Businesses and Economics for Students and Teachers: Where does the money come from?

Posted by Abd. Ghafar ARM

All businesses need money, or finance, in order to operate. They need finance for: start-up items such as premises, equipment and initial advertising; the ongoing running costs of the business, including raw materials, wages and salaries, administrative costs, maintaining and arising from a shortage of cash; expansion, including purchasing additional equipment, larger premises, or even financing the takeover of other businesses.

Sources of finance

Finance can be generate either from within the business (internal sources), or outside (external sources).

Internal sources of finance

1. Profits and reserves

Most businesses retain part of their profits to buy new or replacement machinery and equipment. If the amount retained is not needed immediately, it can be kept as a reserve for future use, either for expansion or in an emergency.

2. Selling assets

Many businesses have assets such as machinery, vehicles and property that they can sell. If a business needs to raise finance quickly, selling assets may be the best to do this, especially if the assets are surplus to requirements or under-utilized. Selling as asset to a finance house, and leasing it back can be a way of raising finance while retaining use of the asset.

3. Owners’ capital

Small businesses are usually set up with finance provided by the owners. The advantage of this is that there are no interests or other charges. The disadvantage is that the owners risk losing the money they put into the business.

External sources of finance

1. Short-term, medium-term and long –term finance
Short-term finance is finance that is required for up to three years; medium-term finance is required for between three and ten years; long-term finance is required for more than ten years.

2. Friends and family

Small business owners may be able to borrow from friends and families. Such loans may well be given without security or charging interest. Normally, however, the amount raised will be small and may only be suitable for short-term finance.

3. Banks

Banks provide two principal types of finance for business: overdrafts and loans.

And overdraft is an agreement whereby the business can draw on its bank account more than it has deposited. Interest charged on the amount overdrawn is usually higher than on finance from other sources, and overdrafts are only appropriate for short-term finance, for example to cover cash-flow problems.

Banks also provide loans, usually for a set period and purpose. Interest is charged on the amount of the loan. With medium- and long-term loans for larger amounts, security is often required so that if the business is unable to repay the loan the bank will be able to sell the item given as security and recover its money. When considering making a loan to a business, a bank will want to see a business plan including budgets, forecast and cast-flow forecast to ensure that the business will be able to repay the loan.

In many Muslim countries, banks are forbidden to charge interest on loans. Instead, Muslim banks may provide finance for business by providing capital in return for a share in the profits of the business.

4. Hire purchase

Hire purchase is a form of credit arranged through a manufacturer or finance house (like a bank). An item such as a vehicle or large machine is bought and paid for in installments. Each installment includes an element of interest on the purchase price. Although the business making the purchase has use of the item throughout, it does not become the property of the business until the final payment is made.

5. Trade credit

Most business purchase are made on the basis that payment will be made at a later date, usually within thirty days of purchase or by the end of the following month. This is called trade credit. If the customer has sufficient standing with the supplier, it may be possible to extend the period of credit. While this may give the purchasing business some additional finance for a short time, it is only appropriate for very short-time finance.

6. Factoring

To overcome the cash-flow problems associated with supplying goods and services on credit and not being paid until some time later, some finance houses provide a factoring service. A factoring house will pay the business up to 80% of the value of its invoices each month immediately. The supplying business therefore business receives an immediate injection of cash without waiting for customers to pay their invoices. The remaining 20%, less the factoring house’s commission, will be received when invoices are paid to the factoring house.

7. Leasing

An alternative to buying items such as property, machinery and vehicles is for a business to lease them from the supplier or a specialist leasing company. A lease is for a set period of time and while the business leasing the asset (the lessee) has full use of the asset during that time, the asset remains the property of the leasing company (the lessor). Leasing assets avoids paying large sums to purchase assets, enabling the money to be used for other purposes. The length of leases tends to make leasing appropriate as a source of medium- to long-term finance.

8. Debentures or corporate bonds

Debentures or corporate bonds are long-term fixed-period loans to the business by Individuals or financial institutions. They are secured against the business and carry a fixed rate of interest throughout the period of the debenture. The rate of interest is lower than other types of loan.

9. Venture capital

Venture capitalists are specialists in providing finance mainly for smaller businesses usually in return for a shareholding in the business. There is thus an element of risk to the person or organization providing the capital. Venture capital is long term, and may be substantial.
10. Issuing shares

A private or public limited company may raise finance by issuing additional shares, as long as the total number of shares issued is within the company’s authorized capital. In the case of a private limited company, additional shares can only be issued to the present shareholders, or new shareholders, whit the agreement of the current shareholders. Any person or organization such as a financial institution can purchase new shares in a public limited company. Public limited companies are able to obtain very large amounts of finance in this way. The principal advantage of raising finance by issuing shares is that the money raised does not have to be paid back.

11. Public sector sources of finance

Grants and subsides for business can sometimes be obtained from local and national government or other public bodies. These normally do not have to be repaid, but are usually only available in particular circumstances, and with conditions attached. For example, a government trying to attack new businesses to locate in an area of high unemployment may offer a grant in respect of every new job created.

How do businesses decide?

When seeking finance, businesses consider various criteria to ensure that the source they choose is appropriate to their needs. The main criteria businesses use are:

1. How long is the finance required? A bank overdraft may be suitable for short-term finance, but is very costly in the long term, when a loan may be more suitable.

2. What is the purpose of the finance? A small start-up business may look to finance from its owners in the first place, while an existing company wanting to ensure a regular cash flow could consider factoring.

3. How much is required? A small amount may be covered by an overdraft, while a successful business seeking large sums in order to expand, perhaps by taking over another company, may seek funding from a venture capitalist, or issue shares.

4. What risk is involved? All business activity involves some risk. However, a business taking out a loan or overdraft must pay interest. If the business is unsuccessful, the interest must still be paid and the loan repaid. The higher the risk involved, therefore, the more likely a business is to seek finance from issuing shares, venture capitalist or the owners of the business, since these sources do not bear interest or have to be repaid.

5. Is the gearing too high? The gearing of business is the ratio of long-term loans to the capital employed. If loans amount to more than about 50% of capital employed, the business is said to be highly geared. This means that the business is relying on borrowed money, and has to pay substantial interest charges. A business that is already highly geared will try to avoid taking out further loans since this will only increase gearing.

What do providers of finance consider?

Providing finance to business always involves some risk for the provider. In order to reduce the risk, banks, shareholders, other financial institutions and other providers of finance will therefore consider the following questions:

1. Will the business be able to make interest or other payments such as dividends? In deciding this, the provider of finance will consider the past financial record of the business, including the business’s accounts, and forecasts of future financial performance.

2. Is the business too highly geared? The higher the gearing, the higher the risk of providing further finance, since a higher proportion of the capital of the business is in form of loans. If the business fails, it may not be able to repay all the money it owes.

3. Is the business efficiently managed? Providers of finance will look carefully at the experience and skills of the people who direct or manage the business, te ensure that their money will be well used.

Summary

· All businesses need money, or finance.

· Short-term, medium-term or long-term finance can be obtained from internal or external sources.

· Internal sources include: profits and resources; the sale of assets and owners’ capital.

· External sources include: loans; hire purchase; trade credit; factoring; leasing; ventures capital and share issues.

· Choosing a source of finance that is inappropriate to the needs of the business can be a costly mistake.

Glossary

Finance: the money a business needs to operate.

Internal sources of finance: sources of finance within the business or provided by its present owners.

External sources of finance: sources of finance from outside the business or its present owners.

Short-term: a period of up to three years.

Medium-term: a period of between three and ten years.