Chapter 19 - Business Finance: Needs and Sources
Learning Objective: The Most Common External Sources of Finance (19.2)
We shall now discuss external sources of finance:
Short-term external finance include overdraft, trade credit, debt factoring;
Long-term external finance include bank loan, hire purchase, leasing, mortgage, debenture, share issue.
Overdraft:
A 'type of short-term loan';
It allows the customer/business to keep on paying its bills even when the account reaches zero;
It acts as an emergency;
The limit is pre-agreed;
It usually carries high interest.
Trade Credit:
The payment terms offered by suppliers to the business - usually businesses want to delay payments to suppliers as much as possible so that they can have less working capital attached to the operations.
However, suppliers will likely try to shorten payment terms:
Suppliers usually offer discounts for early payments and businesses using of trade credit will not benefit from those;
Suppliers may not agree to deliver goods until payment is made;
Businesses that take advantage of trade credit may be required by suppliers to make early payments.
Debt Factoring:
The act of selling trade receivables for a discounted price to debt-factoring businesses.
It allows to immediate access to financing;
However, it eats up some of the profit margin from the business.
Going now into long-term external finance:
Bank Loan: the most common source of external finance:
It can be with a fixed interest, which is advantageous for its predictability;
It can be with variable interest (which goes up and down according to economic factors);
Not readily available to small businesses (high-risk businesses);
When available to small businesses they usually carry high-interests and the need for collateral.
Leasing: a common form of financing for non-current assets (e.g. vehicles, machinery):
Firm pays fixed amount to the leasing company to make use of the asset for a given time;
The firm doesn’t own the asset by the end of the leasing period (which is returned to the leasing company).
Hire Purchase:
Similar to leasing but by the end of the contract the business owns the asset.
Leasing and Hire Purchase both have the same purpose: allowing the business to have access to a non-current (fixed) asset without having to make a large one-off cash investment - the cost is spread out overtime. It is accompanied by interest, though.
Mortgage:
External source of finance for the purchase of properties/real estate;
It comes with interest rate.
Debenture:
A bond issued by businesses;
Buyers (holders) are entitled of a fixed interest through the time of the contract;
The investors' initial investment is paid back to them at the end of the contract period;
Businesses unable to payback investors may go through asset liquidation.
Share Issue:
Public Limited Companies have the ability to sell shares to raise capital;
Shareholders are entitled of dividends;
Shareholders benefit from the growing value of a business shares.
To-Do-List:
Exam-Style Questions #2 (p. 257)
Chapter 19 - Business Finance: Needs and Sources
Comments