise money and they are usually issued with a fixed rate of interest Savings Interest Rate to Depositors @ 1% Interest Loan @ 15% Interest Bank makes 14% Profit Bond @ 10% Interest to People People make 10% Profit vs 1% at the bank Business SAVES 5% on Loan Interest by NOT using the bank

Sources of Financing External – sources from OUTSIDE the business Long-term bank loan A loan from a financial institution. Typically used to purchase land or buildings. Commonly called a mortgage.

Other Sources of Financing External – sources from OUTSIDE the business Venture Capital Specialist organizations that invest in startups that look promising for a return on their investment. They usually expect a share of future profits or a sizeable stake in the company. Think Shark Tank Grants Government agencies willing to fund businesses that will establish themselves in particular locations or create jobs. (Economic Development Funds)

Other Sources of Financing External – sources from OUTSIDE the business Business Angels Wealthy individuals –like venture capitalists – that are willing to risk their personal wealth. They will want partial ownership and share of the profits. Subsidies Government funding that provides financial support which include: May fail due to potential unemployment in the region Need startup assistance in high cost or high failure risk Produce strategically important products Need cost reductions to remain competitive with foreign rivals

Other Sources of Financing External – sources from OUTSIDE the business Micro Finance Providing very small loans to businesses or individuals Often traditional banking services are not available Often made to persons in under developed countries

Evaluation of Internal Financing No direct cost to the business Does not increase the debt of the company No risk of loss of control of the company to another party No shares are sold to others New or unprofitable companies have few assets to sell to raise cash Growth will be constrained by limited cash resources

Evaluation of External Financing Debt VS Equity Financing For long-term financing decisions: Debt Financing No shares are sold so ownership does not change or become diluted with additional shares of stock Loans and bonds will be repaid – so this is not permanent Lenders have not voting rights Interest on loans is paid before taxes / Dividends are paid after taxes are paid on profits Additional costs of interest payments Equity Financing Never has to be repaid Dividends do not have to paid to stockholders Ownership diluted by selling more shares of stock

Financing Options Sole Traders & Partnerships VS Corporations Cannot raise money with sale of stock Unlikely to be able to issue a bond They CAN Bank Overdrafts (credit lines) Loans Trade Credit (credit from suppliers) Bank loans will be limited unless personally guaranteed by the owners personal assets.

Recap Internal Sources of Finance External Personal Funds (sole traders only) Retained Profits Sale of Assets Managing Working Capital Internal Share Issue (Sale of Stock) - Equity Debentures (Bonds)- Debt Long term Loans - Debt Grants Sources of Finance (limited companies) Long Term Leasing Hire Purchase Medium term Loans Medium Term Bank Overdraft Trade Credit Debt Factoring (Selling A/R) External Short Term Venture Capital Subsidies Business Angels Micro Finance OTHER

Factors that Influence Financing Choices What is financing needed for which affects the time period required to finance (TIME) Cost Amount required Legal business structure and desire to retain control Size of existing borrowing Variable needs (seasonal sales)