Topic 2 -3 Management and Sources of Funds HSC Business Studies 2009 Topic 2 -3 Management and Sources of Funds

The Business Studies Syllabus Topic 2 Financial Planning and Management Management of funds Sources of funds -internal (owner’s equity, retained profits). -external (short term / long term borrowing, leasing, factoring, venture capital, grants). Financial considerations – matching the terms and source of finance to business purpose and structure. Comparison of debt and equity financing, including costs and benefits, risks, gearing/leverage.

Sources of Funds To establish themselves and to survive and expand, businesses need funds. Sources of funds may be internal (equity) or external (debt) or Other. Finding the appropriate source of funds for a business is a key factor in good financial management.

Equity Funding Equity funds can be raised in many ways such as: Initial contribution from owners Taking on new partners Inviting new investment by expanding the number of shareholders Selling off unproductive assets Not distributing profits as dividends (retained earnings)

Equity finance is the most important form of finance for companies because it remains in the business for an indefinite time. Equity is generally safer than debt, but requires that sufficient profit be made so that the business can continue to operate. Equity funds provides confidence for lenders and creditors. They act as a safety net against unexpected downturn in sales and profits.

External Sources of Funds Refers to funds supplied by sources outside the business which can include: Government Suppliers Banks and other financial institutions Regular repayments on debt must be made. However Australian taxation laws have made debt financing more attractive by providing tax deductions for interest payments.

Gearing/Leverage The capital structure of a business is determined by the mix of debt and equity. The proportion of debt to equity is known as gearing or leverage. Looked at from another perspective, it is the ratio of external funds to internal funds. More highly geared businesses are more at risk of developing liquidity problems, but they may also carry greater profit potential. In determining the amount of debt a business should borrow, attention must be given to the way control by owners will be influenced.

Short Term Borrowing Bank Overdraft – bank allows business to overdraw its current (cheque) account to a certain limit. Useful in making provision for periods of deficit in cash flow. Costs are minimal and interest rates are lower than on most other bank loans. Bank Bills – a type of bill of exchange usually used for amounts greater than $50000 for period of 90-180 days. Bank acts as guarantor that accounts will be settled. Bills can be traded in the secondary bills market.

Long-term Borrowing Refers to funds borrowed for periods longer than a year. Used to finance real estate, plant and equipment. Mortgage – loan property, factories and equipment. Secured by the property of the borrower. Repaid of a long period such as 10-25 years and carry a competitive interest rate. Lower interest rates than short-term debt instruments. 2. Debentures – issued by companies accepting loans for a fixed period carrying a fixed interest rate. Secured by a charge over the assets of the company.

Leasing Leasing – involves payment of money for use of equipment that is owned by another party. Means business does not have to incur large financial outlay. The lessee hires the equipment from the lessor who owns it. Operating Leases are for a period shorter than the life of the asset. Financial Leases are where the lessor purchases the asset on behalf of the lessee and the contract runs for the life of the asset.

Advantages of leasing Costs of establishing lease may be lower than other forms of financing 2. May place lessee in better position to borrow funds 3. Provides long-term financing without diluting control and ownership 4. Repayments are fixed which makes it easier to make cash flow projections 5. Allows for 100 per cent financing of assets 6. Payments are tax deductable 7. Payments usually includes maintenance, insurance and finance costs.

Factoring

Factoring is a short-term source of finance Factoring is a short-term source of finance. It enables a business to raise funds immediately by selling accounts receivable to a firm that specialises in collecting debts (a finance or factoring business). By having immediate access to funds, a business will improve its cash flow. Factoring agreements may be with or without “recourse”. Factoring is a relatively expensive source of finance.

Trade Credit Important source of short-term (30-90 days) funds for business. It is easy to obtain if a business has a good credit rating. It is a cheap form of finance, provided payments are made on time. Some businesses will allow “stretching” by their regular customers.

Venture Capital

Venture Capital refers to funds – sometimes referred to as ‘seed capital’ - supplied to new businesses or ones wanting to diversify by private investors or specialist investment organisations. It is associated with risky but potentially highly profitable ventures. The Australian Industry Development Corporation (AIDC) specialises in the provision of venture capital. Information regarding venture capital funds is available from Australian Venture Capital Association.

Grants A sum of money made available to a business to be used for growth and development. The provided of the money, primarily the government, places conditions and restrictions on the use of the grant. Funds can be obtained through both state and federal governments.

Matching Source with Purpose A business must find and use sources of funds appropriate to the particular decisions or objectives they wish to pursue. The source and terms of the finance must be suitable for the type of business involved and for the purpose for which the funds are required. Short-term sources of finance should be used for short term objectives such as cash flow management. Long-term sources of finance should be used for long-term purposes such as expanding the business. Borrowing short-term to finance the purchase on non-current (long-term) assets would be a mistake since the funds would have to be repaid before the assets acquired could generate sufficient cash flow.

The cost of each form of funding - be it debt or equity - must first be determined. The expected rate of return should also be calculated and balanced against the cost of each source of funds. Flexibilty and availability of funds, together with attendant control of the business, is also important in assessing suitability of various funding sources. Access to various sources of funding will be affected by the structure and size of the business. Small businesses have fewer opportunities for accessing equity capital than larger businesses.

Comparing Debt and Equity Finance In Australia debt finance does not normally exceed equity finance, even though the gearing ratio will vary from business to business. Debt Finance Debt finance can be attractive as interest payments are tax deductible, something which reduces the cost of debt financing. Short-term borrowing (one year or less) is an important source of finance for business in Australia. The relationship between debt and risk must be carefully considered in deciding how much debt finance to use. There is greater risk associated with borrowing.

Costs, including set-up or establishment costs, plus interest rates must be measured for each available source of funds. Due provision should be made for the fact that these costs fluctuate over time. Flexibility means that debt finance conditions and loans can be renewed easily, and that where a business has excess funds it can pay off loan more quickly. In this regard, bank overdraft is a very flexible form of short-term debt finance. The level of control exercised by lenders over a business becomes a significant factor once business assets are used as security against debt finance. Having given such security, the business is restricted in how it can use or dispose of the assets involved.

Costs to be considered in using debt finance are: Repayment of principal Interest payments Timing of repayments Administrative and legal costs Conditions and terms of borrowing Tax considerations Refinancing when loan has to be repaid Level of control by the lender.

A business must maintain sufficient liquidity or cash flow to ensure it can meet commitments as they fall due. Even though a business is profitable, it can still experience solvency problems that could lead to bankruptcy. In considering the financial structure of an organisation, the interests of stakeholders such as owners, creditors and lenders should be considered. Lending institutions may impose conditions during the period of the loan. Known as restrictive covenants, they tell borrowers what they can and can’t do while they have the loan.

Advantages and Disadvantages of Equity Funding 1. Does not have to be repaid unless owner leaves the business 1. Dilution of ownership and control. 2. Relatively cheap – no interest payments. Better in weak external conditions. 2. Unfilled expectations of owners may destabilise business 3. Low gearing. Less risk for business and owner. 3. May lead to lower profits and returns for owners. Equity finance adds additional costs such as floating shares on ASX. 4. Rate of return paid to shareholders is generally lower, they gain by increase in value of shares. 4. Becoming a public company leads to extra disclosure requirements which may create a competitive disadvantage.

Advantages and Disadvantages of Debt Finance 1. Increased funds leading to increased earnings and profits 1. Increased risk if debt comes from financial institutions as interest, bank and government charges have to be repaid 2. Tax deduction for interest payments 2. Business must supply security. Some lenders might want to restrict business’s operations. 3. Easier to arrange and can generally be organised at short notice. 3. Regular repayments of both interest and principal 4. Debt holdres do not always have rights in management of business. 4. Lenders have first claim on funds if business fails. Seeking more debt may lead to decrease in value of shares. 5. Debt repayment obligations can act as spur to good cash control management. 4. Leaves business more highly geared – higher risk of liquidation if it fails to meet repayments.