Sources of Finance – Part 1

Chapter 25
 Learning objectives

To identify and analyze the need for finance:

• short-term,
• long-term needs and
• start-up or expand.
ccess Criteria
 Brainstorming

Why do you think any business would require

finance to operate?
 Why Do Businesses Need Finance?
For starting up Everyday bill payments

Businesses need
Expansion Take over bid
money for…

Internal Growth to Replace

meet growing machinery/equipment
orders or develop
new products
Can you identify how the sources of finance differ in
these 2 case studies? Pages 210 and 211
 Key considerations when choosing the type of
finance

When raising finance there are three vital questions to ask:

1 How secure is the source?

2 How expensive is the source
3 Is enough being raised?
 The right kind of finance is important

“ Different sources of finance have

different implications for a business, so
it is important that the most appropriate
method of finance is chosen for the
purpose that the business has in mind ”
SHORT-TERM NEEDS
 Short term finance
needs
• The business may have
When raising finance, the first
some minor cash flow question to ask is about the
problems that it needs to timing of the cash requirement. Is
solve the finance needed for a few
weeks or for several years?
• Short term finance may
mean the debt is paid back
in less than one year

• The solution could be:

A. An overdraft on the current
account of the business
B. Owners savings
 Definition: Overdraft

• A business will have a current account with

the bank, they will put in cheques and cash
and pay bills from the account
• In the event of a cash flow shortage a business
may ask a bank for authorisation to draw
more cash for a short period of time
 Short term source of
finance: overdrafts

• Some months a business may need extra cash to tide it

over until a better month. A loan is over many years so
is not suitable.
• An overdraft may be organised by the bank which is
short term lending of smaller amounts of money
• For example, if a business owner has £500 in their
bank account but has a bill for £750, they can use the
overdraft facility to borrow the £250 that they don’t
have.
• Why would this be important when paying suppliers?
 Advantages and
disadvantages of overdrafts

Advantages Disadvantages
• They are extremely flexible • The interest rate charged is
and can even be used for a usually higher than for a
single day if the business has loan
a temporary cash-flow
problem • Banks can demand
• Interest is only paid on the immediate repayment
amount of the overdraft (although this is rare)
being used rather than the • Bank may refuse to give an
maximum level allowed overdraft until the business
• Security is not usually is established
required
LONG-TERM NEEDS
 Long term finance needs
• A business may either have more
significant financial problems or
wish to expand and will need
some long term finance
• Long term in business is usually a
debt that will take over a year to
pay back

• The solution could be:

A. Retained profit (if the business is
established)
B. A bank loan (loan capital)
C. Venture capital
D. Share capital
Definition: Retained profits
• After a year or more of trading a business may
have some profits that they are able to re-
invest into the business to help it grow
• This is called their retained profits because the
business retains it
 Methods of finance:
retained profit

• Retained profit means that the business has made

a profit in the previous year (s) and has kept some
of this profit to invest in future projects. Would a
start-up business have retained profit?
 Advantages and disadvantages of retained
profit
Advantages Disadvantages
• There is no interest to pay • If it is spent then it cannot
on a loan, so this is the be used for any other
cheapest method of finance purpose e.g. to invest in a
• Access to the funds can be new machine, this is the
quick and easy opportunity cost of using
this money
• Not applicable in the first
year of trading as the
business has not made any
profits to retain
Definition: Loans
• A loan is issued by a bank*
• The loan will have monthly repayments plus
interest which will have to be paid back to the
bank
 What is a loan?
• A loan is a sum of money
borrowed from a lender
which must be paid back
together with some interest
• Some loans require security
for example property
• Other loans don’t need
security but may have
higher interest rates
• This is a fixed cost for a
business
 More about loans
• Loaning money from a bank is
like ‘renting’ the money
• Banks will lend to small
businesses but may not lend
when they first start up as
there is no track record or
history of them making money
• Loans are affected by interest
rates – if they go up the cost of
borrowing will go up too and
the business may have to pay
more interest back to the bank
 Advantages and
disadvantages of loans
Advantages Disadvantages
• A medium to long-term • The amount of interest to be
business loan can help with paid on a business loan will
depend on the individual
all the costs of setting up a
circumstances, including how
business, from cash flow to much the business wants to
expenses and paying staff borrow and over what period of
• The longer the term of the time
loan, the lower the monthly • Each month the business will
payments will be, as they have to pay back some of the
are spreading the cost over loan and some interest to, they
will have to do this even if they
a longer period of time
have a bad month
 Definition: Venture Capital
• Venture capital is a loan for a business from a
private individual, not a bank
• The individual who lends the business money is
called a venture capitalist
• The venture capitalist may wish to help run the
business in order to protect their investment
 What is venture capital?
• Venture capital is a form of
financing where capital is
invested into a company,
usually a start-up or small
business, in exchange for
equity in the company.
• Venture capital firms are a
type of investment firm that
fund and mentor start-ups
often tech companies
• Click the graphic to
investigate venture capital
further
 Advantages and
disadvantages of venture
capital
Advantages Disadvantages
• Venture capitalists can bring • Owners may lose some
knowledge to the business control of the business
to help it expand • Venture capitalists may
• They take on high-risk require a large share of the
businesses business
• They can help by providing • Venture capital investment
the business with growth is in high demand and they
capital and strategies may not be investing when
the entrepreneur is looking
for finance
Definition: Share Capital
• Limited companies can issue shares in return for
money, to raise funds to grow or expand
• Private limited company – can issue shares to
friends and family of the owners only (ltd)
• Public limited company can float the share issue
on the stock market and sell to anyone (plc)
 What is share capital?
• Share capital is money invested
into the business by people who
are called shareholders
• Shareholders buy a share of
ownership of the company
• Sole traders may have just one
owner and one shareholder
• When a business becomes a
limited company (ltd) they have
the right to sell shares to family
and friends to raise money
• If the owner issues 100 shares at
£1 each then the share capital is
£100
 Examples of share
certificates

Would you buy shares in either of these companies?

 Advantages and
disadvantages of share
capital
Advantages Disadvantages
• The advantage of raising • Shares
money in this way is that you represent ownership of a
don't have to pay the money business
back or pay interest to the • When an individual buys
investors shares in a business, they
• Attracts new finance become one of its owners
• Acts as an incentive for staff • Shareholders choose who
using shares or share options runs a company and are
as a motivation tool involved in making key
• A way to raise the profile of decisions, such as whether a
the business business should be sold
TO START UP OR EXPAND
 Appropriate finance for
a start-up
• If someone wants to start a
business there are sources
of finance that are suitable
• These might include:
A. A start up loan from the
bank
B. The personal savings of the
owner
C. Venture capital
Business owners will need finance to
• The business will not have help them start-up their businesses
any retained profits as it
will have just started
 Appropriate finance for
expansion
• When a business wants to
expand it may need some
finance to help them do this
• It is quite normal for
businesses to borrow to
fund an expansion
• Source of finance might
include:
A. A share issue (if the business Jet Blue needed $3.8billion to merge
is an Ltd or Plc) with Spirit Airlines to become the fifth
B. A bank loan largest airline in the USA

C. Retained profits
 Plenary Quiz
• Identify which of the following sources of finance would be
suitable for a sole trader start-up business
1. Personal savings
2. Share capital
3. Retained profit
4. Overdraft
5. Venture capital
6. Loan capital
 Plenary Quiz Answers
1. Personal savings YES
2. Share capital NO
3. Retained profit NO
4. Overdraft YES
5. Venture capital YES
6. Loan capital YES
Sample question 1
 Answer question 1

• The correct answer is D Bank loan

Sample question 2
 Answer question 2

• Correct answer is B reinvested profit