3.1 Sources of Finance

Chapter 18

Part 1

What is finance?

The ability to access money in order to fund business activities.

Many different business activities need finance.

Can you name some?

Business Activities to Finance

What is Capital? Can be Cash, Equipment, Buildings

Startup Capital Money needed to start a business to: buy equipment,

rent/buy a building, purchase inventory

Working Capital Money needed to operate the day-to-day activities of the

business: pay bills, pay employees, buy supplies

Business Expansion Move to a larger location, hire more people, equipment

upgrades

Business Activities to Finance

Business Expansion Expansion can occur by purchasing other

businesses; may need extra money to do this Special Situations

Decline in sales could leave company without enough cash; a customer could fail to pay his bill in time; unexpected repair expenses

Research and Development Invest in new markets, create new products

Time to Finance

Short-Term Financing One year or less

Medium-Term Financing One to five years

Long-Term Financing Over 5 years

Financing Expenditures

Capital Expenditures Purchasing fixed assets that will last over one year (things

that aren’t consumed in the day-to-day operation of the business)

Buildings, machinery, or cars (What are ASSETS?)

Revenue Expenditures Spending that occurs in order to produce your product or

service Wages, inventory, supplies, utilities

Financing these two different types of spending will be very different as the length of time for “pay back” is different.

Sources of Financing

Internal Money Money raised by the business’s own assets or from the

profits left over from the business. Profits Retained by the business Sale of Assets Reductions in Working Capital

External Money Sources from outside the business

Bank Overdrafts (Credit Line) Trade Credit Debt Factoring (Selling Receivables at a discount)

Internal Sources of Finance

Profits retained by the business Profit that is kept by the business after taxes and

dividends are paid New companies or companies that experience a

LOSS may not have access to this type of financing. This type of financing is permanent because it is not

“paid back”

Revenue$100,000Expenses 30,000Profit $ 70,000

Taxes @10% - 7,000Dividends paid - 20,000Profits Retained $ 43,000

Internal Sources of Finance

Sale of Assets Companies can sell assets they no longer need or use to

raise cash for financing.

Example: A company owns 2 cars worth $10,000 each

Total: $20,000 in Asset Value NOT Cash

$20,000

$10,000 CASH

$20,000

Liquidate car asset to raise cash.

Internal Sources of Finance

Lease Option Company sells equipment that has a loan outstanding to

a leasing company; then leases the equipment back for a cheaper price. Raising cash by reducing cash outlay.

Example: A company is buying a car worth $20,000 and bank loan balance $15,000 with a monthly loan payment of $500.

Loan Payment $500

Lease Payment $175$3000 raised cash + $325 cash extra cash per month

Sell car to leasing company for $18,000 - $15,000 loan=$3000 raised cash

Internal Sources of Finance

Reductions in Working CapitalWorking Capital = Assets -Liabilities

Money owed to the business (Asset) = $20,000

Liabilities (loans on cars) = $5,000

Working Capital = $15,000 Debt to Asset Ratio: 1:4 For every $1 in debt, I can pay it back 4X

Collected Money owed (Assets)= $5,000 Cash = $15,000 Spend Cash=$15,000Total Assets = $5,000

Liabilities = $5,000

Working Capital = $15,000 Debt to Asset Ratio: 1:1But $20,000 now in cash For every $1 in debt, I can pay it back 1X

External Sources of Finance

Bank Overdrafts (Credit Line) Most Flexible types of financing Pre-arranged with a banking/lending institution Expensive with high interest rates Used on a day-to-day basis to cover the cash

needs of a business

External Sources of Finance

Trade Credit Delaying payment of your vendors Early payment discounts cannot be taken Suppliers may not be happy if you take to long to

pay your bills

What is “Trade” – buying from a supplier in your industry.

External Sources of Finance

Debt Factoring Selling Accounts Receivable at a discount to a

collector(What is Accounts Receivable? Money owed to you by your customers.)

Money Owed You:

Accounts Receivable: $10,000

You Sell to a Debt Collectorfor immediate cash: $ 7,000

Debt Collector Profitswhen debts are collected: $ 3,000

This is not BAD Debt Collection.

Evaluation of Internal Financing

No direct cost to the business Does not increase the debt of the company No risk of loss of control of the company to

another party No shares are sold to others New or unprofitable companies have few

assets to sell to raise cash Growth will be constrained by limited cash

resources

More Vocabulary

Hire Purchase (A LOAN) Purchasing an asset over a period of time

Example: buying a car, equipment using a loan

Ownership

Leasing A contract with a company to pay a fee but not

actually acquire ownership of the item. Example: leasing a car, or equipment

No Ownership

More Vocabulary

Debentures (Corporate Bonds) Bonds issued by a company to raise money and

they are usually issued with a fixed rate of interest

Loan @ 15% Interest

Bank makes 14% Profit

Savings Interest Rate to Depositors @ 1% Interest

Bond @ 10% Interest to People

People make 10% Profit vs 1% at the bank

Business SAVES 5% on Loan Interest by NOT using the bank

More Vocabulary

Rights Issue Existing shareholders have the right to purchase

more stock at a discount in order to raise capital for the business.

Grants Government agencies willing to fund businesses

that will establish themselves in particular locations or create jobs. (Economic Development Funds)