Question

Businesses may choose to finance their operations with external or internal sources. a. Briefly describe each of the main sources and give examples. b. What factors should be taken into account when determining the balance between short-term and long-term debt finance? c. How lenders can gain further protection for their loan?

Answer 1

whether you're starting up or looking to grow your business, you won't get very far unless there's cash available. Finance, in the form of personal savings, loans and overdrafts, is essential for the purchase of labor and materials, to meet your operating expenses and to finance expansions. Businesses acquire long-term financing from two major sources. External finance comes from banks and other sources outside the company while internal finance is the cash you generate from inside the business.

External Versus Internal Sources of Finance

Businesses are faced with a seemingly endless list of options when it comes to financing their startup or growth ambitions – bank loans, overdrafts, angel investing, loans from family members, personal savings and shares issues to name just a few. All these sources fall into one of two categories: external or internal sources of finance. External sources of finance comprise the funds you raise from outside the company. Bank loans, overdrafts, credit cards and share issues are examples of external sources of finance. Internal finance is the cash you generate from inside the organization. The obvious example is cash from sales, but it also includes the owner's investment, the sale of assets and collecting on the company's debts.

There are many sources. Some of them given below..

Owner's Investment

Most entrepreneurs will invest at least some of their savings to get a business idea off the ground. In fact, it may be the only financing option for an early-stage business that does not yet have the credit history or revenues to support a loan application. The advantage of an owner's investment is that it's cheap money. Where the business is incorporated, the company will issue shares in return for the owner's cash. This benefits both parties: the company does not have to repay the investment, and the owner retains control over the business as the majority shareholder. Owner financing is not usually enough to get a business off the ground, but it is a good start.

Retained Profits

Of all the internal finance examples, perhaps the most obvious is the company's profits. When you're making more money than you need to cover your operating expenses, you have the option of ring-fencing the excess and investing it back into the company. The beauty of retained-profit financing is the money is already yours, so you don't have to worry about debt obligations. However, it may be several years before you generate enough profit to cover major capital investments.

Discounted Selling

Retail businesses have the option of selling unsold inventory to raise much-needed finance. For example, you might sell a surplus of last season's fashions at a reduced price to raise cash very quickly – this also saves on storage costs. The thing to watch out for here is pricing: price too low and you risk losing profits from lower margins. Asset sales are another sales-related source of finance. Companies can raise money by selling the machinery or vehicles they no longer need. The market is much smaller for used business assets, however, and it may take some time to find a buyer.

Debt Collection

If you have customers who do not pay on time (or at all), then collecting these debts is a relatively easy way to reduce the cash cycle and tap into existing sources of internal funds. Invoice factoring is a specialist finance service that pays you 80 percent of the invoice value upfront and collects the invoices for you. You get the balance of the invoice, less the factoring company's fees when the customer pays. Invoice factoring is an internal source of finance since it's not a loan – you're merely selling the invoices of the business. It's not a long-term solution, but for businesses with temporary cash flow problems, invoice factoring can help you raise money from the work you have completed much faster than waiting for a customer to pay on 30-or 60-day terms.

2) Long term versus short term borrowing

When sourcing finance, we also need to consider whether we should obtain long term or short term funding. In many cases, it may be appropriate to match the type of funding to the nature of the asset.

If we are obtaining a noncurrent asset, for example, a piece of machinery that will form a permanent part of our operating base, then we would consider using a long term source of finance to fund this asset.

Long term finance will be repaid over a longer period and include bank loans, hire purchase, debentures and retained profits for example.

On the other hand, if we were obtaining an asset that was more flexible in nature and could be paid at short notice, such as an asset obtained to meet seasonal demand or money to cover the day-to-day operations of our business, then we would finance this using a short term source of finance.

This kind of finance is intended to be paid back in a matter of months rather than years. As a result, there is less risk involved for the lender. Overdrafts and supplier credit would be an example of short term finance.

However, it can be difficult to make this distinction at times, due to the difficulty in predicting the life of an asset.

Flexibility will also have an important bearing when choosing an appropriate source of funding. If interest rates are high but are forecasted to lower in the future, we may choose a short-term source of funding to delay a commitment to long-term sources until a future debt.

Short-term financing can often appeal more as they often come with no additional penalty for early payment, which is not the case with some sources of long-term finance.

Despite lower interest rates and no penalty for earlier repayment of short-term funding, it does come with disadvantages. These can become apparent with refunding risks. Short term finances will have to be reviewed more regularly than their long-term counterpart and as a result, can prove a problem if our business is in financial difficulty or there is a shortage of funding available. As a result, long-term funding may be more desirable.

As a result, long-term funding may be more desirable.

Finally, interest rates will play a fundamental role when we are deciding our financing options. Due to the increased risks associated with long-term borrowing, lenders will require extra as compensation for this increased risk as their funds are tied up longer. This will be reflected in higher interest rates.

Lenders often require additional security to safeguard against you defaulting on a loan. For example, if you obtain a mortgage you are using your house as security so if you don’t repay the loan amount, your property may be repossessed by the lender and sold to recoup the money owed.

While this may make short-term funding more desirable, it is critical to consider the other costs as short-term financing will need to be reviewed more regularly thereby increasing costs.