Sources of Finance; External Sources of Finances & Internal Source of Finance
There are six different options businesses might use to help them out with liquidity problems or raise more considerable sums of money for capital expenditure projects. We highlight the differences between each, advantages, and limitations are.
Sources of Finance: External Sources of Finances & Internal Source of Finance
An overdraft is a facility that businesses can arrange with their banks; therefore, they happen on their bank accounts.
Essentially, an overdraft allows the firm to spend even when they have run out of money.
An overdraft is almost like an extension to your bank account. When the account balance is zero, or don’t have any funds left, an arranged overdraft facility will allow you to spend beyond the zero limits. Small businesses might have overdrafts for, say, $500- 1,000
Larger organizations might have overdrafts agreed for hundreds of thousands, perhaps even millions. They can carry on spending up to the limit that they’ve agreed with their bank.
Advantage of Overdraft
The advantage of overdraft is that it allows businesses to continue purchasing the assets they need for their organization even when they don’t have any cash of their own. They could start almost spending the bank’s money.
Disadvantage of Overdraft
The downside is, is that you have to pay to have an overdraft facility. Every month that you use your overdraft, you go beyond your bank account of limited zero on into the bank’s overdraft facility, you get charged A fee on the interest. This fee is much larger than you would pay, even if you were borrowing from the bank in a bank loan.
Overdrafts can be reasonably expensive ways of borrowing money. Still, they are great, almost like a safety net for organizations to carry on meeting their financial commitments even when their own bank balance has gone down to zero.
Retained Earnings /Profit
Another source of finance that businesses might use is retained profit. At the end of the financial year, when the business has calculated how much profit has been made for the period. There are two options that they can do with it.
They can distribute it to their shareholders, in which case it leads the organization.
Or they can choose a portion or a percentage of the profits to retain in the business for spending for growth and expansion on development.
Advantage of Retaining Earnings
The major advantage of retaining some of your profits in the organization and using them on your business to grow is, you don’t have to pay any interest on that money.
It’s an internal source of finances raised by the organization itself, so it doesn’t require paying back in any way.
The Disadvantage of Retaining Earnings
The downside is that that is money that you are in taking away from your shareholders. Technically, your shareholders might be looking at those profits that the organization has made on thinking that they are entitled to all of that, that all of that is going to get rewarded amongst the different owners.
But by retaining some of those profits, you’re taking that money back out of shareholders’ hands. Now, short-term shareholders that are looking for quick returns from the organization might see too much-retained profits as a signal to sell their shares in the business and go and invest elsewhere.
However, your longer-term shareholders will probably look favorably on the use of Retained profits. If it’s a signal that the business uses it to grow and expand on the dividends in years to come, it might be even larger.
This debt factoring is where if you are owed money by one of your customers, one of your trade receivables. Still, you can’t afford to Wait, your business is perhaps suffering some short-term cash crisis, some liquidity problems, or you’ve got a big order from a customer, but you can’t afford to wait for that customer to pay up anymore.
You can sell that debt to an organization known as a debt factoring company. For instance, imagine you’ve got a trade receivable $10,000, and it’s coming to you in three months. You know that in three months, one of your significant customers is going to pay up $10,000, but you need cash now to meet your own financial commitments, maybe pay your own supply.
You can sell that $10,000 debt that you’re waiting to receive to another organization. They won’t buy it from you for its full value because they’re going to make a profit. That’s how debt factoring organizations function. They make profits by buying debts from the business for less than their full value. In this case, they can pay you $80,000 for this debt that you are owed.
They can then wait for that debt to mature in full three months. But for your organization, it means that you get cash now today when you need it.
It brings the cash into your organization that you need now to solve your own liquidity crises.
Advantages of Debt Financing
The advantage of this is that it allows businesses to release cash when they need it in order to solve their own liquidity.
Disadvantages of Debt Financing
The downside is that you miss out on the full value of the sales you have made by selling that debt onto a debt factoring organization.
A significant finance source for organizations is looking to raise quite large sums of capital when looking to raise money for growth and expansion and development. The organization is to use share capital.
That is bringing new owners into the organization to give them a stake or percentage of share of the business’s ownership.
Advantages of Share Capital.
One of the advantages of this method of finances it can bring in quite large sums of money. In return for a stake in the organization, people may be prepared to pay quite large sums.
Besides, those shareholders that joined the organization in LTDs might bring with them some industry knowledge, expertise, some experience of being involved in businesses, and might even bring contacts that they have in the industry that can aid the business.
The Disadvantage of Share Capital.
The limitation of share capital is that bringing in that finance and bringing in the expertise remains to relinquish some of the organization’s control.
Some shareholders may not want to be involved in the organization’s direction and a happy just to pick up a dividend. But other shareholders may expect a have some say, so they can almost direct to the organization now that they’ve got a stake in it. And now that they’ve got funds are tied up for at-risk in this organization.
It can lead to the original shareholders in the organization having to relinquish some of the power of the control they have to involve and look after these new shareholders’ needs.
Another source of finance is to seek loans from financial institutions like banks and building societies. If it’s for the property, this could be in the form of a mortgage that is alone just to secure office space, factories, warehouses, and sites the business’s needs.
Or it could just be a bank loan to invest in our IT or vehicle machinery, whatever assets that business is looking to procure.
Advantage of Bank Loan
Bank loans are advantageous because you can raise significant sums of money from bank loans. A formal agreement with the organization was structured repayments that the business could plan for that the business can include despite its cash flow forecasts.
The business can really plan years into the future how much they’re going to have to repay on this bank loan, and they can monitor it and manage it.
The Disadvantage of a Bank Loan
The limitation of bank loans is obviously that they have to be repaid back with interest. If you borrow $100,000 to invest in your business in the former bank loan, you will end up paying that $100,000 back, plus an agreed rate of interest on top. It can be an expensive way of raising finance for your organization.
However, you contrast it to something like share capital on a bank loan means that you don’t have to relinquish any of the control of your organization paying interest, could be preferable to you rather than involving new owners in the organization and you contrast it with something like retained profit on a bank loan means that all of your profit than can be distributed to the shareholders to keep them sweet so it can a preferable source of finance.
The final source of finance we could bring through attention is venture capital. This has crossovers with both bank loans and shares capital here because venture capital can come in two forms.
Venture capital means involving other entrepreneurs, wealthy individuals, sometimes we call them business angels and inviting them to invest in your organization.
Business angels might want to invest in that business in return for a share of that organization’s ownership. It works just like selling share capital in the business on business.
Angels will absolutely, rather than be silent partners, want to be involved in our organization, bring us their knowledge, bring us their expertise, bring this their industry contacts.
Advantages of Using Venture Capital
One of the advantages of using venture capital to raise finances if they take a stake in the organization will bring a lot of expertise that your business can utilize.
There are instances where we might use venture capital and money from rich, wealthy, successful entrepreneurs that don’t actually involve selling a stake in the organization.
Rather than taking loans from banks, we might find wealthy individuals or venture capital organizations that are prepared to invest in our business. Sometimes, businesses use venture capital loans when banks might have rejected them; they might have been turned down for bank loans, especially if they’re new organizations.
But they might be able to find venture capitalists that maybe are prepared to take a higher risk in investing in a new business that a bank is prepared to take. Lend the organization money again.
That loan from the venture capitals will come with expertise and advice and support, and industry contacts.
Disadvantages of Using Venture Capital
Borrowing from venture capitalists often involves repayments at a higher rate of interest to compensate because you’re perhaps a more of a risky organization to loan money to.
Venture capital is great in that you are borrowing money when you’ve been turned down from a bank, or it’s great that they might be buying a stake in your organization. They can bring expertise and advice and support knowledge, but you’re either going to have to pay them a dividend and involve them in the organization’s ownership.
Or if it’s just a venture capital loan, the repayment rates may be higher than bank loans.