Choosing the right source of finance to pay costs requires consideration of factors that may influence the choice of finance. Businesses will need to consider many things before they decide how to pay for their costs.
Profitability of the business is usually considered first when managers make a financing choice. The size of the business and the reason why finance is needed are clearly other key considerations. Finally, some sources of finance may affect the ownership of the business. Therefore, the original owners will need to decide how much control over their business they are willing to give up in exchange for new capital.
Internal Sources of Finance
1. Personal funds
Personal funds are personal savings of the owners. The owners, especially as sole traders and in partnerships, will use their own money as the main source of finance for their businesses. Personal funds can also be used to start up rather small private limited companies when their owners do not want to face the issues of having unlimited liability for the business’s debts.
2. Retained profits
Retained profit is the amount of business’s net income that is kept within its accounts. Once a business has paid all of its costs of production (e.g. raw materials, wages for production workers, packaging, etc.) and all of its other expenses (e.g. rent, salaries for managers, interest on borrowings, TAX, etc.), then the Net Profit remaining belongs to the company and its owners.
3. Sale of Fixed Assets
An asset sale happens when a business organization sells some of the property it owns to another party – an individual, an organization, a company or a government. A business manager at a well-established mature company often finds that the business has some assets that are no longer fully employed. These assets could be sold to easily raise cash for funding new projects to stimulate business growth. In this way, the business is able to raise finance through the sale of unwanted or unused Fixed Assets. For example, selling old computers that have been replaced with new faster models, or selling old production machinery.
4. Reductions in Working Capital
Working Capital is the money kept in the business to finance the day-to-day running expenses of the business organization, and to pay short-term debts. Those companies with a long cycle of capital turnover will be able to benefit the most from reductions in Working Capital. However, when the business decides to reduce the amount of Working Capital, then additional money can be released to be used by the business as a source of finance. So, businesses may be able to use some of their Working Capital to raise additional funds for other long-term projects.
External Sources of Finance
Short-term
5. Family and friends
Owners of small businesses can raise informally a significant amount of finance from close friends and family members. This source of finance is very popular and quite common in many cultures featuring collectivism such as China and India. Money from family and friends is mainly used by unincorporated businesses – sole traders and partnerships.
6. Overdraft
Overdraft is when the bank agrees to let the business spend more money than the business has in its official bank account. The business is allowed to overdraw its corporate bank account up to an agreed limited.Overdraft is provided to most of the corporate customers by the bank in the form of extended credit line which comes into effect once the main balance of the account reaches zero. This allows the business to temporarily take out more money than it has in its account.
7. Trade credit
Individual customers pay in cash for goods and services which they purchase. But, businesses buy most of their resources on credit. The business buys now and pays later. The sale is made by the seller at the time of purchase. However, the seller does not receive the cash from the buyer immediately, but at the later date. In this way, the seller provides trade credit to the buyer when purchasing raw materials, components or finished goods. In fact, the supplier is lending the money for the cost of products for the length of the agreed trade credit period, usually between 30 and 180 days.
8. Debt factoring
Although individual retail customers pay cash for any purchase, most businesses buy goods and services on credit. For example, when the business from the primary sector sells supplies to the manufacturer from the secondary sector on the 30-days trade credit, the supplier will not receive any payments until the following month. When a business organization sells products to the customers who buy now but pay later, those customers become Debtors to the business. Debtors owe money to the business and are shown as Trade Receivables on the Balance Sheet. The longer the time allowed to pay up the invoice, the more short-term finance the business will need to meet day-to-day expenses and pay other short-term debts in order to carry on trading. And, Trade Receivables grow. If a business gives too much credit to its clients, it faces a higher chance of bad debt. Bad debtors are those who are unable to repay the money owed, perhaps due to their own financial problems. And now the business has a big problem what to do with so much bad debt. Debt factoring is the process of a business selling its debt to a debt factoring company. The debt factoring company buys the unpaid invoice, so that the business can obtain immediate cash to finance its normal operations.
9. Microfinance providers
Microfinance is providing financial services such as bank loans and overdrafts to low-income customers. Small amounts of money are loaned to entrepreneurs in countries where traditional business finance is difficult to obtain. The microfinance loans are usually for very small amounts. They are also typically repaid after a relatively short period of time within six months to a year. Once the loan has been repaid, it then becomes available to other borrowers.
Medium-term
10. Leasing
Leasing is obtaining the right to use assets in exchange of paying a leasing charge, or rent, over a fixed period of time. The business does not need to raise long-term capital to buy the asset. Through leasing, the business acquires, but not necessarily purchases, Fixed Assets over the medium term. This is a form of hiring whereby a contract is agreed between a leasing company (the lessor) and the business (the lessee). The lessee pays rental income to hire assets from the lessor. The lessor is the legal owner of the assets. Whilst the ownership remains with the leasing company. Periodic payments are made over the life of the agreement, but the business does not have to purchase the asset in the end.
11. Sale-and-leaseback
Sale-and-leaseback is a transaction when the business sells a particular Fixed Asset to raise finance, and immediately lease that asset back. In particular, this will include selling land, buildings, machines, office equipment, tools or vehicles owned by the business, and then renting them from the new owner. Businesses will sell some of the Fixed Assets that they still intend to use, but which they do not need to own. In reality, the business transfers the ownership on paper although the physical asset does not even leave the business’s premises. Through sale-and-leaseback, the firm is able to raise a substantial amount of capital. However, there will be additional Expenses, or Fixed Costs, as the business will now be leasing the asset, hence need to pay rental payments.
12. Hire purchase
Hire purchase occurs when an asset is sold to the buyer who agrees to pay fixed payments over an agreed period of time. The term of a typical hire purchase agreement generally spans over two to five years. The asset belongs to the buyer, but is legally the property of the creditor until all payments have been made. Hire purchase allows a business to own the asset from the beginning, and yet, pay its creditors in installments over a medium-term. Usually, a down payment of 10%-30% is required to secure a hire purchase deal from the seller. Obviously, if the buyer defaults on the agreement by falling behind on repayments, then the lender can repossess the asset.
Long-term
13. Long-term bank loan
A long-term bank loan is provision of finance by the lender to the business for a long period of time. The lender is usually a commercial bank. The amount borrowed is paid back in installments over a predetermined agreed period of time usually 10, 20 or 30 years. The recipient of a long-term bank loan incurs a debt and is liable to pay interest on that debt until the whole amount is fully repaid. So, the borrower must repay the principal amount borrowed plus interest.
14. Mortgage
A mortgage is a long-term bank loan used by the business for the purchase of land or buildings. A mortgage is very similar to a long-term bank loan. While long-term bank loans can also be used for business expansion, buying machinery or equipment, mortgages are used specifically for the purchase of land or buildings only. The borrower obviously pays interest on the amount borrowed. The amount borrowed is paid back in installments over an agreed period of time usually 10, 20 or 30 years. By the end of the mortgage term, the amount borrowed must be completely repaid to the lender. If the borrower defaults on the loan payments (fails to repay on time and in full), then the bank can seize the property (take it back) without returning any money back to the borrower. The mortgage gives the lender the right to sell the property to repay the loan, if the payments are not made as agreed.
15. Bonds (debentures)
Bonds, or debentures, are financial instruments, essentially long-term loans issued by a business to investors. The business in this case is a borrower. Investors include private individuals, other businesses or even governments. By borrowing money from others, the company can raise significant amount of finance in the long-term. When a company wants to raise long-term finance, it will sell a bond. Bonds are fixed-income instruments meaning that the buyer of the bond receives regular payments of the stipulated fixed interest rate per year. Bonds typically come with annual or semi-annual interest payments. Those regular payments of fixed interest are called ‘coupons’. The coupons are paid at a predetermined frequency between the bond’s issue date to the bond’s maturity date. The life of the bond can be up to 20 to 30 years. At the end of the bond term, the full purchase price of the bond must be repaid to the bond holder. Because the bonds do not have an owner’s name printed on them, they can be transferred or sold to another party.
16. Convertible bonds
A convertible bond, or a convertible debenture, is a type of bond that the holder can convert into shares in the issuing company. Each bond can be converted into a specified number of shares of common stock in a limited company. A convertible bond is a hybrid security with both debt-like and equity-like features. It usually has a maturity period greater than 10 years. The conversion from the bond to stock can be done at certain times during the bond’s life. And, it is usually at the discretion of the bondholder.
17. Share issue
Share issue is the process by which limited companies pass on new shares to investors. All limited companies issue shares at the beginning when they are established. Investors purchase shares in order to become co-owners of an incorporated business. The money from investors injected into the business is permanent capital which will never be returned. The finance raised will be used for business growth – buying Fixed Assets, inventing new products, hiring new workers, etc. Only limited companies are able to sell shares to raise money from investors.
18. Crowdfunding
Crowdfunding is the use of small sums of money from a very large number of private individual people to finance a new business venture. Usually, sole traders and partnerships will use crowdfunding as a source of finance for their start-ups. Crowdfunding is usually done online through websites including Kickstarter, Indiegogo, Crowdcube, Patreon, GoFundMe, CircleUp, Crowdfunder, Fundly, Mightycause or SeedInvest. These crowdfunding websites allow small entrepreneurs to promote their new ideas to millions of people who might be willing to invest small sums of money such as USD$10 or USD$20 or USD$50. Investors will keep on committing those small sums of money until the expected by the particular entrepreneur target sum of money is reached. Through these established websites, entrepreneurs will explain what their businesses are all about, what products they offer, what their business objectives are, why they need finance, etc. If the new business venture is successful, crowdfunding investors will receive their initial capital back with interest, or an equity stake – meaning a share in profits.
19. Venture Capital (VC)
Venture Capital (VC) is capital invested in business start-ups, or growing small and medium businesses offering innovative technology. These companies have high market growth potential along with extraordinary profitability. But, at the same time have high risk of failure. As traditional lenders are usually not very willing to invest in risky new technology, these businesses find it difficult to raise finance for their groundbreaking high-tech products. This is because of many risks to the business. Hence, specialized Venture Capital (VC) firms, long-term investment funds and wealthy individuals take high risks of investing their capital in exchange for a large part of the business. They will take those risks, but only for acquiring a sizeable number of shares. Venture Capitalists (VCs) will usually ask for between 30% to 70% ownership of the business. They will also expect a share of the future profits in return for their investment. In exchange, they will not only provide the business with that much needed cash, but also with invaluable advice about strategic business growth.
20. Business Angels
Sometimes all of us need our own angel. So, do entrepreneurs who have interesting ideas that may change the world, but neither banks nor Venture Capitalists (VCs) consider funding them. Traditional lenders always require assets as collateral before lending any money while most Venture Capital (VC) firms focus on technology start-ups. This is when Business Angels fly in handy. Business Angels are informal wealthy investors who invest in high-risk and high-return entrepreneurial businesses at a very early stage. These businesses do not have any tested product yet or even a proven business model. But, what they have is life-changing ideas accompanied with high growth potential in the future. Owners of start-up businesses who reach out to Business Angels for help will usually require large sums of money up to USD$500,000.
21. Government grants
A grant is money given to the eligible business by the government for a specific purpose. Government grants are non-repayable funds. It means that this ‘financial gift’ from the authorities is a complimentary finance that does not need to be repaid in the future. Grants also often come as a one-off payment with strings attached – conditions and restrictions. For example, a new business which received the grant is obliged to operate for a certain amount of time, must be registered in a specific location or hire a certain number of workers. If these conditions are not met, the grant may need to be repaid.
22. Subsidies
Subsidies are sums of money given by the government to producers of commodities which are widely used by the majority of the society. The government will offer subsidies for essential goods and services such as food, energy, medications, education services, transportation, etc. This government incentive in the form of financial aid is granted to a business, or even the whole industry, to keep commodity prices low, or maintain them unchanged. Thanks to subsidies from the state, the producers will not increase prices. It is because with subsidies, the producers will be able to lower the cost of production. This will help them to maintain their profit margins without charging customers higher prices at the same time. The profit is made up by receiving the financial support of the government subsidy. Otherwise, there would be no profit for producers, if prices remain unchanged. So, subsidies are given out not to maximize the producer’s profits. But, to provide extended benefits to the whole society. Higher prices may negatively influence the customers. Or, go against the public interest.
In summary, business managers need to know as accurately as possible the cost of each product produced by the firm. Only, in that way, with correct costs data, they will be able to make important business decisions how to choose the appropriate source of finance to pay business costs.
