All businesses require finance to survive initially and thrive over the
long term, yet with such a wide variety of options to choose from selecting the
most suitable source of finance can be a very confusing process. Businesses can
acquire finance from either internal or external sources across both short and
long term options. However choosing the best option for the business is crucial
for its future cash flows whilst limiting the additional cost payable
over the long term. This video explains the common sources of finance available
to businesses including the advantages and disadvantages of each.
A bank overdraft is the first source of finance we're going to look at. In simple
terms a bank overdraft is when the business makes payments from their
businesses current account which exceeds the cash they actually have available.
They are a very common way for small and medium-sized business enterprises to
source finance especially for businesses that have finance requirements which
fluctuate on a regular basis. Typically the bank would offer an overdraft to a
business on either a rolling basis with no set end date with interest added at
regular intervals or over a fixed period of time. In addition to this overdrafts
can be pre agreed between the bank and the business in the form of an
authorised overdraft which typically has lower interest rates in comparison to an
unauthorised overdraft, we will typically see the business charged additional fees
on top of the interest, therefore if the business can foresee the requirement for
additional funding it is better to arrange an authorised overdraft to keep
the additional cost down. It is classed as a short-term external method of
finance as it should in theory be paid off soon after the business receives it,
this is due to the varying amounts of interest which can be added daily and
ultimately it is repayable on demand by the bank. The actual amount
of cash the business goes into the overdraft will vary over time depending
on the cash flows of the business itself and if the size of the overdraft
increases to a significant amount the bank may require the business to secure
the overdraft against the assets of the business. Importantly if it becomes a
common occurrence for a business to be in an overdraft it may want to consider
alternative options such as a bank loan to reduce the additional amounts of
interest and one-off charges incurred with an overdraft. Some of the key
advantages of a bank overdraft include the business only pays interest when
it's overdrawn and typically it is quick and easy to arrange and funds are
available immediately after it's been set up unlike other sources of finance
there is typically no charge for clearing the balance earlier than
expected. However, it is important to understand the disadvantages associated
with bank overdraft, firstly on the typical overdraft interest rates vary,
therefore it is difficult for the business to accurately predict the cost
of borrowing and not repaying the overdraft can have serious consequences
for the business as interest will keep adding to the
total amount repayable. Also the business may lose assets in the process whilst
directors of the company can also be personally liable dependent on the
overdraft agreement. Now we move on to bank loans which are a very common
source of business finance when a business takes out a bank loan it
receives a set amount of money from the bank. However it's important to note that
the actual amount of money that a business can loan from the bank and the
amount of time it has to repay the loan depends on a number of factors. Let's
imagine you are a business and you require £10,000 to fund an
upcoming project or expansion therefore you apply for a £10,000 bank loan,
the bank will receive your application and ask questions and conduct numerous
checks on the business and its owners they do this before deciding the maximum
amount they are willing to lend and how long they're willing to let the business
have to repay this debt. Bank loans are commonly agreed and repaid over a one to
five year period but can be longer if both parties agree.
Therefore it is classed as a medium to long term external source of finance and the
interest on the bank loan can be set at a fixed rate at the time of the loan
agreement such as 7.9 percent APR and this will be the set amount of interest
that is charged until the loan has been repaid. Alternatively the business may
choose to have interest charged on a variable basis meaning that the amount
of interest charged on the amount borrowed will vary over time according
to any changes in the market when things are going economically well in terms of
growth and inflation, interest rates are likely to increase to discourage
spending and influence people see savings as a more attractive option and
borrowing as a more costly one. Whereas in economic downturns such as a
recession interest rates are often cut to encourage spending therefore a
variable rate can see the business pay much less in interest over the terms of
loan yet this is a risk if during the loan there is an economic upturn and
interest rates keep rising, so will the amounts of interest that business pays
on their loan. The key advantage of a bank loan is that both the business and
the bank enter the loan agreement knowing the exact amount borrowed the
interest charge and the repayment schedule, this provides both the business
and the bank with more accurate information for their cash flow planning
whilst providing the business with a guaranteed source of finance. Also there
are no additional charges as long as the business adheres to the loan agreement. The
cost of finance such as interest and additional charges are typically lower
than many other sources of business finance, if the business is taking a loan
to purchase an asset such as a car or machinery it can match the length of
this loan to match the estimated lifetime of their asset meaning that they can renew
their loan and purchase the new asset at this point. However there are a number of
drawbacks to bank loans which businesses must consider when applying. One of the
most important drawbacks is the bank's legal right as a secured creditor with
collateral over the business's assets if the business gets into financial
difficulty and fails to repay the loan the bank has the legal right to acquire
the business's assets before the shareholders. Also, dependent on the type
of business the owner's personal assets may be at risk. If the business wants to
repay the loan early they may also be charged with an early repayment fee and
they also need to pay interest on the money that they're never actually used.
For example let's imagine a business takes out a £10,000 loan over a five
year period for an expansion project and a year into this expansion project they
realise that the only actually require £6,000, they will still be
charged interest on the additional £4,000 part of borrowing. The same
business then decides that they want to repay the £10,000 loan in full
after three years. They may also then incur additional charges for not
adhering to the full term agreement even though it has been paid back in full and
early. A final key disadvantage is the time it takes to a range of business loan
agreement and the fact that the bank is under no obligation whatsoever to loan
any money to any business. This is a real disadvantage for small businesses and
startups that the banks may deem them to be a greater risk due to their smaller
cash flows, lack of valuable assets for security or simple a limited history of
the business. We now move on to owners capital there are a few businesses that
start without some form of financial input from the owner this comes in many
forms and isn't always a cash injection. Typically an entrepreneur will save up
money or sell personal assets to fund a business start
this is a low-risk option for the entrepreneur given the fact that all
they have to lose is the money that they actually invested into the business if
this was the sole form of finance for the business then they owe no money at
all to any other stakeholders or shareholders which is a great financial
strength for any business. Having said that if the business owner did want to
source more finance for the business it also shows potential investors or the
banks that the owner is committed and believes in the business. It's important
to be aware at this point the personal funding is not just for business startups
and many business owners invest their own personal money into their business
at various times over its lifetime. Therefore it is seen as a long-term
internal source of finance. We now move on to trade credit which in its simplest
form is when a business has an account set up with their supplier, this
account allows a business to purchase and receive goods or services without
having to pay at the point of sale. It is a short-term external source of finance
and is an essential element of many businesses cash flows essential allowing
them to make a profit before paying for the goods in the best case scenario.
Imagine you own a small convenience store and you purchase a hundred
chocolate bars on your account through trade credit at your local wholesalers
for £50, so each chocolate bar cost you 50p, the terms on your credit account
allow you 30 days before you have to pay the balance in full. Now you're a busy
convenience store and chocolate bars are popular so you put these on sale for £1
pound each and they all sell within 10 days. This is great it means you've made
a profit of £50 and you still have 20 days before you have to pay the
balance this puts you in a great position as you can even reinvest these
profits further and buy more chocolate bars or you can just pay off your trade
account with the money that you've made this is a great scenario for the
business. However it's worth noting that not every trade credit transaction is as
simple as this and it's important that the business has sufficient funds to pay
the account in full by the agreed date should they fail to generate any revenue
from the original purchase of supplies, otherwise this could lead to a breakdown
in relationship with the supplier and bad word-of-mouth for the business. Trade
credit has a key advantage is very easy to organise between the
business and the supplier, it is also widely available across many industries
and it is typically a low-cost source of finance as there is usually no
additional fees. However some key drawbacks include the possible breakdown
between the business and supplier should one not stick to the agreed terms
especially if the business fails to pay on time
they may lose a critical supplier . In contrast to this there may be a demand
from the business's own customers who want the facility of trade credit which
will then impact the business's cash flow negatively. Whilst it may
increase the footfall of customers, they may then not pay on time causing
Additional time and money to chase the payment or even force the business
to use a debt factoring service. Moving on
to retained profits which is one of the most crucial sources of finance for many
businesses, the concept of retained profits is truly the heart of
business growth, essentially a business makes a net profit and then simply
reinvest its profit back into the business
rather than receiving it personally or making a payment to shareholders. Retained
profits are seen as a long-term internal source of finance providing the owners
with complete freedom on how they reinvest it back into the business. They
could spend it on expanding the range of stock to attract more customers,
it could be spent on machinery or tools to increase efficiency or it could just
be left in the bank account for a rainy day.
Some key advantages of using retained profits as a source of finance include
the fact that the owners of the business have complete control over how this is
spent in the business importantly by retaining these profits the business
does not have to repay this money back to any person or bank in the future and
doesn't have the additional charges such as interest which is added in many of
other sources of finance. However there are a number of drawbacks to this source of
finance, firstly the business owner should be aware of potential
disagreements in how the profit should be shared or retained which may upset
shareholders if they believe they should have received more of this retained
profit personal in the form of dividends. Also the business cannot rely on
retained profits as a consistent form as finance as they are not guaranteed to
make a profit year on year. It's also very important for business owners to
consider the impact of retaining profits every year
as this can make the business look less attractive to potential investors in the
future. Moving on to share capital, so share
capital is when a business looks to source finance by selling shares in the
business to investors, it is seen as a long-term source of finance within which
an investor will receive a percentage share in the business in return for a
monetary amount which is agreed between them and the business, the investor then
becomes a shareholder and is protected by a limited liability and will see
return on their investment in the form of dividend payments or the profit made
if they decide to sell their share in the future. Share capital has a number of
advantages for a business including the fact that the business is not required
to repay anything for this source of finance and no interest is charged which
is a huge positive in comparison to alternative sources of finance such as a
loan or an overdraft however every time the owner agrees to sell more shares in
the business to raise money they are reducing the shares that they
personally own and ultimately the control they have in the business. Another
positive of share capital is that the business has full control of how many
shares they want to sell how, much they want to sell the share for and who they
actually sell the shares to if it is a private limited company but a public
limited company unfortunately doesn't have this luxury. Also because shareholders
profit from the business's success over the long term
not only does this raise additional finance but the investor would actually
want the business to succeed in the future and can support the business with
their additional skills and experience. A final consideration for a business owner
is that shareholders also share the profits of the business according to
their share in the business reducing the amount of profit the initial
owner takes. We are now going to look at venture capital which is regarded as a
long-term external source of finance within which an investor known as a
venture capitalists would invest their own money into a business in exchange
for an agreed share in the business's equity. Venture capital is commonly used
when there is an element of risk and a high potential for business growth
within which investors invest their money into the business startup or one
that is looking to expand. Typically a venture capitalist would look to invest
in businesses with high growth potential within the next five years
and would usually look to sell and cash in on their share of the business within ten
years of investing. Venture capitalists come in the form of individuals but more
commonly in the form of venture capital firms or business angels
The key advantage is that it is widely available for businesses which are
deemed to be more risky within which over forms of finance such as a loan or
a grant may not be available. However due to risky nature of venture
capital finance the business owner would typically have to exchange a high
proportion of equity in order to secure the funding, also many businesses who
were applying for venture capital get rejected after the initial review of
their business plan and even if they do get past this initial stage the typical
process takes around three to six months to secure funding which is a much longer
time scale than many other sources of finance. And the final source of finance
were going to look at today is crowdfunding which is an alternative
source of business finance commonly used by business startups instead of venture
capital. Crowdfunding relies on multiple contributions from a wide range of
people via internet platforms with each platform having slightly different
processes but ultimately the entrepreneur will pitch their business
as a project suggesting why they want to start the business what its purposes is and how
much funding they need to get it started. It is classed as a long term external
source of finance and as an incentive to contribute, the contributors are
typically offered rewards dependent on the amount they contribute, the higher
the contribution, the more lucrative the reward. There are many advantages of
crowdfunding especially how simple, accessible and quick it is to set up and
reach an audience of potential contributors. Following this the business
owner still retains full control of business while creating a community of
loyal fans before the business has even started, this community of contributors
will typically have a vested interest in the business and would usually be
willing to listen to the business's ideas and provide feedback along the way
within which early contributors may identify weaknesses in the brand or its
products and suggest improvements before it goes to mass market. However it's
important to consider some of the potential drawbacks before pursuing
crowdfunding, none more so than the fact that the business may not receive any
contributions at all no matter how good the idea is due to the intense
competition in the crowdfunding arena because of it's clear advantages
to the businesses who receive contribution. Another key consideration is the risk of
your idea been stolen once it is in a crowdfunding platform as it's available for
the general public to see and potentially copy with many examples of
this happening today such as Pressy which raised $600,000 through crowdfunding but the
idea was copied, manufactured and launched before Pressy was even
shipped. Well I hope this has been a helpful introduction to the different
sources of finance available to businesses, if it has remember to give
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is also an activity worksheet in the description of this video if you would
like to test your knowledge further. Thanks for listening and all the best