Sources of Finance

Trade credit Trade Credit - The purchase of stocks on credit. Period trade creditors allow for payment varies widely – e.g. 14 -70 days. Advantages: - It is equivalent to a loan from the supplier and is interest free - It allows companies to use money for other purposes. Disadvantages: - But there are usually discounts for prompt payments - And failure to pay on time can present problems on future orders

Debt factoring Debt Factoring - This involves a firm which has sold goods on credit selling its debts to another business (a factor) specialising in collecting debts Advantages ensures early payment reduces uncertainty- the factor takes on bad debts reduces need for overdraft reduces cost of chasing late payments Disadvantages: - But the factor buys at a discount - Factors typically pay 80% of the value of debtors and in addition will charge a fee of 5% of the debt

Bank overdraft Bank Overdraft - This is where the firm’s bank account is permitted to go into deficit up to an agreed limit Advantages: - It allows firms to borrow up to agreed limits without notification for as long as they wish - Overdrafts are flexible and easy to obtain - Overcomes temporary cash flow problems - Only pay interest on the amount and the time overdrawn Disadvantages: - Interest charged is 2 - 4% above base rate - But repayable on demand and as result overdrafts are treated as current liabilities

Short term loan Short Term Loan - A short term bank loan from a bank or other financial institution Advantages: - Repayment and interest are formally agreed Disadvantages: - Tend to be more expensive than an overdraft - Security is often required - Small businesses often pay higher interest

Asset sale Asset sale - Sale of a fixed asset for cash Advantages - Sale of idle assets is desirable - avoids interest charges Disadvantages - But crisis sale of needed assets jeopardises the future of the business Sale and leaseback - Raises cash but allows the firm to continue to use the asset - Some agreements include maintenance and upgrading - But the drawback is that it creates a liability for the future - Asset will no longer be owned and will no longer appears on the balance sheet

Long term finance

Retained profit Retained Profit - Re-investment of past profit. A proportion of profit will be retained rather than distributed as dividend. This is available to reinvest in the business Advantage - is that no interest is paid on finance raised in this way but the opportunity cost in terms of interest foregone should be taken into account Disadvantage - Shareholders may resent retention of profits which is at expense of dividends – if the profit reinvested does not go on to earn a satisfactory return - Reliance upon retained profits will mean that expansion will be slow and limited if profits are low or non-existent

Example - Marks and Spencer The profit and loss account for the year end 2nd April 2005 reports profits attributable to shareholders as £442m Out of this M and S paid out dividends totalling £203m This meant that £239m was retained to reinvest within the business The balance sheet at 2nd April 2005 records the cumulative total of retained profits (a reserve shown as transferred from the P&L Account) as £4,032m In effect this means that over the years M and S has withheld from shareholder a total in excess of £4b-they have done so in order to finance the expansion of the business

Long/Medium term loan Long/Medium term loan- From high street banks and specialist finance companies. Advantages: - Repaid in instalments - Makes financial planning easier - Interest can be fixed or can be variable Disadvantages: - Borrowers will be expected to provide security (collateral) - Small businesses often pay high interest rate

Share issue Share issue - Selling shares to raise finance. Shareholders are seen as risk takers and therefore only receive dividends out of profit. Advantage - The company does not have a commitment to meeting fixed interest payments. Disadvantages - But shareholders have rights of participation - High administrative cost involved in issuing shares - Difficult to estimate the market price of shares and, as share prices rise or fall, a shares issue might not raise sufficient finance - Share issue dilutes ownership.

Mortgages Mortgages - These are loans secured against property. Mortgages are used to purchase property - up to 85% of the value of the property Advantages - Repayment is over 20/25 years - Flexible interest rates but can be fixed for medium terms. Disadvantages - Only available for large sums

Long term loan (loan capital) Long Term Loan - Loan capital is repaid. Advantages: - Holders of loan capital do not own the business - Interest on loans is a deduction from profits - not a distribution of profits Disadvantages - Most loans will be secured either on general assets or on a specific asset - Loan holders have first call on company assets in the event of liquidation

Leasing Leasing - A method of acquiring assets without owning them. Firms sign a rental agreement with the owners of the asset . Advantages: - Additional credit is obtained above normal debt capacity - No capital outlay is required - Reduces capital tied up in fixed assets - Availability of certain assets may be possible only through leasing - Easier to obtain than a loan since the asset remains the property of the lessor - Fixed contract - unlike an overdraft, a finance lease contract cannot be withdrawn - Leasing pays for equipment out of pre-tax expenditure rather than after tax - Provides hedge against obsolescence - Contract provides for maintenance and allows for upgrading Disadvantages: - Ownership of the asset remains with the finance company. - Phases the payment over a long time - It avoids large initial cash outflow but is more expensive over the long run - As the asset is not owned it will not show up in the firm’s balance sheet and cannot be used as collateral for future loans

Leasing Disadvantages: - Ownership of the asset remains with the finance company. - Phases the payment over a long time - It avoids large initial cash outflow but is more expensive over the long run - As the asset is not owned it will not show up in the firm’s balance sheet and cannot be used as collateral for future loans

Hire purchase Hire Purchase - Purchase of assets by instalment payments. Finance provided by finance houses Advantages: - Unlike leasing ownership is eventually transferred - The asset acquired without large capital outflow Disadvantages: - The business does not own the asset until the final payment is made - Over the long run the asset will cost more than if purchased outright for cash

Debentures Debentures - A debenture is in effect a long term loan Advantages: - It can be secured against specified assets or can be unsecured - Fixed rate of interest and repayable on a specific date Disadvantage: - Only large companies can issue debentures

Venture capitalists Venture capitalists - are specialist providers of risk capital. Finance is offered on a medium term basis Advantages: - Management support also available - VCs accept some risk as inevitable Disadvantages - VCs expect non controlling equity stake of 20-40% in the firm’s capital as the return for investment - They require a negotiating charge for arranging the finance - VCs usually exit (i.e. sell their investment) in the medium-term (e.g. 5-10 years)

Government/EU support Government/EU Support - Private sector firms might enjoy some limited top up financial assistance in the form of loans grants and subsidies from the government, the EU and the various lottery funds But these forms of assistance tends to be very selective are only available if the firm demonstrates that it activities benefit the community and economy (e.g. investment, job creation, spin off benefits) are usually based on the principle of additionally (additional to money secure from sources)