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Sources of Finance Unit 3 KS4 Business Studies Icons key:

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1 Sources of Finance Unit 3 KS4 Business Studies Icons key:
Photo © 2006 Jupiterimages Corporation Icons key: For more detailed instructions, see the Getting Started presentation Flash activity. These activities are not editable. Teacher’s notes included in the Notes Page Extension activities Sound Web addresses 1 of 20 © Boardworks Ltd 2007

2 Learning objectives What sources of finance are available to businesses? Which sources of finance are internal sources and which are external sources? Which sources of finance are short-term, which are medium-term, and which are long-term? What are the advantages and disadvantages of different sources of finance, and what factors affect a business’s choice of source? 2 of 20 © Boardworks Ltd 2006

3 When does a business need finance?

4 Sources of finance Sources of finance are classed as being either internal or external. Internal sources: finance from within the business. External sources: finance from outside the business.

5 Internal sources of finance
Internal finance is a quick and easy way to solve short-term financial problems for most firms. It saves a business from borrowing from a lender and having to pay back interest. Retained profits: profits that owners have reinvested into the business after paying costs and tax. Owners’ funds: money put in by the owners themselves. Sale of assets: a one-off way to raise money, generally used during financial struggles. Possible answers: Retained profits – irrespective of the size of the business, there is always only so much retained profit available. If a business sees an opportunity for a major expansion, it may well not have enough retained profit to sufficiently cover costs. Owners’ funds – these are always likely to be limited and so a single owner might not have enough money to start the business by themselves in the first place. Moreover, if a business proved to be unsuccessful, the owner would lose his or her assets, as well as the business. Sale of assets – this is often seen as a backward step, although there are times (such as when a business will make more money selling their assets than keeping them on) when it makes good business sense to do this. However, it can also be difficult to actually sell the assets. Fixed assets are particularly difficult to sell on as they may be business-specific (machinery for example) and there may therefore be limited demand for them. Also, loss of such assets may adversely affect the productivity of a business, which is likely to put it into further difficulty. Photo: © 2007 Jupiterimages Corporation What are the disadvantages of each source of internal finance?

6 External sources of finance
External sources of finance come from outside a business and are more difficult to arrange than internal sources. Short-term finance: is used for daily expenses. It is sourced from an overdraft and is usually repaid in a year. Medium-term finance: is used to pay for repairs and small improvements. Sources include: loans, hire purchase, trade credit and debt factoring. It is usually paid back over 1–5 years. Long-term finance: is used to pay for major expenditure, such as buying new premises. Sources include: issuing shares, debentures, mortgages, venture capital and government grants. It is paid back over many years.

7 Short-, medium- and long-term finance

8 Owners’ funds The owners of businesses often use their own savings to help them to start up. It is common for two or three people to combine their money to start up a business. What are the advantages/disadvantages of this source? Advantages Disadvantages Avoids interest on loans. Owners keep complete control of the business. If the owners remortgaged and the business fails, they could lose their homes. There is a limit to how much money can be raised.

9 Retained profits When a business is performing well financially, it may choose to reuse some of the profits it made in previous years to help fund development/expansion projects. What are the advantages/disadvantages of this source? It is similar to owners’ funds as there are no interest costs to pay. But it may not leave the business with a buffer of funds to use if the project fails. However, the business keeps full control of the new development/expansion because it will be using money that it already has.

10 Selling assets A business can sell off some of its assets to raise finance. What assets could a business sell to raise finance? vehicles buildings Photos: © 2007 Jupiterimages Corporation machinery land However, buyers can be scarce, advertising costs money, and the assets may have to be sold cheaply.

11 Overdrafts

12 Loans When a business needs a substantial amount of finance, it is likely to apply for a bank loan. The disadvantages of banks loans are: the interest rates are often high banks usually require security for loans in the form of assets which the business could lose if it starts missing repayments banks do not take control of the business but they do ask for regular updates on its progress. Extension activity: the students could research the loans offered to businesses by HSBC, Lloyds, Barclays, Natwest. Photo: © stock.xchng Pick three banks and investigate the types of business loans they offer.

13 Government grants The British Government and European Union offer some financial assistance to help businesses which meet certain criteria, such as small businesses starting up, businesses in assisted areas or ones developing new technology. The Department of Trade and Industry (DTI) is the government department responsible for helping UK businesses to operate efficiently. These bodies give out grants, so no costs are involved. However, a grant can be recalled if a business does not keep to the conditions attached to it. Grants can also be small, meaning that other sources of finance can still be required. Here are some useful websites which the students could use to research the types of grants that are available to businesses: Research some of the different types of grants that are available to businesses.

14 Hire purchase and leasing
When a business cannot afford to buy assets outright, such as vehicles, machinery and equipment, it could choose to hire purchase or lease them. When hire purchasing, a business must pay a deposit and monthly payments for the term of the agreement. At the end of the contract the business owns the assets. Leasing involves paying monthly instalments to use an asset, but a business doesn’t own it afterwards. Extension activity: ask the students to research the cost of buying a Ford Transit van versus hiring or leasing one. Ask them to think about the advantages and disadvantages of each method, e.g. buying is cheaper in the long term but it is expensive at first, and the business would have to pay for the repairs. Hiring would be more expensive in the long term but the payments would be spread out and the business would own the van at the end of the term. Leasing a van would spread the cost and the leasing company would pay for repairs, but leasing would work out to be the most expensive in the long term as the business would not own the asset at the end of the term. Photo: © stock.xchng Interest is charged for both sources, and the assets can be reclaimed if the repayments are not made.

15 Issuing shares A limited company (Ltd or plc) can issue shares in the company to raise extra finance. Issuing shares poses no risk for a company but it will have to pay dividends to the shareholders every year to reward them for their investments. The shareholders do take on a risk as the value of shares can fluctuate. The company keeps control of its day to day operations, but the shareholders become the owners and in theory would be able to vote for changes. A plc also becomes vulnerable to a hostile takeover. Photos: © 2007 Jupiterimages Corporation

16 Venture capital Venture capital businesses are large businesses which lend money to smaller businesses, not plcs. The lender becomes a shareholder in the business. Their aim is for the business to grow rapidly over a 3–7 year period so that the share price increases. Then the venture capitalist would sell its shareholding at a profit. Venture capital companies often play an active role in the business in which they are investing. For example, they may choose to appoint people onto the board of directors or may even become involved in the running of it. To find out more about the venture capitalists who appear on Dragon’s Den and to watch clips of them interviewing small start-up businesses, visit: Photos: © 2007 Jupiterimages Corporation Now look at the website of the TV show Dragon’s Den to find out more about venture capital.

17 Factors affecting choices
As an extension activity visit the Bank of England’s website and draw a graph to map the changes in interest rates over the last 2 years:

18 Question time! Give four reasons why businesses need to raise finance.
What are the main types of internal finance? What are the three different categories under which sources of external finance sources can be classed? What factors affect a business’s choice of method? Name an advantage and a disadvantage of using owners’ funds as a source of finance. Answers: Businesses need to raise finance when they are starting up, are having cash flow problems, need to renew or update their operations or want to expand. The main types of internal finance are owners’ funds, retained profits and the sale of assets. The different types of external finance are short-term, medium-term and long-term. The factors that affect a business’s choice of funds include the amount of money needed; the cost; the risk involved; whether the funding is needed in the short-, medium- or long-term; whether the business is willing to relinquish control of its affairs; and whether the business is happy to take advice. One advantage of using owners’ funds is that the owners keep total control of their business; a disadvantage is that if the owner secures an asset to raise the funds (e.g. by re-mortgaging their own homes) they may lose that asset if they can’t keep up with the repayments.

19 Who wants to be an A* student?
Answers: Retained profits An overdraft Hire purchase Venture capital Security Assisted areas Must return it Dividends Share price Hostile takeover

20 Glossary

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