Sources of Finance (Cambridge International AS Accounting)
Spec point — sources of finance and methods of funding for these types of business entity including: – loans (secured and unsecured) – bank overdrafts – payment by instalments – rental/leasing as an alternative to purchase – trade credit – sources of finance for limited companies as in 1.5.4
Sources of finance
What are short-term sources of finance?
-
The main sources of short-term finance are:
- bank overdrafts
- trade credit
- short-term loans
Bank overdrafts
- A bank overdraft is where the bank allows a business to use more money than they have available in their bank account
| Advantages | Disadvantages |
|---|---|
| - Interest is only charged when the customer uses their overdraft - The overdraft is flexible and is available when needed - The funds are available immediately | - Interest rates for overdrafts can be high - The business can become reliant on an overdraft - The amount available in the overdraft is not usually high |
Trade credit
- Trade credit is where the business purchases goods and assets but pays at a later date
| Advantages | Disadvantages |
|---|---|
| - This improves working capital as cash is kept in the business for longer - It is quick to arrange - It is usually interest-free if paid on time - It builds relationships with suppliers | - There are penalties and interest for late payment - Late payments can damage relationships with suppliers |
Short-term loans
-
A short-term loan is an amount of money that is borrowed by a business from a lender or bank and repaid within a year
- These are also known as working capital loans
| Advantages | Disadvantages |
|---|---|
| - These give quick access to cash - Improves working capital - Able to budget the repayments as they are regular, fixed amounts | - The business has to pay interest on the loan - The amount has to be repaid within a short time frame, such as a year |
What are long-term sources of finance?
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The main sources of long-term finance are:
- Bank loan
- Leasing
- Hire purchase
- Owner's or partner's capital
- Introducing a new partner
- Issue of shares
- Debentures
Bank loans
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A bank loan is an amount of money that is borrowed by a business from the bank and repaid over several years
-
A bank loan is secured or unsecured
- Secured means that the bank could seize ownership of assets if the loan is not repaid
| Advantages | Disadvantages |
|---|---|
| - Large amounts of cash are available to borrow - Able to budget the repayments as they are regular, fixed amounts - The owner(s) do not lose control of the business - Spreads the cost of an asset over several years | - The business has to pay interest on the loan - The amount has to be repaid regardless of whether the business makes a profit or loss - The business may be required to offer an asset as security for the loan - There might be penalties for early repayments |
Leasing
-
Leasing is where a business rents an asset from a company
- They do not own the asset
| Advantages | Disadvantages |
|---|---|
| - No large upfront costs - Able to budget the payments as they are regular, fixed amounts - Access to expensive assets which the business might otherwise be unable to afford - Maintenance of the asset is usually included in the lease agreement | - The business does not own the asset - It can cost more to lease an asset than to buy |
Hire purchase
-
A hire purchase is where a business pays a deposit for an asset and then pays the rest of the value in instalments
- They do not own the asset until it is fully paid off
| Advantages | Disadvantages |
|---|---|
| - It spreads the cost of the asset over several years - The business owns the asset at the end of the hire purchase - Able to budget the payments as they are regular, fixed amounts | - It is more expensive than buying the asset outright - Instalments must be repaid regardless of the position of the business - A deposit is required - The asset can be repossessed if payments are missed |
Owner's or partner's capital
-
The owner or a partner can introduce more of their own money as capital to the business
- This is only available to sole traders and partnerships
| Advantages | Disadvantages |
|---|---|
| - The business does not need to pay interest - The business does not need to repay the amount - Avoids borrowing from external parties | - The owner or partner can lose the money if the business goes bust - The owner or partner might not have large sums of money available to invest |
Introducing a new partner
-
A new partner can be introduced with their capital
- A partnership can introduce a new partner
- Or a sole trader can form a partnership
| Advantages | Disadvantages |
|---|---|
| - The business does not need to pay interest - The business does not need to repay the amount - Avoids borrowing from external parties - New skills are introduced to the business | - Profits are shared - Control of the business is diluted - There is potential for conflict between the partners - It feels more permanent as it is difficult to remove a partner |
Issue of shares
- A limited company can issue shares to raise funds
| Advantages | Disadvantages |
|---|---|
| - Large amounts can be raised - The business does not need to pay interest - The business does not need to repay the amount - Avoids borrowing from external parties | - Control of the business might be diluted - It can be expensive to sell shares - Dividends might have to be paid |
Debentures
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A limited company can issue debentures to investors upon the loan of money
- The amount is paid in full at an agreed date in the future
- Interest is added to the amount owed each year
| Advantages | Disadvantages |
|---|---|
| - Large amounts can be raised - There is no loss of control - Interest can be budgeted as it is predictable | - Interest must be paid regardless of profits - The amount must be repaid in the future - Security might be required |
Exam Hint This topic is normally tested on the multiple-choice question paper. However, there are some questions on Paper 2 that require you to compare two or more different sources of finance.
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