Why firms need finance?
All businesses need finance. Organizations can get funds from internal sources such as the owner’s finances or profits, or external sources such as banks or investors. Firms need finance to create, run and grow. In creating a business, owners need finance to fund working capital and fixed assets including developing a new product, searching the market or buying new equipment, and in running the business to pay salaries, suppliers, rents or promotional campaigns. In growing the business, owners need capital to advertise, invest in working capital or finance expansion plans. New firms may face difficulties in raising funds because they are new, have limited or no previous financial track record, and are risky for lenders who may be concerned about a higher risk of start-up failure. Start-up owners may not fulfil any collateral requirements imposed by lenders, since many are sole traders or partnerships which are unincorporated, meaning that the owners are solely responsible for repaying of debts. If a start-up fails, the owner may not repay any borrowed money.
Short and long-term sources of financing
Short-term sources of finance must be repaid within a year, as with a loan from a bank, invoice discounting, factoring or trade credit. Short-term funding can be generated from internal or external sources. Unlike short-term finance, long-term finance can be repaid over many years, as with credit facilities, loans, leasing or selling shares in equity. Short-term financing charges lower rates of interest than long-term finance because it is repaid in a shorter period and is relatively less risky. Businesses tend to prefer short-term funding to pay salaries, suppliers or rent, while they use long-term funding to finance expansion projects or buy equipment.
Internal and external sources of financing
Internal financing comes from the operation and capital sources of a business, for example, net profit, selling an asset or the owner’s savings. In the UK, 36% of small businesses use external financing, and the rest use internal financing. The advantages of such funding are that it is easy to access, quickly obtained and cheaper to acquire. External financing comes from outside a business, in the form of money from friends, family members, loans from banks, or selling shares in equity. The advantages of such funding are that it is possible to get more significant amounts, and it improves the cash flow of the business.
A company can secure funds through issuing bonds or obtaining loans from banks or friends. The cost of a loan is the interest rate paid by the borrower to the lender, and any interest payments are considered as expenses, which can be offset against revenue in the company’s income statement. The main disadvantages of such loan financing are that it is expensive, difficult to secure or may result in management control by lenders. Loan financing includes asset-based lending, factoring, invoice discounting, leasing and other corporate financing facilities.
The company seeks equity funding when it sells shares to investors or issues common stock, and equity funds are used to finance capital initiatives, such as creation or expansion. In return for providing capital, investors demand a return on their investments (ROI). ROI can be in the form of dividends, capital appreciation or management control. The drawback of equity funding is that it dilutes the shares of any existing shareholders, so their share and voting influence is reduced. Equity financing can be obtained from family, friends, business angels, venture funds or crowdfunding.
This article is extracted from my new book- Mastering Enterprise Skills for Potential Entrepreneurs, which can be found on www.amazon.co.uk. If you want to receive more information about the book and our activities, you can register in our newsletter by using this link.
Prepared by: Munther Al Dawood
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