Evaluating the different sources of business finance.

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COLLEGE NAME  :  CITY OF LONDON COLLEGE

COURSE NAME    :  APDMS

SUBJECT NAME   :  MANAGING FINANCIAL PRICIPLES AND

                                     TECHNIQUES

TEACHER NAME :   MRS.SAFEENA ANAS

STUDENT NAME :   ARVINDKUMAR KAHAR

STUDENT ID         :   000100452

MANAGING FINANCIAL PRINCIPLE AND TECHNIQUES

TASK 1

The finance available for a business may be divided by two types-

  • Internal
  • External

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Internal sources

This is a source of finance, which comes from owner’s equity, owner personal savings or

Selling assets, business angels (owners family and friends) and owner's business activities

(Retained profits)

Advantages of internal sources of finance

  • Flexibility: Internal sources of finance usually have the advantage that they are

flexible, because this sources are might use current assets financing as well as

long term financing also it will be use for future invest proposal.

  • Immediate arrange: This sources are obtained very quickly-particularly for

working capital finance.

  • No Interest: using this sources any need to require to paying any interest.

  • No third party and cost: It could be arrange without any cost and compliance

of other parties. The business owners have power to the profits without

agreement of the shareholders.

According to McLane et al (2005) (PG-515), “Internal sources mean sources that

do not require the agreement of anyone beyond the directors and managers.”

Internal sources includes following:

Retained Profits

Retained profits are the major source of internal finance for most business.

Retained profits consider an internal source because owner has a power to retain

profit without agreement of the shareholders

Owners Equity

This is the fund provided by its owners that does not have to be repaid as long as

organisation continues as a going concern. The business owners finance in the

business by own cash as well as personal savings. It is a cheapest form of finance

since it carries no obligation to pay any interest. On the other side, equity is

expensive forms of finance because of owners are expected that dividend will be

higher than the interest rate.

Business Angels

Business angels means that family members and friends of a business owners who

are common sources of finance for a private limited company. They are most likely

to invest due to their relationship with the business owner. Family members and

friends provide a small amount of equity funding. Although, it is relatively easy to

obtain money from family members and friends without paying any interest.

Advantages and disadvantages of business angels

If the business owners finance in the business by get the money from family

members and friends, than business will be benefited because against that money

no need to pay any interest.

Sometimes family members or friends may want to get the business share also

want to get the profit of the business against their money. In these circumstances,

the relationship between business owners and business angels will be fall.

All sources of finance, there are positive and negative aspects.

External sources

Generally, external sources of finance are sources that come from outside the business.

When internal funds are no longer sufficient, small business turn to a variety of external

sources. External sources includes the increase shareholders by selling share, bank loan,

bank overdrafts, debentures, trade credits, hire purchase (HP), finance leases,

governments grants etc.

“This is finance that comes from outside the business. It involves the business

owing money to outside individuals or institutions.” (http://www.teachnet-uk.org.uk)

An external source of finance includes the following:

Overdrafts

Overdraft financing is provided when businesses make payments from their

business current account exceeding the available cash balance. An overdraft

facility enables businesses to obtain short-term funding - although in theory the

amount loaned is repayable on demand by the bank. The bank may also charge

interest as an overdraft facility fee. Interest is charged on the amount overdrawn - at

a rate that is above the Bank Base Rate.

Overdrafts are generally meant to cover short-term financing requirements that

are not generally meant to provide a permanent source of finance. Many

Businesses use an overdraft for support to working capital; helping buy stock, pay

staff, etc in order for business to function. It is ideal for business day-to-day

expenses, particularly uses in cash flow problems.

As per Watson et al (2007) (PG-70), “An overdrafts is a flexible source of

finance in that a company only uses it when the needs arises. However, an

overdrafts is technically repayable on demand, even though a bank is likely in

practice to give warning its intention to withdraw agreed overdrafts

facilities. .......

Overdrafts interests are only paid on the amount borrowed, not on the agreed drafts

limits.”

Advantages of overdrafts

  • Interest: Customer only pays interest when overdrawn amount borrowed not the

              agreed overdrafts limits.

  • Flexibility: Bank gives the flexibility to review and adjust the level of the

              overdraft facility, perhaps on a short-term basis.

  • Immediate arrange: Overdraft effectively and immediately could be used as a

              source of finance for raises working capital.

  • Financial gearing: Being part of short-term debt, the overdraft balance is not

              normally included in calculations of the business’ financial gearing.

  • Quick: Overdrafts are easy and quick to arrange, providing a good cash flow

              backup with the minimum of fuss.

Disadvantages of overdrafts

  • High interest rate: Overdrafts carry high interest rate and fees, it is too much

             higher then the bank loan.

  • Not suitable: Overdrafts is not suitable for long-term finance because an

              overdraft is likely to cost and expensive more than a bank loan.

  • Security: Using overdrafts may need to be secured against business assets,

which put them at risk if the business cannot meet repayments?

Bank Loan

Bank provides a specified amount of money to business organisation (customers)

for finance in the business as a form of loan. And that amount must needs to be

repaid with interest before fixed date.

Bank loan includes the following:

  • Specified sum of money
  • Repayments date (period of loan- short-term/long-term)
  • Rate of interest
  • Consumers instalments, overdrafts, credit cards
  • Residential mortgage
  • Security
  • Direct financing leases

According to Gallati (2003) (Pg-130), “ A 'loan' is a financial assets resulting from

the delivery of cash or other assets by a lender to a borrower in return for an

obligation to repay on a specified date or dates, or a demand, usually with

interests.”

Advantages of Bank Loan/Debt Financing

  • For raising the fund it is cheaper method than the issue of new share to the

             shareholders.

  • In inflation borrower might be beneficial because the value of interest payments

             will diminish.

  • Bank loan interests are expenses, which is assumed before corporate tax is

             assessed, while dividend is accumulated after corporate tax. In this

             circumstances, bank loan is the better than the issuing new share for the Mayor

             Plc.

  • There are no dilutions of ownership with debt/loan financing.

Disadvantages of Bank Loan/Debt Financing

Loan is one kind of contract between lender and borrower. This contract represents

that, borrower commitment to pay the lender the principle amount with interests. If

the borrower is unable or fail to make its repayments on due time, then it can face

serious consequence such as foreclosure. Foreclosure can result in the liquidation

of the business. When the business is liquidated, government agencies and other

creditors are at the front of the line when the businesses are converted into cash.

The owners of the business get the table scraps if any exist when the liquidation is

completed.

Another disadvantage is any loan charge must be paid irrespective of business

performance. And also excessive finance by loan may affect business flexibility.

Finally, Debt or loan must be repaid even when a business looses/decline the profits

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or costs rises unexpectedly.

Trade Credits

Many businesses rely on their creditors as a form of short-term finance. Because

most of the suppliers allows their customers to take somewhere between one and

three months to pay for goods supplied, the debtor company can use what is

effectively an interest free loan of up to 90 days to pay others bills. Creditors will

often give incentives in the form of cash discount if payment is made earlier, but by

delaying payment, the debtor can use money owned to finance other current assets.

According to Watson and et al ...

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