Chapter Four – Sources of Finance

1. Chapter Four – Sources of Finance

2. Sources of Finance • Internal Sources • Refers to funds that are generated from within the firm itself – from owner’s equity. This could consist of the owner contributing more capital or using retained profits to finance business operations. • External Sources • Refers to funds that are sourced from outside the business – from liabilities. This includes various forms of borrowing, such as using a bank overdraft, trade credit, a lease or a loan.

3. Trade Credit • Trade credit refers to the facility offered by suppliers which allows its customers to purchase goods or services immediately, and then pay at a later date. As a result of a credit purchase, the supplier becomes a creditor of the firm making the purchases, as the purchasing business owes the supplier for the goods or services it has not yet paid for. Credit terms can be 30, 60 or even 90 days, with the due date for payment specified on the purchase invoice which accompanies the goods/service.

4. Bank Overdraft • A bank overdraft is a facility provided by a bank (or other financial institution) that allows a business to withdraw funds greater than the current balance of its account. The amount overdrawn is then owed to the bank. This type of finance (normally attached to a cheque account) can provide a safety net for firms that have irregular cash flows, with most banks happy for the account to remain overdrawn as long as it does not exceed the overdraft limit. Although an overdraft represents a readily accessible form of finance, it usually incurs a high interest rate (compared to other loans), which is calculated on a daily basis.

5. Term Loan • Term loans are funds provided by a bank or other lender for a specific purpose, and repaid over time. Increasing the length of the loan may reduce the amount of each installment, but will usually increase the total amount repaid over the term of the loan. In some cases, the lender will require that the loan is secured against a particular asset (this security is usually the asset for which the loan is obtained) so that if the borrower defaults on the loan, the lender is entitled to claim that asset to settle the debt. (A mortgage is a specific type of term loan that is secured against property.) Unsecured loans usually attract a higher interest rate to compensate for the higher risk accepted by the lender.

6. Leasing • A lease is a form of rental agreement that allows a business to use and control an asset for a length of time in return for specific periodic payments, and is very useful for assets that need to be replaced frequently. The business applying for the lease is known as the lessee and the business granting the lease is known as the lessor. The lessee has full control of the asset for the period of the lease agreement; however, it will never own the asset.

7. You! • Review advantages & disadvantages of all sources of finance. • Complete Review Questions • Q’s 4 & 6.

8. Guidelines for Seeking External Finance • With a variety of options to choose from, businesses must be careful to select the form of finance appropriate to their specific needs. • The term of the finance should match the life of the asset. • In general, short-term assets should be purchased using short-term finance, and long-term assets should be purchased using long-term finance. • The cost of interest must be considered. • The interest rate is equivalent to the cost of using borrowed funds, and the borrower must be able to repay both the principal (the amount borrowed) and the interest charges. Unsecured loans will usually incur a higher interest rate than secured loans, but the method which is used to calculate the interest charge is also important.

9. Guidelines for Seeking External Finance • The conditions of the loan should be tailored to suit the borrower • Generally, the longer the term, the lower the installments but the higher the total interest charges. Interest only loans only require the borrower to make regular interest payments, with the entire principal repaid at the end of the term of the loan. This will reduce the amount of each regular installment, and may be suitable for the purchase of an asset, which will generate little cash over its life, but much on its sale. Principal and interest loans require larger repayments over the borrowing period, but reduce the need for a large cash outlay at the end.

10. Guidelines for Seeking External Finance • Consider the impact on Gearing and the firm’s ability to borrow further • Gearing measures the extent to which a business is already reliant on borrowed funds, soa lender will be interested in the firm’s Gearing to provide an indication of the firm’s ability to repay the debt. Businesses which are already highly geared – and have a large proportion of their assets already funded by debt – could be forced to accept a higher rate of interest (as the risk to the lender is higher), or could be denied further finance altogether.

11. You! • Review Question 4.2 • Q 3.

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13. Applying for a Loan • When applying for a business loan, the lender will be interested in information such as: • Amount and purpose of the loan • Business details • ownership structure (e.g. sole trader, partnership, company) • nature of operations (e.g. trading, service, manufacturing) • future direction and goals. • Financial statements: • Statement of Receipts and Payments to determine if the business generates sufficient cash flows to be able to meet the debt servicing requirements of the loan • Cash Budget to show the likely impact of the loan on the firm’s future cash flows • Profit and Loss Statement to determine whether the firm is likely to continue trading into the future • Balance Sheet to determine the firm’s current Gearing, and the impact that the loan will have on its stability

14. Applying for a Loan • Credit rating: The lender will be keen to see that all previous borrowings by the business have been repaid on time and that there have not been any defaults or a history of bankruptcy. If this is the firm’s first loan the bank may focus on the owner’s personal credit rating as well. • Deposit – the amount that will be contributed by the business (or more specifically its owner) towards the purchase. • Security – the collateral (assets) the business will provide as security in case the loan repayments cannot be met. Small business owners frequently have put up personal assets as collateral to ensure that their business can get the loan.

15. You! • Review Questions 4.3 • Q2.

16. Calculating Interest • Simple interest • Interest calculated as a percentage of the original amount borrowed. • If you increase the term of the loan, the repayments will be lower (but you pay more interest). • Reducing balance • Interest is calculated as a percentage of the current balance of the loan. • As long as the borrower is making repayments off the principal, the amount owing will be lower than the amount borrowed, meaning that the interest charge on a reducing balance loan should be lower than that charged on a simple interest loan.

17. You! • Review Questions 4.4. • Q 3.

18. Gearing • The percentage of a firm’s assets that are financed by (external) liabilities. • Gearing formula • Gearing = Total Liabilities • Total Assets x100

19. Gearing • Dangers of high Gearing • High Gearing would indicate a high reliance on liabilities, and consequently a high risk of financial collapse, as the business must be able to meet not only the loan repayments, but also the interest charges. If expected cash inflows do not eventuate, the business must still meet its repayments: if it cannot, it could result in the financial collapse of the business. Further, high Gearing may actually prevent a business from being able to access more borrowed funds as lenders perceive that the risk is too high. • Benefits of high Gearing • However, borrowing does give the business access to funds to purchase assets that it may not have been able to afford trying to raise funds internally. These assets should allow the business to expand its revenue earning capability and increase its profits. Further, high Gearing will mean a higher return for the owner, as he or she has less capital invested, but still earns all the profits. That is, high risk will mean high return for the owner.

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21. You! • Review Questions 4.5 • Q 3, 4 & 5.

22. GEARING AND RETURN ON OWNER’S INVESTMENT • When assessing the level of Gearing the owner should also consider its relationship to the Return on Owner’s Investment (ROI). Return on Owner’s Investment assesses how profitable the owner’s investment has been by measuring how many cents profit the business earns for every dollar invested by the owner.

23. Return on Owner’s Investment • A profitability indicator that measures how effectively a business has used the owner’s capital to earn profit. • Return on Owner’s Investment (ROI) = • Net Profit Average Owner’s Equity x 100

24. Return on Owner’s Investment • A Return on Owner’s Investment of 25% means that for every dollar of capital invested, the owner has earned 25c profit. The level of Gearing will have a direct and significant effect on ROI. High Gearing means high risk, but it should also mean a high ROI because the business is earning profit, but using outside funds to do so. That is, the owner still receives all the profit earned by the business, but has had to contribute very little in the way of capital to earn that profit.

25. You! • Read Summary • Do five exercises