Sources of Finance Choices 

A business has a variety of choices it can make about how it obtains

(sources) the finance it needs.

A business needs to assess the different types of finance based on the

following criteria:

Amount of money required – a large amount of money is not available

through some sources and the other sources of finance may not offer
enough flexibility for a smaller amount.

How quickly the money is needed – the longer a business can spend
trying to raise the money, normally the cheaper it is. However it may need
the money very quickly (say if had to pay a big wage bill which if not paid
would mean the factory would close down). The business would then have
to accept a higher cost.

The cheapest option available – the cost of finance is normally measured

in terms of the extra money that needs to be paid to secure the initial
amount – the typical cost is the interest that has to be paid on the borrowed
amount. The cheapest form of money to a business comes from its trading
profits.

The amount of risk involved in the reason for the cash – a project which
has less chance of leading to a profit is deemed more risky than one that
does. Potential sources of finance (especially external sources) take this
into account and may not lend money to higher risk business projects,
unless there is some sort of guarantee that their money will be returned.

The length of time of the requirement for finance - a good entrepreneur

will judge whether the finance needed is for a long-term project or short
term and therefore decide what type of finance they wish to use.

Short Term and Long Term Finance

Short-term finance is needed to cover the day to day running of the

business. It will be paid back in a short period of time, so less risky for
lenders.

Long-term finance tends to be spent on large projects that will pay back

over a longer period of time. More risky so lenders tend to ask for some
form of insurance or security if the company is unable to repay the loan. A
mortgage is an example of secured long-term finance.
 The main types of short-term finance are:

 Overdraft
 Suppliers credit
 Working capital

The main types of long-term finance that are available for to a business are:

 Mortgages
 Bank loans
 Share issue
 Debentures
 Retained profits
 Hire purchase

Internal and External Finance

Internal finance comes from the trading of the business.

External finance comes from individuals or organisations that do not trade

directly with the business e.g. banks.

Internal finance tends to be the cheapest form of finance since a business

does not need to pay interest on the money. However it may not be able to
generate the sums of money the business is looking for, especially for
larger uses of finance.

Examples of internal finance are:

 Day to day cash from sales to customers.

 Money loaned from trade suppliers through extended credit.
 Reductions in the amount of stock held by the business.
 Disposal (sale) of any surplus assets no longer needed (e.g. selling a
company car).

Examples of external finance are:

 An overdraft from the bank.

 A loan from a bank or building society.
 The sale of new shares through a share issue.
Finance: Other External Sources of
Finance
In addition to the traditional bank loan and bank overdraft, there is a variety
of other potential external sources of finance for a business.

Leasing

Leasing is like renting a piece of equipment or machinery. The business

pays a regular amount for a period of time, but the item belongs to the
leasing company.

Most company cars are leased to businesses. The business pays a monthly
fee for the car and at the end of the period (normally about two years), the
business swaps the car for a newer model.

The advantages of leasing are:

 Cheaper in the short run than buying a piece of equipment outright.

 If technology is changing quickly or equipment wears out quickly it
can be regularly updated or replaced.
 Cash flow management easier because of regular payments.

The disadvantages of leasing are:

 More expensive in the long run, because the leasing company

charges fees which make the total cost greater than the original cost.

Hire Purchase

Business hires the equipment for a period of time making fixed regular
payments. Once payments have finished it then owns the piece of
equipment. Hire purchase is different to leasing in that the business owns
the equipment when it has finished making payments. With an equipment
lease, the equipment is handed back to the leasing provider.

Debt Factoring

A business sells its outstanding customer accounts (those who have not
paid their debts to the business) to a debt factoring company.

The factoring company pays the business - say 80-90% of face value of the
debts - and then collects the full amount of the debts. Once it has done this
it will pay the remaining amount to the business less a charge.
It is a good way of raising cash quickly, without the hassle of chasing
payments. BUT it is not so good for profits since it reduces the total revenue
received from those sales.

Government Finance

The government and the European Union provide help to businesses for
the following reasons:

 Protect jobs in failing/declining industries.

 Help create jobs in areas of high unemployment.
 Help start up new businesses.
 Help businesses relocate to areas of high unemployment.

Some of the main sources of funds are:

 European Structural Fund

 Assisted Areas
 Regional Selective Assistance
 Small Loans Guarantee Scheme

Trade Credit

A business does not always have to pay their bills as soon as they receive
them. They are given period of credit, normally around 30-60 days. By
trying to extend this period they can improve their short-term finance
position.

Small businesses now have some protection under law that prevents larger
firms exploiting their credit terms.

Trade credit is an important source of finance for nearly all businesses –

since it is effectively a free source of finance.

Retained Profits

The cheapest form of finance is the business' own profits. In the UK over
80% of retained profits are reinvested back into the business. Since it is not
being borrowed from anyone, it does not cost money to use.

Own Capital

For sole traders and partnerships a common source of finance, especially

for start up is money from the individuals who are forming the business.
They may also borrow money from family and friends. Own capital is a
costless form of finance, but carries the risk of the money being lost.
Working Capital

Working capital is the amount of money available for the day to day running
of the business. It is the difference between current assets and current
liabilities. See below for more details of how working capital can be used.

Sources of Finance for Public Sector Organisations

Public sector organisations receive from both the normal sources that most
businesses receive money, but also from tax revenues. Most public sector
organisations, such as schools and hospitals obtain more straight from the
government - who have previously collected the money from tax payers.

Other organisations gain money from sales, e.g. stamps for the Post Office,
and licences for the BBC.