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Businesses need finance for two main reasons: Working capital finance
± to purchase stock ± to finance other working capital items ± this is known as revenue expenditure ± ± ± ± ± ± to finance capital investment to finance R&D to pay off debts to finance exports to deal with unexpected problems. This is known as capital expenditure
Fixed asset finance
Revenue expenditure is payment for a current year s goods and services It is expenditure incurred in the day to day running of a business It is used to pay for day to day running costs It covers the cost of fuel, components, raw materials, labour costs These are items that will be used up in the short run This expenditure is charged to the profit and loss account - i.e. it is a negative item on the P&L Account
Capital expenditure Capital expenditure is a payment to purchase an asset with a long life Expenditure to acquire fixed assets which will be used over a long period of time: property. vehicles and production equipment These items appear as fixed assets on the balance sheet In any one year the value shown in the balance sheet is historical cost less accumulated depreciation Annual depreciation is shown as a negative item on the profit and loss account .
Sources of finance Internal ± generated from within the business by its operations Short term-up to one year ± working capital ± investment in short lived equipment External ± secured from outside the business Medium term-1-5 years ± purchase of assets with a medium term life Long term.5 years + ± purchase of long term assets .
tighter credit control Stock management .Summary of sources Short term Internal Controlling working capital Cash management Debtor management .reduced stock levels Retained profit Overdraft Short term loan Invoice discounting Debt factoring Trade credit Hire purchase Leasing rather than buying Sale of assets Sale and lease back Long term Retained profit External Leasing Share issue Long term loans Sale and leaseback Debentures Venture capital Government grants and loans .
existing interest commitments Relationship with providers of finance The security available to guarantee a loan The purpose for which it needs the finance .Factors affecting the ability to raise finance The track record of the business seeking finance Market expectations Gearing .
private company.Factors in the choice of finance (1) The type of business ± legal status: sole trader. partnership. public company Size of the business ± some sources of finance are only available to large companies The stage of business development ± the age and history of the business Objectives of the owner ± ± ± ± does the owner seek growth or just a satisfactory return is it an entrepreneurial or a proprietorial business? the extent to which owners wish to retain control share issues or taking on partners will weaken the founder s control of the business .
against assets Market conditions ± is the market expanding or depressed? The terms of the finance ± rate of interest and schedule for repayment Level of gearing and the interest rate commitment ± high gearing (high interest commitments) will be off putting to lender .Factors in the choice of finance (2) Current financial position of the business ± willingness of banks and others to lend The availability of collateral (assets that could be sold) to guarantee a loan ± lenders might be unwilling to lend unless the loan is secured.
What are the risks involved? What are the tax implications? .Questions to be asked before deciding on source How much is required? What is the finance is needed for? How soon is the finance required? How long is the finance needed? What is the cost of finance?.
The matching principle The source of finance should be matched to its purpose Capital investment should be financed by long term loans or equity Working capital should be financed by short term loans and overdrafts .
Sources of short term finance Sources Internal Working capital management External Overdraft Bank loan Debt factoring .
g.Trade credit Careful management of this and other working capital items will make available funds for investment The purchase of stocks on credit Period trade creditors allow for payment varies widely e. 14 -70 days It is equivalent to a loan from the supplier and is interest free It allows companies to use money for other purposes But there are usually discounts for prompt payments And failure to pay on time can present problems on future orders .
the factor takes on bad debts reduces need for overdraft reduces cost of chasing late payments 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 .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.
Bank overdraft This is where the firm s bank account is permitted to go into deficit up to an agreed limit 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 Interest charged is 2 .4% above base rate But repayable on demand and as result overdrafts are treated as current liabilities .
Short term loan A short term bank loan from a bank or other financial institution Repayment and interest are formally agreed Tend to be more expensive than an overdraft Security is often required Small businesses often pay higher interest .
Asset sale Sale of a fixed asset for cash Sale of idle assets is desirable .avoids interest charges 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 Sources of finance Internal Retained profits External Share issues External Long term borrowing External Leasing/sale and lease back .
This is available to reinvest in the business The 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 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 .Retained profit Re-investment of past profit A proportion of profit will be retained rather than distributed as dividend.
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.Example .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 .
as share prices rise or fall. a shares issue might not raise sufficient finance Share issue dilutes ownership .Share issue Selling shares to raise finance Shareholders are seen as risk takers and therefore only receive dividends out of profit The company does not have a commitment to meeting fixed interest payments But shareholders have rights of participation High administrative cost involved in issuing shares Difficult to estimate the market price of shares and.
Long/Medium term loan From high street banks and specialist finance companies Repaid in instalments Makes financial planning easier Borrowers will be expected to provide security (collateral) Interest can be fixed or can be variable Small businesses often pay high interest rate .
up to 85% of the value of the property Repayment is over 20/25 years Flexible interest rates but can be fixed for medium terms Only available for large sums .Mortgages These are loans secured against property Mortgages are used to purchase property .
Distinguishing features of loan capital Loan capital is repaid Interest on loans is a deduction from profits not a distribution of profits Holders of loan capital do not own the business 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 A methods of acquiring assets without owning them Firms sign a rental agreement with the owners of the asset 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 Leasing payments can be offset against tax Contract provides for maintenance and allows for upgrading 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 .
a finance lease contract cannot be withdrawn Leasing pays for equipment out of pre-tax expenditure rather than after tax Provides hedge against obsolescence .Advantages of leasing 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 rentals provide a hedge against inflation Fixed contract .unlike an overdraft.
Hire purchase Purchase of assets by instalment payments The business does not own the asset until the final payment is made Finance provided by finance houses Unlike leasing ownership is eventually transferred The asset acquired without large capital outflow Over the long run the asset will cost more than if purchased outright for cash .
Debentures A debenture is in effect a long term loan It can be secured against specified assets or can be unsecured Fixed rate of interest and repayable on a specific date Only large companies can issue debentures .
sell their investment) in the medium-term (e.g.they accept some risk as inevitable Finance is offered on a medium term basis Management support also available 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. 5-10 years) .e.Venture capitalists Venture capitalists are specialist providers of risk capital .
investment. spin off benefits) ± are usually based on the principle of additionally (additional to money secure from sources) .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.g. 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. job creation.