Sources of Finance
Section 1 – Sources of Finance There are 4 main types of business ownership: • Sole trader • Partnership • Private limited company (Ltd) • Public limited company (Plc) Each of these types of business needs to raise finance for capital investment Sole Trader This is a business that is owned by one person. Sole Traders are responsible for raising all the finance to set up and run the business. Usually a sole trader would be for a small business/ (businesses with a flat organisational structure). A Sole Trader can be held responsible for all the debts of the firm.
Most owners like to feel in control of their own business, so this may lead to many small businesses to stay as Sole Traders, even though this will limit funding. Sole Traders have no legal formalities to go through, besides registering for VAT if their turnover reaches a certain amount. Partnership This is a business that owned by a number of people between 2 to 20. All partners can contribute to the financing of the business to help manage the success of the business. A partnership can also be held responsible for all the debts of the firm.
Having more partners in the business will cut down the amount of control that the owners have over the business. Partnerships have no legal formalities but may choose to sign a Deed of Partnership. Private Limited Company (Ltd) This is a business that is owned by shareholders (friends and associates). Private limited companies could sell shares to family, friends and associates. The owners of the private limited company can be held responsible up to the value of their investment in the business. Usually when forming limited companies, they have to produce two documents;
Memorandum of Association and Articles of Association. Public Limited Company (Plc) This is a business that is owned by shareholders (the general public). Public organisations are usually run by the government. Public limited companies can raise finance by selling shares on the stock market. Sole trader/ Partnership Personal Capital – this is the money that an individual, partner or shareholder has saved up to help in the process of running the business. If the person uses the money to invest in their own or another business, then the source of finance is classified as personal savings. Advantages |Disadvantages | |It is a quick way of funding the business |If the business goes bankrupt then the individual is also to | | |lose the money in the process and will not get the money back | |You wont have to pay it back if you lose the money in the | | |business | |
Retained profit – This is when a business makes a profit and keeps it and doesn’t spend it, the finance department simply call it Retained Profit. The retained profit will be useful for the business in buying important facilities such as new machinery, vehicles, computers and this money will be used to develop the business. Retained profit is also kept for the future just in case the business goes bankrupt. Advantages |Disadvantages | |If the retained profit is kept in advance, and then the |If you use the retained profit to develop the business such as | |business goes bankrupt, at least it could use the retained |buying new machinery then you wont e able to reward staff for | |profit to help it in its finance |their hard work and keep them motivated | |Easily accessible and no interest charge on the retained |The business risks its own money | |profit | |
Sales of assets – Business balance sheets have several fixed assets on them. A fixed asset is anything that is not used in the production of goods or services; this includes things such as buildings, fixtures and fittings, machinery. When a business desperately needs money, it can decide to stop offering certain products or services and because of that it could start selling its fixed assets. Advantage |Disadvantage | |The assets are ready to be sold |You are going to reduced the amount of assets the business has | | |got | Mortgage – A mortgage is a form of a long term loan, though it will tend to be on property or some other fixed asset. This is also known as a secured loan, this means that the loan is secured to the asset it was borrowed for.
If lets say the person who has lent the money from the lender, then the lender can take legal proceedings to repossess the asset. There are two types of major mortgages which are; • Repayment mortgages • Interest only mortgages |Advantages |Disadvantages | |You are able to pay the money monthly for a certain amount of |You end up paying more money than you borrowed | |time for example, you could pay a mortgage for ? 25 a month for| | |10 years if you borrowed ? 20k | | Loan – A loan is a type of debt. Like all debt instruments, a loan requires the redistribution of financial assets over time, between the lender and the borrower. The borrower initially receives an amount of money from the lender, which they pay back, usually but not always in regular instalments, to the lender.
The service is generally provided at as cost, referred to as interest on the debt. |Advantages |Disadvantages | |You are able to borrow a lot of money |You will end up paying more money in interest than you borrowed| |You are able to pay back the money at a time that suits you | |
Bank overdraft – This usually occurs when a check is presented for collection and there are not sufficient funds on deposit to make normal payment. Bank overdrafts are a very common form of borrowing money in the UK. The bank and the borrower agree upon the maximum size of the overdraft, but interest is only charged to the extent that the overdraft is used. Advantages |Disadvantages | |They are flexible |When borrowing money you are limited to how much you should | | |take | |They don’t have a fixed amount of money paid every month | |
Leasing – Leasing is a contract between the leasing company and the customer (lessee). The company will buy and own the asset that the customer requires. The customer hires the asset from the company and has to pay the rental fee over a pre-determined period for the use of the asset. There are two types of leasing; • Finance leases – under a financial lease the rents will cover all the costs of the asset therefore the value of the rental is equal to or greater than 90% of the costs of the asset. Operating leases – this type of lease is normally used when the asset has a probable resale value, for example aircraft or vehicles The most common form of operating lease is known as contract hire. Essentially, this gains the customer the use of the asset together with added services. A very common example of an asset on contract hire would be a fleet of vehicles. Advantages |Disadvantages | |You can avoid buying expensive needs for the business when |Some leases contain hidden costs | |starting up | | |Flexible terms |Some leasing requires restoration of the leased equipment | | |before returning it |
Hire purchase – Hire purchase is a method of obtaining business assets without having to invest the full amount in buying them. A hire purchase agreement allows the hire purchaser sole use of an asset for a period after which they have the right to buy them, often for a small or nominal amount. Advantages |Disadvantages | |The payments do not change as the interest rate is usually |Hire purchase is a long term commitment, it may not be | |fixed |possible, or prove costly to terminate them early | |Easy and quick to raise finance | Trade credit – Trade credit is when a business provides goods or services to a customer with an agreement to bill them later. It can be viewed as an essential element of capitalization in an operation business because it can reduce the required capital investment to operate the business if it is managed properly. Advantages |Disadvantages | |You can pay the creditors some time after the goods are |You have a credit limit amount which is the key element in | |delivered |credit insurance policies and is the maximum amount for which a| | |business can be insured in respect of a buyer at any one time |
Credit cards – A credit card is a type of retail transaction settlement and credit system, named after the small plastic card issued to users of the system. A credit card is different from a debit card in that the credit card issuer lends the consumer money rather than having the money removed from an account. It is also different from a charge card (through this name is sometimes used by the public to describe credit cards) in that charge cards require that the balance be paid in full each month.
In contrast, a credit card allows the consumer to revolve their balance, at the cost of having interest charged. |Advantages |Disadvantages | |You can make purchases conveniently |Credit cards carry high interests rates | | |It is a costly way of borrowing and is similar to overdraft |
A small sole trade in my local area has big plans to expand her business over the next 10 years. The sole trader, Jane Moss, produces and prints T-shirts to order. Her business currently employs 5 staff. Her plans to explain tie in with her business plan produce fashion items and accessories for high street retailers. Her plan has 3 stages Stage one is to move from sole trader to partnership. This will help to increase the amount of T-shirt printing capacity. Expenditures Stage two is to expand from a partnership to Ltd by inviting family and friends to invest in shares.
This will enable the business to invest in a small factory to produce a limited range of fashion clothing to supply to selected outlets. Stage three is to become a Plc, floating on the stock market. This will enable the fashion factory to expand to cater for the high street market The table below highlights the sources of finance needed to finance expansion for the business. |STAGE |SOURCES OF FINANCE x2 |ADVANTAGES |DISADVANTAGES | |1. SOLE TRADER – PARTNERSHIP |1.
Bank Loan |Responsibility is shared in |You don’t have enough control | | |2. Partners Capital |the business and this means |over the business as you would | | | |that work in the business is |have if you were a sole trader | | | |done faster | | |2. PARTNERSHIP – PRIVATE |1.
Financial institutions |The company is owned by the |In a private limited company | |LIMITED |2. Private shareholder’s funds|shareholders who have equal |there are more people who are | | | |part of the business |involved and this means you wont| | | | |be the boss of the company | | | |because it might be owned by | | | | |someone else | |3. PRIVATE LIMITED – PUBLIC |1. Private holders funds |One of the main advantages is |The accounts have to be made | |LIMITED |2.
Public funds |that the owner has limited |public to the employees, because| | | |liability, which means they |it is a public company where any| | | |will need lots of money to buy|one can buy stock. | | | |stock, pay wages and so on… | | The Money Cycle Cash flow within a business accounts for money flowing in and out of the business. Below is a table that shows some examples of in flows and out flows. Money in (receipts/income) |Money out (payments/expenditure) | |Customer – cash and credit customers |Taxes | |Grants |Electricity | |Loans |Monthly instalments for loan or mortgage | |Mortgages | |
What is a Money cycle? The Money cycle is basically the movement of money going in and out of the business. If the business has no money, it cannot pay for its expenses and buy its raw materials to be able to make sales, and therefore it will have no revenue. The cycle has to be continuous. [pic]Simplifying the money cycle Managing the cash flow cycle Most of the small businesses seem to fail as a result of bad cash planning, so it is a fundamental key factor that the industrialist gets this important concept at an early stage, presumably in the introduction of the business.
The main aim of a business in the case of managing the cash flow cycle is that it has to make sure that there are enough inflows. A business can achieve this aim by making sure that their customers pay in time and by trying to reduce outflows. How do debtors and creditors differ? The difference between debtors and creditors is that, debtors are people who owe money to the business and creditors are a business or a person that is owed money. Type of business |Indicators of problems | |Supplier |Difficulty in fulfilling orders | | |Late delivery | | |Asking for payment on delivery | |Debtor |Late payment | | |Reduced order | | |Offering partial payment or seeking to negotiate other | | |arrangements | |Creditor |Asking to be paid early | | |Asking for payment to be made on delivery or trying to | | |negotiate new terms | What is a current asset?
Current assets are items that a business own and they could be turned into cash in the short term, such as stock or debtors. Property, including cash, that will be or could be converted into cash, in the normal operation of the business, or earlier, usually within one year, e. g. , cash, accounts receivable, inventory. Assets that form part of the working capital of a business and are turned over frequently in the source of trade. The most common current assets are stock in trade, debtors, and cash. An illustration from Jane Moss’s business would be the building where she has based the business, and the transport that she uses to transport the goods, e. g. t-shirts. What is a current liability? Debts or accrued amounts owed that are to be paid within a year.
Current liability categories include accounts payable, notes payable, taxes payable, current portion of principal on intermediate-term or long-term debt, cash dividends payable, accrued interest and other accrued liabilities. Examples of Jane Moss’s liabilities are the accounts payable (due within a year from the balance sheet date), salaries payable and taxes. ‘Working capital’ Working capital is the difference between current assets and current liabilities. It is money that a business needs to run the business from day to day. It is also an essential key element that the current assets remain higher that the current liabilities. Examples of working capital include paying wages and buying new stock.
Why is it important to control working capital and how can this being achieved by a business? It is important to control working capital and how it is being achieved because it the money that a business needs to run from day to day and you need it to pay your debts and short term liabilities. Making sure that your customers pay their debts in time can control your working capital. [pic] The working capital cycle Businesses always have to make sure that their current assets are higher than their current liabilities to make sure that they have enough money to run the business from a day to day basis. Current assets involve stock, and stock itself needs careful management.
A Stock turnover analysis and just-in-time production is usually involved to help reduce the amount of money spent on stock. Section 3 – Cash Flow Forecast A Cash Flow Forecast is an estimate of when and how much money will be received and paid out of a business. It usually records cash flow on a month-by-month basis, for a period of two years. Inflows: Loan ? 15,000 – January Sales – Jan/Feb/March – ? 9000, April – ? 8500, May/June – ? 8400 Savings – January – ? 1000 Outflows: Materials – Jan/Feb/march – ? 600, April – ? 400, May/June – ? 350 Wages – Each month ? 5000 Rent for outlet – each month – ? 500 Heating – January – ? 100, May ? 75 Light – January – ? 40, May ? 35 Insurance – each month – ? 200 Equipment – April – ? 1500 |January |February |March |April |May |June | | | | | | | | | | | | | | | | | |Inflows | | | | | | | |Loan |15000 |0 |0 |0 |0 |0 | |Sales |9000 |9000 |9000 |8500 |8400 |8400 | |Savings |1000 |0 |0 |0 |0 |0 | | | | | | | | | |Total Inflows |25000 |9000 |9000 |8500 |8400 |8400 | | | | | | | | | |Outflows | | | | | | | |Materials |600 |600 |600 |400 |350 |350 | |Wages |5000 |5000 |5000 |5000 |5000 |5000 | |Rent |500 |500 |500 |500 |500 |500 | |Heating |100 |0 |0 |0 |75 |0 | |Light |40 |0 |0 |0 |35 |0 | |Insurance |200 |200 |200 |200 |200 |200 | |Equipment |0 |0 |0 |1500 |0 |0 | | | | | | | | | |Total Outflows |6440 |6300 |6300 6100 |6160 |6050 | | | | | | | | | |Net Cash Flow |18560 |2700 |2700 |2400 |2240 |2350 | | | | | | | | | |Opening Balance |0 |18560 |21260 |23960 |26360 |28600 | | | | | | | | | |Closing Balance |18560 |21260 |23960 |26360 |28600 |30950 | Assume Jane encounters the following situations: • wages have to rise by 20% • suppliers materials cost rises by 10’% • the bank only agree to a ? 7500 loan |January |February |March |April |May |June | | | | | | | | | |Inflows | | | | | | | |Loan |7500 |0 |0 |0 |0 |0 | |Sales |9000 |9000 |9000 |8500 |8400 |8400 | |Savings |1000 |0 |0 |0 |0 |0 | | | | | | | | | |Total Inflows |17500 |9000 |9000 |8500 |8400 |8400 | | | | | | | | | |Outflows | | | | | | | |Materials |660 |660 |660 |440 385 |385 | |Wages |6000 |6000 |6000 |6000 |6000 |6000 | |Rent |500 |500 |500 |500 |500 |500 | |Heating |100 |0 |0 |0 |75 |0 | |Light |40 |0 |0 |0 |35 |0 | |Insurance |200 |200 |200 |200 |200 |200 | |Equipment |0 |0 |0 |1500 |0 |0 | | | | | | | | | |Total Outflows |7500 |7360 |7360 |8640 |7195 |7085 | | | | | | | | | |Net Cash Flow |10000 |1640 |1640 |-140 |1205 |1315 | | | | | | | | | |Opening Balance |0 |10000 |11640 |13280 |13140 |14345 | | | | | | | | | |Closing Balance |10000 |11640 |13280 |13140 |14345 |15660 |
The problems now faced by Jane are that in April there is a negative cash flow so she has to make sure that she has a flexible overdraft from the bank. Cash flow and Working Capital Management The cash flow forecast of the business is very essential in that it will help the business monitor where it is getting its income and how the money is flowing out of the business. There are some reasons why cash flow problems might occur and these are; Overtrading Overtrading tends to happen in a business which is growing rapidly. Sometimes an entrepreneur will be too keen to chase the new business and handle more work than is expected. Pushing the business can be a good thing thought sometimes this will result in unnecessary problems which could have been avoided in the beginning.
In other words overtrading is the activity of a firm that even with high profitability cannot pay its own way for lack of working capital and finds itself in a liquidity crisis. Overtrading is a common problem, and it often happens to recently started businesses and to rapidly expanding businesses. Cash often has to leave the business before more cash comes into it. For example, wages and salaries are usually payable weekly or monthly and there may also be other expenses that need to be met promptly, such as the telephone bills and rent. Below is an example of overtrading I found on a very useful website; www. businesslink. gov. uk An example of overtrading Emily’s business is three years old. Her annual turnover is ? 200,000 and her annual profit is ? 18,000.
She operates with a bank overdraft of up to ? 25,000. Her working capital is sufficient to steadily expand the business. Emily succeeds in winning a contract to supply Business A. The order is for ? 40,000 a month for two years. She will be paid 75 days after delivery. She rings her suppliers. She orders everything that she will need to fulfil the contract in the first few months. She tells them all to deliver everything as soon as possible. The first month Things go very well. All the suppliers start delivering as promised. The only problem is that she is short of space. The second month Things still look good. She has made the first delivery to Business A.
She increases her overdraft. The third month Emily has problems. She has made more deliveries to Business A but her overdraft is at the limit. She is getting calls from unpaid suppliers. The fourth month Emily has a crisis. She cannot pay all her suppliers. Some have stopped delivering and are threatening legal action. She thinks that she will be fine because she is still supplying Business A. The fifth month Her overdraft is ? 4,000 over the limit. Three suppliers start legal action. The bank refuses to pay her any more cheques. But her first payment from Business A arrives on time. The sixth month The next Business A payment does not arrive on the due day.
She cannot fulfill any more orders. The bank demands that the overdraft be repaid within seven days. Emily closes the business and blames the bank. However, if timings and payments of deliveries from suppliers and to customers had been negotiated and regulated more successfully beforehand and at the start, the closure may have been avoided. Below is another way of avoiding overtrading: Karen’s business is three years old. Her annual turnover is ? 200,000 and her annual profit is ? 18,000. She operates with a bank overdraft of up to ?25,000. Her working capital is sufficient for her to steadily expand the business. Karen wins a contract to supply Business B. The order is for ? 0,000 a month for two years. She will be paid 75 days after delivery. Karen’s plan Karen asks Business B to pay her in 45 days in return for a small reduction in the contract price. Business B agrees. Karen rings her suppliers to place the orders. She orders carefully and schedules the delivery dates so that her payments are delayed for as long as possible. She asks her biggest supplier to wait an extra 15 days for payment. In view of the bigger orders they agree. She decides to devote more time to persuading all her other customers to pay on time. She decides not to take any money out of the business for three months. She has savings and can manage to do this.
She draws up an impressive written plan and presents it to the bank. The bank agrees to increase the overdraft limit to ? 50,000. The contingency plan Karen finds out about factoring. She does not intend to do it but she works out how much money she could obtain if she did. What happened? Due to her careful resourcing of cash, the plan worked brilliantly. She did not need to factor her debts because she got the balance just right. Business B was pleased and after six months increased the size of the order. Karen considered the risks of being too dependent on just one customer and began to look for new business opportunities to complement her existing business. Ways to avoid overtrading Setting new payment terms – Negotiating payment terms, or telling customers that new terms will apply for future orders, but the business should also be aware that customers may object. Much will depend on the strength or weakness of competitive position. • Offering discounts for prompt payment – This can be effective in accelerating payment, boosting cash flow and reducing bad debts. However, there are disadvantages – it can be expensive and must be policed to ensure that customers only take discounts when they pay promptly. • Using factoring or invoice discounting – Factoring involves selling your invoices to a specialist finance company which takes on the administration and cost of recovering the invoice payments.
With invoice discounting, you raise a loan from a finance company against the value of your invoices, but you keep the responsibility and cost of recovering invoice payments. • Improving stock control – it costs money to hold stock and raw materials, so turning them over more quickly will cut costs. Faster stock turnover means that there will be a shorter interval between the time that the business has to pay their suppliers and the time that their customers pay the business the same goods. Section 4 – Solvency There are two main solvencies used by business owners to assess their levels of solvency ? current ratio ? acid test ratio Current ratio The current ratio is a test of a business’s financial strength.
It calculates how many in assets are likely to be converted to cash within one year in order to pay the business’s debts that come due during the same year. The current ratio is calculated by dividing the total current assets by the total current liabilities. The current ratio is worked out by dividing the current assets by the current liabilities:- CURRENT RATIO =Current assets Current liabilities Acid Test Ratio An Acid Test Ratio is an accounting ratio which determines whether a company can meet its short-term obligations. It consists of current assets as shown on the balance sheet less stock expressed as a ratio of current liabilities. If this is positive, the company can meet its current liabilities out of liquid assets held. ACID TEST RATIO =Current assets – stock
Current liabilities The possible causes of a business becoming insolvent are that • This means that your liabilities are too much and this also means that you will have debts with the creditors • Debts with the bank 5 methods a business could use to avoid becoming insolvent (insolvency – a term for going bankrupt applied to companies or bankrupt) • Business could carry out a ratio analysis from time to time so they can determine how well they are able to meet their liabilities • Business could also compare the ratio analysis with other businesses in the industry • They could also provide enough working capital • They could have credit checks on new debtors They could negotiate deals with creditors Indicators of problems Usually the main difficulty in a business is when it faces insolvency and what makes it harder is to try and keep a low profile on its financial problems. Other businesses in the area can put the business in a worse position by chasing in on their misfortune. |Type of business |Indicators of Problems | |Supplier |Difficulty in fulfilling orders | | |Late delivery | |Asking for payment on delivery | |Debtor |Late payment | | |Reduced order | | |Offering partial payment or seeking to negotiate other | | |arrangements | |Creditor |Asking to be paid early | | |Asking for part payment to be made on delivery or trying to | | |negotiate new terms | |Sainsbury Plc |2005 |Restated | | |? m |2004 | | | |? | |Fixed assets |7,299 |8,452 | |Stock |559 |753 | |Debtors and other assets |3,063 |2,740 | |Cash and current asset investments |697 |562 | | | | | | | | | |Current Assets Total |4319 |4055 | |Current Liabilities |5097 |4906 | | | | | Net assets |4,459 |5,099 | | | | | |Shareholders’ funds |4,374 |5,018 | |Minority interest |85 |81 | | | | | |Capital employed |4,459 |5,099 | The working capital situation of the business (current assets – current liabilities) for 2004 and 2005 is that Working capital: 2004 = 4055 – 4906 = -? 851m 2005 = 4319 – 5097 = -? 78m The current assets were more in 2005 and than in 2004 despite the fact that there was more capital employed in 2004. The table also shows that is has a negative impact on Sainsbury. The year in which Sainsbury was able to meet financial obligations on time would have to be 2005 because they bought less stock and make more money coming into the business. Sainsbury could maintain adequate levels of solvency by making sure that their customers pay in time, Sainsbury could reduce their borrowing if they need money to run the business and they could make sure that the different departments in the store have set strict budgets for their spending.
How solvency ratios can be used to monitor the financial health of the business To achieve Merit / Distinction: Explain how solvency ratios can be used to monitor the financial health of the business Apply the solvency ratios to the business. Do the current ratio and acid test ratios give different impressions of the situation? Have Sainsbury managed to reduce their stock levels and has this had a positive effect on their solvency position? What do these ratios tell us about the businesses ability to meet its debts and its level of solvency? Based on the information evaluate the financial health of the business ———————– Make Sales Pay Expenses Cash In Creditors Production/ service Cash Debtors