Why businesses need finance and types of finance

Businesses require finance to operate and grow, covering both major investments and routine expenses. This funding can come from various sources, depending on the business's needs and circumstances.

Reasons businesses need finance

• To purchase fixed assets, such as manufacturing equipment, retail premises, or production machinery
• To cover day-to-day operational costs, including employee wages and utility bills

Categories of finance sources

• Internal finance - Funds generated from within the business itself, such as through profits
• External finance - Funds obtained from outside the business, like bank loans or investments from shareholders

Time-based classifications of finance

• Short-term finance - Used for immediate needs, such as paying suppliers or addressing temporary cash shortages, typically repaid within one year
• Long-term finance - Required for substantial investments, usually repaid over three or more years

Factors to consider when choosing sources of finance

Selecting the right source of finance involves evaluating several key aspects to ensure it aligns with the business's structure, needs, and risks.

Key considerations for finance selection

• Legal structure of the business - Limited companies can issue shares, while sole traders cannot access this option
• Amount of money required - Larger sums are less likely to be raised internally and may need external sources
• Level of risk involved - High-risk ventures may struggle to secure bank loans but could attract venture capital investors
• Whether short-term or long-term finance is needed - This depends on the repayment timeframe and the purpose of the funds

Internal sources of finance

Internal finance uses resources already available within the business, avoiding the need to borrow or seek external investment. The main methods include retained profit and rationalisation.

Retained profit

Retained profit involves reinvesting earnings back into the business rather than distributing them as dividends. Profits accumulated over time can be set aside for future investments.

Advantages:

• No interest payments are required
• Maintains full ownership

Disadvantages:

• Not all businesses generate enough profit to use this method
• Shareholders may prefer dividends instead
• Could lead to missed opportunities if funds are not available when needed

Rationalisation

Rationalisation involves reorganising the business to improve efficiency, often by selling assets to raise capital. Managers may sell off underused assets and lease them back if required later.

Advantages:

• Generates capital without interest payments

Disadvantages:

• The business loses ownership of the assets
• Introduces ongoing leasing costs
• Assets like electronics or vehicles depreciate over time, reducing their sale value

External short-term sources of finance

External short-term finance provides quick access to funds from outside sources, ideal for covering immediate cash needs. Common options include overdrafts and debt factoring.

Overdrafts

An overdraft allows a business to withdraw more money than is in its bank account, up to an agreed limit.

Advantages:

• Easy and flexible to arrange
• Interest is only charged on the amount used

Disadvantages:

• High interest rates apply
• May include fixed fees
• Not suitable for long-term needs

Debt factoring

Debt factoring involves selling unpaid customer invoices to a financial institution for immediate cash. The factoring company pays the business a percentage of the invoice value upfront and collects the full amount from the customer later.

Advantages:

• Provides instant access to money owed, improving cash flow

Disadvantages:

• The business receives less than the full invoice value due to the factoring company's fee

External long-term sources of finance

External long-term finance supports major investments and is sourced from outside the business. Options include bank loans, share capital, venture capital, and crowdfunding.

Bank loans

A bank loan provides a fixed sum of money that is repaid over an agreed period with interest. Bank loans require collateral, such as property, to secure the loan and are suitable for start-ups or buying assets but not for everyday costs.

Advantages:

• Funds are guaranteed for the loan term
• Only the loan and interest need repaying
• Maintains full business ownership
• No profit-sharing
• Lower interest rates than overdrafts

Disadvantages:

• Hard to obtain without sufficient security
• Repayments can strain cash flow
• Risk of losing secured assets on default
• Possible charges for early repayment

Share capital

Share capital is raised by selling ownership shares in the business, available only to limited companies. Investors buy shares, providing funds in exchange for partial ownership.

Advantages:

• No repayment required
• New shareholders may offer expertise or networks

Disadvantages:

• Original owners lose some control
• Must pay dividends
• Shareholders gain a say in decisions

Venture capital

Venture capital involves investment from specialist firms or individuals in high-risk businesses. It is provided as share capital or loans, often with business advice, and involves a detailed application process.

Advantages:

• Access to funds and expertise for risky ventures

Disadvantages:

• Lengthy approval process
• Investors may demand significant control or returns

Crowdfunding

Crowdfunding raises money from many individuals through online platforms. Contributors can donate, lend, or buy shares, and campaigns often include rewards like discounted products or early access.

Advantages:

• Broad access to potential investors
• Can generate publicity

Disadvantages:

• Platforms take a fee
• May reduce profits if rewards are costly
• Success depends on effective online campaigns