Why a business needs finance:
Finance: the management of large amounts of money, especially by governments or large companies. can be a real benefit when it comes to business success as well. your own personal finance helps you to understand how to manage not only business finances, but set goals and create fundamentals skills in planning and decision-making
Internal financing is the name for a firm using its profits as a source of capital for new investment, rather than a) distributing them to firm’s owners or other investors and b) obtaining capital elsewhere. Internal financing is generally thought to be less expensive for the firm than external financing because the firm does not have to incur transaction to obtain it, nor does it have to pay the taxes associated with paying dividends. Funds an organization can raise from the employee contributions, member contributions, retained profits, sale of assets, sale of goods and services, etc. Internal sources of finance are funds found inside the business.
For example, profits can be kept back to finance expansion. Alternatively the business can sell assets (items it owns) that are no longer really needed to free up cash. Internal sources of finance are recorded under equity in the balance sheet. These sources are reinvested profits and the capital contributed by owners when the business began This money may be: personal savings, an inheritance, a gift from parents, a payout from being retrenched from a job, a personal loan or mortgage loan using the family home as security. Internal sources (raised from within the organisation)
Put (the profit on a previous investment) back into the same scheme.
Capital is immediately available
No interest payments
No control procedures regarding creditworthiness
Spares credit line
No influence of third parties
Expensive because internal financing is not tax-deductible
No increase of capital
Not as flexible as external financing
Losses (shrinking of capital) are not tax-deductible
Limited in volume (volume of external financing as well is limited but there is more capital Available outside – in the markets – than inside of a company)
Capital contributed by owners:
Own capital is a costless form of finance, but carries the risk of the money being lost. For sole traders and partnerships a common source of finance, especially for start up is money from the individuals who are forming the business Retained Earning:
Retained earnings are an easy source of internal financing to use because they are liquid assets. Retained earnings are the portions of net income that you have retained in your company and not paid out. In a small business, retained earnings are usually paid out to the owners, who often do not draw a budgeted salary. Instead of paying out retained earnings, you can reinvest them into the company. Net profit that is reinvested into the business. Retained profit is added to equity because it increases the owners’ claim on the assets of a business. This source of finance is only available for a business which has been trading for more than one year It is when the profits made are ploughed back into the business This is a medium or long-term source of finance
Companies can increase funds by retaining profits and not distributing them as dividends. The shareholders deprived of capital will expect retained profits to be invested to achieve a competitive rate of return. Most big businesses retain 50% of profits to fund expansion. The cheapest form of finance is the business’ own profits
Since it is not being borrowed from anyone, it does not cost money to use.
Doesn’t have to be repaid
No interest is payable
Not available to a new business
Business may not make enough profit to plough back
External sources of finance are found outside the business, eg from creditors or banks. External (raised from an outside source) is the phrase used to describe funds that firms obtain from outside of the firm Venues for obtaining funds that come from outside an organization. External sources of finance might include taking on new business partners or issuing equity or bonds to create long term obligation, or commercial paper to take on shorter term debt. Small business owners often need to find sources of external financing in order to fund or grow operations.
A bank overdraft gives a business flexibility to borrow money from a bank at short notice through its cheque or current account. A bank may allow a business to overdraw their current account up to a specified maximum limit as agreed between the bank and the business. This overdraft facility allows a business to have a negative value in its account. Later, when the business receives cash from sales, money is deposited into the bank account, thereby reducing the overdraft. This is where the business is allowed to be overdrawn on its account This means they can still write cheques, even if they do not have enough money in the account This is a short-term source of finance
Businesses can access funds by maintaining a negative balance on its bank account. The advantages of using an overdraft include flexibility, competitive interest rates and can become a long term source of finance (dependent on the confidence inspired by the borrower). But, reliance on an overdraft can have devastating consequences, since it is repayable on demand. Advantages
This is a good way to cover the period between money going out of and coming into a business If used in the short-term it is usually cheaper than a bank loan Disadvantages
Interest is repayable on the amount overdrawn
Can be expensive if used over a longer period of time
Bill of exchange
This is money borrowed at an agreed rate of interest over a set period of time This is a medium or long-term source of finance
Set repayments are spread over a period of time which is good for budgeting Disadvantages
Can be expensive due to interest payments
Bank may require security on the loan
Financial institutions provide negotiable loans in which the rate of interest, repayment dates and security for the capital offered must be agreed.
This method allows a business to obtain assets without the need to pay a large lump sum up front It is arranged through a finance company
Leasing is like renting an asset
It involves making set repayments
This is a medium-term source of finance
Under this arrangement, a business will select an asset, which is then purchased by a finance company. The lease will then be paid in a series of rentals or instalments.
Businesses can have the use of up to date equipment immediately Payments are spread over a period of time which is good for budgeting Disadvantages
Can be expensive
The asset belongs to the finance company
+ Good way of boosting day-to-day finance.
– Other businesses may be reluctant to trade with the business if they do not get paid in good time. Trade credit is summed up by the phrase: buy now pay later
Typical trade credit period is 30 days
This is a short-term source of finance
Usually in business dealing supplier give a grace period to their customers to pay for the purchases. This can range from 1 week to 90 days depending upon the type of business and industry. Trade credit is an important source of finance for nearly all businesses – since it is effectively a free source of finance 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.
Business can sell the goods first and pay for them later
Good for cash flow
No interest charged if money is paid within agreed time
Nointerest has to be paid
Discount given for cash payment would be lost
Businesses need to carefully manage their cash flow to ensure they will have money available when the debt is due to be paid The business may not get cash discount
This can increase cash assets by providing savings in credit management and certainty in cash flows. The firm may be able to sell their debts to a specialist debt-factoring company. This means that the firm sells their debts to the factoring company who pay them a proportion of the debts immediately. In this way the firm raises some immediate finance. The debt factoring company make their money by collecting the whole debt when it is due It involves the business selling its bills receivable to a debt factoring company at a discounted price. In this way the business get access to instant cash.
Small business credit cards provide business owners with easy access in order to make purchases, pay expenses and withdraw cash. Small business credit cards provide business owners with easy access Used by a small business to make purchases and pay expenses
Becoming more common as banks are offering low interest rates and loyalty programmes
an asset used as security for a loan. A lender can sell it if the borrower fails to pay back a loan.
The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. A high level of trading activity characterizes liquidity. Assets that can be easily bought or sold are known as liquid assets. The ability to convert an asset to cash quickly. Also known as “marketability.” There is no specific liquidity formula; however, liquidity is often calculated by using liquidity ratios. In accounting, liquidity (or accounting liquidity) is a measure of the ability of a debtor to pay their debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities. Liquidity is the ability to pay short-term obligations.
The history of the business and how it effects their business in the present A business with a bad image could be negatively affected by their actions In the past. A business with a good image could be positively affected due to customer loyalty and word-of-mouth sponsorship. Positive actions in the history of the business can be documented in hopes of being used for profit in the future through advertising and long-term fundraising (donating to a fund for a number of years).