5.3.1 Making financial decisions: sources of finance 5 Decision making to improve financial performance How many possible sources of finance can you list for a business? Try to think of both internal and external sources. 5.3.1 Making financial decisions: sources of finance AQA Business

5.3.1 Making financial decisions: sources of finance In this topic you will learn about Internal and external sources of finance Advantages and disadvantages of different sources of finance for short- and long-term uses

Sources of finance Sources of finance are the options available to a business when seeking to raise funds to support future business actions For a start-up business this might be raising sufficient capital to establish the business For an established business this might be to fund growth or implement a new strategy e.g. relocation Sources of finance can be: internal i.e. from within the business e.g. retained profit External i.e. from outside of the business e.g. loans

Sources of finance Sources of finance include: Debt factoring Overdrafts Retained profit Share capital Loans Venture capital

Debt factoring Recap. How could factoring be used to improve cash flow? The process of selling the debts owed to a business to a financial institution The business will receive funds immediately but at a reduced rate e.g. may only receive 80% of the total value of the debt After the debt has been paid the business will receive further payment but the financial institution will keep a percentage of the repayment as a fee An external source of finance

Debt factoring Advantages Disadvantages Receives a large amount of the debt immediately Good source of short-term finance to address cash flow problems Debts are chased by experts saving managers time Reduces the risk of bad debts Reduces profitability of the firm as a result of the fee paid to the financial institution May damage the reputation of the firm as they are seen to be in need of short-term finance Check your understanding of factoring. https://www.youtube.com/watch?v=XVmfxfDPFPQ CIT Presents: What is Factoring?

Overdrafts An overdraft is the facility to overspend on a current account up to an agreed sum The business in effect can withdraw money from the account that is not there meaning they go overdrawn or in the red Interest is charged on the overdrawn amount This is a good short-term source of finance An external source of finance provided by banks and building societies Overdrafts can also help with personal short-term financial shortages. But at what cost? http://www.bbc.co.uk/news/business-16002022 UK banks charging as much as 800,000% on overdrafts

Overdrafts Only borrowed when required allowing flexibility Advantages Disadvantages Only borrowed when required allowing flexibility Only pay for the money borrowed Quick and easy to arrange No charges for paying off the overdraft The bank can call it in at any time Only available from your current bank account Interest payments tend to be variable making it more difficult to budget Banks may secure the overdraft against the business’ assets

Retained profit Profit kept within a business from profit for the year to help finance future activities An internal source of finance Advantages Disadvantages Avoids interest repayments Does not dilute the business ownership Only an option if sufficient retained profit exists within the business May cause shareholder dissatisfaction if this is at the expense of dividend payments Reduces the security blanket of keeping retained profits for unforeseen situations or take advantage of new opportunities http://www.bbc.co.uk/news/uk-scotland-tayside-central-31815131 Scots firm Stagecoach to invest £80m in 470 new buses Stagecoach reinvests £80m profit in 470 new buses.

Share capital Finance raised from the sale of shares What is the main difference between a Ltd and a Plc? Finance raised from the sale of shares This is a form of equity capital i.e. the shareholder becomes a part owner of the business Shareholders will be rewarded for their investment by the payment of dividends but may also benefit from an increase in share price increasing the value of their shares Only an option for incorporated businesses i.e. Ltds and Plcs Issuing shares is a complex and costly process so only really an option for raising large amounts of finance to fund long term projects

Share capital Advantages Disadvantages Only need to pay dividends if a profit is being made and the amount of dividend is not fixed Possible to raise large amounts of finance No interest repayments Loss of ownership as shareholders are part owners Potential risk of loss of control for a Plc with a threat of hostile takeovers Complex and costly process of issuing shares, especially for a Plc Why has Sony’s share prices fallen following an announcement to issue more shares? http://www.bbc.co.uk/news/business-33323195 Sony shares fall 8% on fund raising plan

Loans A set amount of money provided for a specific purpose, to be repaid with interest, over a set period of time May be secured against an asset and if there is a default on repayments the asset can be taken Financial institutions can vary interest rates depending upon the amount of risk placed on the loan An external source of finance generally considered to be more suitable for longer-term projects However this will depend upon the size of the loan and the repayment period Recap. What is meant by the proportion of long term funding that is debt?

Loans Quick and easy to secure Advantages Disadvantages Quick and easy to secure Fixed interest rates allow firms to budget Improved cash flow The borrower retains ownership of the company Interest must be paid regardless of financial performance A firm that is highly geared may be seen as high risk A firm normally provides security known as collateral Often more expensive than other forms of finance Can be charged a penalty for early payment

Venture capital Investment from an established business into another business in return for a percentage equity in the business Also known as private equity finance Venture capitalists will normally look for a high rate of return in a specific time period The business or entrepreneur may also benefit from expertise and mentoring from the venture capitalist Often associated with high risk start-ups Why might a Bitcoin start-up opt to use venture capital as a source of finance? http://www.bbc.co.uk/news/technology-25360849 Bitcoin start-up raises $25m venture capital funding

Venture capital Potential for large sums of money for investment Advantages Disadvantages Potential for large sums of money for investment Expertise to help the business Makes it easier to attract other sources of finance Provides the required capital for expansion A long and complex process Expert financial projections are likely to be required Initially expensive for the firm e.g. legal and accounting fees Partial loss of ownership Risk of conflict or perceived interference

Questions – Raising Finance State and justify an appropriate source of finance for the following purchases for a florist setting up as a sole trader Delivery van Additional stock Premises Advertisement in local paper How would your recommendations change if the florist were a private limited company? Why is a florist unlikely to secure the financial backing of a venture capitalist?

Crowdfunding Crowdfunding involves raising finance from a large number of people each investing different, often small, amounts of money The business uses the internet to explain how much money is required, how it will be used and the exit strategy stating predicted return on the investment The investor is only tied into their promised contribution if the total amount is raised http://www.bbc.co.uk/news/uk-28138286 How does crowdfunding work? How does crowdfunding work?

In pairs For each source of finance state whether it is primarily appropriate as a short-term or long-term source of finance. Justify your decision. Source Internal or external Justification Debt factoring Overdrafts Retained profits Share capital Loans Venture capital Crowd funding

5.3.1 Making financial decisions: sources of finance In this topic you have learnt about Internal and external sources of finance Advantages and disadvantages of different sources of finance for short- and long-term uses