Sources of finance - OCRWays of raising finance externally

Overdrafts

Overdrafts are one of the most common forms of finance and are generally used to cover short-term cash flow problems. However, they should be used carefully and only in emergencies as they can become expensive due to the high interest rates charged by banks. Overdrafts are used by all types of business, both new and established.

Common features of overdrafts include:

• variable interest rates - the cost of borrowing money changes when the interest rate changes
• flexibility - a business uses its overdraft only when it needs to, the business only pays interest when the overdraft is in use
• the bank can demand full payment - banks can demand full repayment of an overdraft within 24 hours

Trade credit

Trade credit must be agreed with a supplier via a credit agreement. This source of finance allows a business to obtain raw materials and stock but pay for them at a later date. This is therefore an example of a short-term source of finance. The payment is usually made once the business has had an opportunity to convert the raw materials and stock into products, sell them to its own customers and receive payment. This source of finance is suitable for all businesses.

Common terms and conditions found in a credit agreement include:

• credit limit - the maximum amount of credit available to the business
• credit period - the length of time the business has to pay what is owed, usually 30, 60 or 90 days
• frequency of payment - how often payment is required, usually monthly
• method of payment - the way in which the business will make payment, eg bank transfer, cheque or card payment
• retrospective discount - a discount given when the business has purchased a certain amount of stock or raw materials

Trade credit often allows a business to receive payment from its customers before it pays its suppliers, which improves cash flow. Trade credit is also often free from interest. However, businesses must pay their suppliers even if they aren’t able to sell products to customers. If a business fails to pay within the agreed credit period then the supplier charges interest on the money that is due.

Loan

A loan is money lent to an individual or business that is paid off with interest over an agreed period of time. Usually the rate of interest is fixed. Having to repay a loan with interest is a disadvantage of taking out a loan, but it does mean that a business knows in advance what the cost of borrowing will be and what monthly repayments will be required. This is an advantage of taking out a loan as it allows a business to plan ahead.

To get a bank loan, a business must apply to a bank. The bank then carries out credit checks to see the financial history and reliability of the business. The bank may require the business to secure its assets against the loan. This means that if the business is unable to repay the loan, the bank can demand the sale of the assets to raise money to pay back the loan. If a business does not have enough assets, a bank may require a guarantor to repay the loan if the business does not make its repayments on time.

Share issue

Share issue is money raised by shareholders through the sale of ordinary shares. Buying shares gives the buyer part ownership of the business and therefore certain rights, such as the right to vote on changes to the business. This can slow down decision-making processes.

Advantages of share issue include:

• Share issue is a source ofpermanent capital – shareholders cannot have a refund on their shares. Instead, if they want to sell their shares, they must find someone else who wants to buy them.
• There are nodividendsto be paid if the business has a poor year – shareholders are not promised dividends every year, as dividends are only paid if the business has made sufficient money to pay all of its costs.

Disadvantages of share issue include:

• It dilutes control for thefounders – the more shares that are issued, the more shareholders there are who own part of the business. This results in the founders having less control. In order to have a majority stake in the business, the founders must hold more than 50 per cent of the shares.
• The business is vulnerable totakeover – as a business grows and sells more shares, it becomes vulnerable to the threat of a takeover. This is because the shares are sold publicly and if an individual or group buys enough shares, they can persuade other shareholders to vote for a new management team.

Crowdfunding

Crowdfunding involves a large number of people investing small amounts of money in a business, usually online. Commonly used crowd-funding websites include Crowdfunder, GoFundMe and Kickstarter.

Advantages of crowd funding include:

• It acts as a form of market research. If people don’t invest, it means the business idea is not attractive or distinctive enough, which indicates that the business is likely to fail.
• It provides opportunities for individuals to start up a business even if they don’t have access to other sources of funding.

Disadvantages of crowdfunding include:

• The business must be interesting. Crowdfunding is most successful when the business idea is appealing, interesting and innovative.
• It can be difficult to reach the funding target. Statistics from crowd-funding websites indicate that under 33 per cent of businesses achieve their funding target.

New partner

Taking on a new partner can bring new finance to a business. It is usually used for buying or replacing capital equipment or to help business growth.

Advantages of taking on a new partner include:

• it can bring new skills and expertise to the business
• it doesn’t incur any new costs to raise the finance

Disadvantages of taking on a new partner include:

• the new partner will share the profit, from the business
• the new partner will have an equal say in how the business is run

Other key factors

Various other factors need to be kept in mind regarding sources of finance:

• Sole traders and partnerships cannot sell shares to raise finance.
• Limited companies are unable to take on extra partners to raise more finance.
• Banks are unlikely to offer overdrafts or loans to businesses with poor financial track records.
• Businesses that want to undertake risky activities and ideas that appear to have a limited future, eg a fad, will also find it difficult to raise finance.