3.1 Sources of Finance Chapter 18 Part 1

What is finance? The ability to access money in order to fund business activities. Many different business activities need finance. Can you name some?

Business Activities to Finance What is Capital? Can be Cash, Equipment, Buildings Startup Capital Money needed to start a business to: buy equipment, rent/buy a building, purchase inventory Working Capital Money needed to operate the day-to-day activities of the business: pay bills, pay employees, buy supplies Business Expansion Move to a larger location, hire more people, equipment upgrades

Business Activities to Finance Business Expansion Expansion can occur by purchasing other businesses; may need extra money to do this Special Situations Decline in sales could leave company without enough cash; a customer could fail to pay his bill in time; unexpected repair expenses Research and Development Invest in new markets, create new products

Time to Finance Short-Term Financing Medium-Term Financing One year or less Medium-Term Financing One to five years Long-Term Financing Over 5 years

Financing Expenditures Capital Expenditures Purchasing fixed assets that will last over one year (things that aren’t consumed in the day-to-day operation of the business) Buildings, machinery, or cars (What are ASSETS?) Revenue Expenditures Spending that occurs in order to produce your product or service Wages, inventory, supplies, utilities Financing these two different types of spending will be very different as the length of time for “pay back” is different.

Sources of Financing Internal Money External Money Money raised by the business’s own assets or from the profits left over from the business. Profits Retained by the business Sale of Assets Reductions in Working Capital External Money Sources from outside the business Bank Overdrafts (Credit Line) Trade Credit Debt Factoring (Selling Receivables at a discount)

Internal Sources of Finance Profits retained by the business Profit that is kept by the business after taxes and dividends are paid New companies or companies that experience a LOSS may not have access to this type of financing. This type of financing is permanent because it is not “paid back” Revenue $100,000 Expenses 30,000 Profit $ 70,000 Taxes @10% - 7,000 Dividends paid - 20,000 Profits Retained $ 43,000

Internal Sources of Finance Sale of Assets Companies can sell assets they no longer need or use to raise cash for financing. Example: A company owns 2 cars worth $10,000 each Total: $20,000 in Asset Value NOT Cash $20,000 Liquidate car asset to raise cash. $10,000 CASH $20,000

Internal Sources of Finance Lease Option Company sells equipment that has a loan outstanding to a leasing company; then leases the equipment back for a cheaper price. Raising cash by reducing cash outlay. Example: A company is buying a car worth $20,000 and bank loan balance $15,000 with a monthly loan payment of $500. Loan Payment $500 Sell car to leasing company for $18,000 - $15,000 loan=$3000 raised cash Lease Payment $175 $3000 raised cash + $325 cash extra cash per month

Internal Sources of Finance Reductions in Working Capital Working Capital = Assets -Liabilities Money owed to the business (Asset) = $20,000 Liabilities (loans on cars) = $5,000 Working Capital = $15,000 Debt to Asset Ratio: 1:4 For every $1 in debt, I can pay it back 4X Collected Money owed (Assets)= $5,000 Cash = $15,000 Spend Cash=$15,000 Total Assets = $5,000 Liabilities = $5,000 Working Capital = $15,000 Debt to Asset Ratio: 1:1 But $20,000 now in cash For every $1 in debt, I can pay it back 1X

External Sources of Finance Bank Overdrafts (Credit Line) Most Flexible types of financing Pre-arranged with a banking/lending institution Expensive with high interest rates Used on a day-to-day basis to cover the cash needs of a business

External Sources of Finance Trade Credit Delaying payment of your vendors Early payment discounts cannot be taken Suppliers may not be happy if you take to long to pay your bills What is “Trade” – buying from a supplier in your industry.

External Sources of Finance Debt Factoring Selling Accounts Receivable at a discount to a collector (What is Accounts Receivable? Money owed to you by your customers.) Money Owed You: Accounts Receivable: $10,000 You Sell to a Debt Collector for immediate cash: $ 7,000 Debt Collector Profits when debts are collected: $ 3,000 This is not BAD Debt Collection.

Evaluation of Internal Financing No direct cost to the business Does not increase the debt of the company No risk of loss of control of the company to another party No shares are sold to others New or unprofitable companies have few assets to sell to raise cash Growth will be constrained by limited cash resources

More Vocabulary Hire Purchase (A LOAN) Leasing Purchasing an asset over a period of time Example: buying a car, equipment using a loan Ownership Leasing A contract with a company to pay a fee but not actually acquire ownership of the item. Example: leasing a car, or equipment No Ownership

More Vocabulary Debentures (Corporate Bonds) Bonds issued by a company to raise money and they are usually issued with a fixed rate of interest Savings Interest Rate to Depositors @ 1% Interest Loan @ 15% Interest Bank makes 14% Profit Bond @ 10% Interest to People People make 10% Profit vs 1% at the bank Business SAVES 5% on Loan Interest by NOT using the bank

More Vocabulary Rights Issue Grants Existing shareholders have the right to purchase more stock at a discount in order to raise capital for the business. Grants Government agencies willing to fund businesses that will establish themselves in particular locations or create jobs. (Economic Development Funds)