There are different sources of money that a new business can use. You need to know what these are, and you also need to know some of the advantages and disadvantages of each type.
Why do businesses need finance?
- Start up capital (money needed to set up a business)
- To compensate for poor initial cash flow
- To compensate for customers who delay payments to the business
- Help with day to day running costs if the business is struggling
- In order to expand a\ business may need additional finance to do this
Short-term sources of finance
- Trade credit – this is where a business gets certain items on credit from its suppliers for a period of time, often up to 90 days. Advantage – the business has time to earn the money to pay for its debt. Disadvantage – the business may be charged more for getting products on credit, it might be difficult to get trade credit if you are a new business as you have no track record of successful trading.
- Overdraft – this is short term lending of smaller amounts of money. The firm’s bank is effectively lending the firm money that the fiirm doesn’t have in order to tide it over in the short-term. Advantages – flexible (can be used for just one day), interest is only paid on the amount of the overdraft used. Disadvantages – very high interest rates are charged, the bank can demand repayment at any time.
Long-term sources of finance
- Personal savings – the owner of the business can use their own personal money to help finance the business. Advantages – easy access to the money, no paperwork to complete, no interest rate to pay. Disadvantages – the owner cannot spend this money on anything else such as a new car or a holiday. This is called OPPORTUNITY COST.
- Venture capital – venture capitalists are people who will invest in high risk start ups (think: Dragons’ Den). Advantages – they have knowledge, skills and contacts which may help the business succeed. Disadvantage – in return for their investment the owner may have to relinquish some control of the business to the venture capitalists.
- Share capital – the owner of the business can issue shares to raise revenue. Advantages – the business has the money permanently (the owner of the shares has to sell them if they want rid) and there is no need to pay a dividend in a bad year. Disadvantages – ownership of the business might be dilted if too many shares are issued, and if the business becomes a Public Limited Comapny then the company can become vulnerable to takeover.
- Loans – are where the bank lends money to the business over a longer period of time. Interest has to be paid on top of the loan amount. Sometimes the lender will require security such as a house or business premises. Advantages – can help with business costs, relatively quick to arrange, can be taken out over a number of years thus spreading the cost and keeping monthly repayments at a manageable level. Disadvantages – if the loan repayments are too high this will increase fixed costs and make the break-even point more difficult to reach, if the business has a bad month the repayment will still have to be made.
- Retained profits – after trading for 12 months the business may be able to use some profit as a source of finance. Advantages – no interest to pay and easy to arrange. Disadvantages – the profit cannot therefore be used for other expenditure (opportunity cost), and it is not applicable in the first 12 months anyway.
- Crowdfunding – is when people contribute towards a new business idea (often online), it’s often used for creative and innovative business ideas. Advantages – can act as an advert for the business, might be the only option available for some firms. Disadvantages – might not raise enough money, might alert competitors to your activities.
Now that you’re familiar with sources of finance, have a go at these tasks to test yourself.