Sources of Business Finance (VCE SSCE Business Management): Revision Notes
Sources of Business Finance
Finance is essential for business success. It refers to the management of money belonging to a person, group, or organisation. All businesses require finance across different areas of operation.
Why businesses need finance
Businesses require finance for three main purposes:
Three Key Areas Requiring Finance:
Establishment costs cover the initial setup expenses when starting a business, including:
- Legal expenses
- Feasibility studies
- Business registration
Operating costs provide resources for day-to-day business activities:
- Renting or purchasing premises
- Setting up facilities
- Paying and training staff
- Providing essential capital resources
Capital resources are long-term assets needed for business operations:
- Buildings or factories
- Motor vehicles
- Machinery and equipment
- Tools
- Inventory (stock)
Factors to consider when choosing a source of finance
Businesses face many funding options, and selecting the most suitable can be complex and time-consuming. Four key factors should guide this decision.
RCCT Framework for Finance Decisions:
When choosing a source of finance, always consider these four critical factors:
- Risk - What are the consequences if we can't meet commitments?
- Cost - How do we minimize costs while maximizing profit opportunities?
- Control - Will this dilute our ownership or decision-making power?
- Time - Do we need long-term or short-term borrowing?
Risk
Risk refers to the potential consequences if a business cannot meet its financial commitments. When choosing finance, businesses must assess what happens if they default on payments or cannot repay borrowed funds. The goal is to minimize financing-related risk while still obtaining necessary funds.
For example, if a business uses its property as security for a loan and cannot make repayments, it risks losing that property. Different finance sources carry different levels of risk.
Cost
Every source of finance has both benefits and costs. The primary aim is to minimize the cost of finance while maximizing opportunities to create profit. This requires careful analysis of:
- Interest rates or fees charged
- Repayment terms and periods
- Future business growth projections
- Expected cash flows
- The business's ability to maintain repayments
A cost/benefit analysis helps compare different options and make informed decisions. Remember that the cheapest option isn't always the best choice - other factors like flexibility and timing also matter.
Control
Some financing methods can dilute ownership and reduce control over business decisions. Understanding how finance affects control is crucial:
Finance that maintains control:
- Loans with agreed repayment periods don't affect business control
- Once repaid, the business owner retains full decision-making power
Finance that may reduce control:
- Raising funds from investors typically means sharing ownership
- Offering shares through stock market activity brings new shareholders who gain voting rights
- These shareholders can influence business decisions and strategic direction
Business owners must decide whether maintaining complete control is more important than accessing certain types of finance.
Long-term versus short-term borrowing
Businesses must match the finance duration to their needs:
Long-term borrowing suits purchases that will become permanent parts of operations:
- Bank loans
- Hire purchase agreements
- Finance for equipment, buildings, or vehicles
- Typically repaid over several years
Short-term finance works for temporary needs:
- Covering unexpected expenses
- Managing cash flow fluctuations
- Taking advantage of sudden opportunities
- Usually repaid within months rather than years
- Generally carries less risk for both business and lender
Sources of business finance
Bootstrapping
Bootstrapping means financing a business without borrowing significant cash or taking on investors. The term comes from the metaphor "pulling yourself up by your own bootstraps." This approach allows entrepreneurs to retain full ownership and control.
Bootstrapping involves three main strategies:
Keeping costs down:
- Operating from a garage or spare room (where legally permitted) rather than renting commercial space
- Taking on multiple roles (multiskilling) - the owner handles cleaning, phones, and paperwork
- Minimizing overhead expenses wherever possible
Maintaining good cash flow:
- Avoiding large payments before revenue arrives
- Carefully timing expenses with income
Growing using revenue:
- Taking advantage of interest-free periods on credit cards for supplies
- Restricting credit offered to customers
- Selling directly to cash-on-delivery customers rather than distributors requiring credit terms
- Requiring cash advances or deposits from customers before work begins
- Leasing or hiring equipment rather than purchasing with cash
The Three Pillars of Bootstrapping:
Remember: "Keep Low, Flow Good, Grow"
- Keep costs low wherever possible
- Maintain good cash flow by timing payments carefully
- Grow using revenue rather than external funding
This approach reduces dependence on loans and investors, but requires careful financial management and may limit growth speed.
Owners' equity
Many business owners invest personal savings into their new ventures. This approach offers significant advantages:
Advantages:
- Owners retain full ownership and control
- No interest payments or repayment schedules
- Often the easiest and most cost-effective way to begin
Disadvantages:
- Establishment and operating costs are typically high
- Few owners have sufficient personal equity
- Other financing options become necessary when personal funds run out
Using personal savings works best when combined with other finance sources as the business grows.
Family or friends
Borrowing from family or friends can provide flexible financing, but requires careful handling.
Advantages:
- Arrangements are often flexible
- Money may be lent interest-free
- Longer repayment periods can be negotiated
- Less formal application processes than banks
Disadvantages:
- Misunderstandings about the financial arrangement can damage personal relationships
- Unclear expectations may cause conflicts
- Family dynamics can complicate business decisions
Protecting Relationships and Business:
To minimize risks, consider establishing a formal debt finance arrangement through a solicitor. This legal documentation establishes clear expectations, repayment terms, and consequences if problems arise, protecting both the relationship and the business.
Private investors and business angels
A business angel is an individual who provides capital to a small business startup, generally in return for ownership equity or convertible debt. Business angels invest in new or expanding businesses and typically become directly involved in the business or act as mentors.
What business angels provide:
- Development capital for growth
- Business skills and expertise
- Industry contacts and networks
- Strategic guidance
Business angels can be individuals or businesses interested in risk capital - so called because when they invest, they take on part of the risk of growing a new business.
Advantages:
- Investment decisions made fairly quickly
- Brings expertise along with capital
- Flexible terms compared to traditional finance
Disadvantages:
- Requires sharing ownership and potentially control
- Angel has influence over business direction
The Angel Investment Network (AIN) maintains an investor register that matches businesses with suitable private investors.
Venture capitalists
Venture capital is money given to startups and small businesses with perceived growth potential. Large corporations supply venture capital, investing substantial sums in businesses they believe will achieve high growth and large profits.
Key characteristics:
- Typically involves large investment amounts
- Targets high-growth potential businesses
- Venture capitalists take an active role in company performance
- Provides guidance and valuable industry connections
Advantages:
- Access to significant capital
- Professional business guidance
- Industry connections and expertise
- Credibility that comes with VC backing
Disadvantages:
- Venture capitalists actively influence strategic direction
- May result in loss of autonomy and control
- Pressure to achieve rapid growth
- Investors expect significant returns
Crowdfunding
Crowdfunding is a method of gathering finance through donations from the public for a one-off project. It's typically used by artists and entrepreneurs.
How crowdfunding works:
- The campaign idea or business idea is posted on a crowdfunding website (such as Pozible)
- Details about the project and its budget are provided
- A monetary goal and time frame are set
- Individuals interested in supporting the campaign (called "backers") donate money
- Contributors usually pay their pledged amount only if the campaign reaches its target
Advantages:
- Gains a customer base committed to the product
- Provides opportunity to interact directly with customers and gain feedback
- Generates free word-of-mouth marketing
- Tests market interest before full launch
Disadvantages:
- Requires time and effort to campaign and present the product
- Need to provide incentives and rewards to backers
- Must compete with other businesses seeking crowdfunding
- No guarantee the funding goal will be reached
- If target isn't met, may receive no funding at all
Worked Example: Maya Newell's Crowdfunding Strategy
Maya Newell demonstrates how to build successful crowdfunding campaigns through strategic preparation:
Step 1: Start Small
- Launched initial campaign for $10,000 to create a short film
- Used this to understand her audience and test the platform
Step 2: Learn and Refine
- Studied what worked and what didn't
- Built relationships with backers
- Refined her approach based on feedback
Step 3: Scale Up
- Second campaign targeted $100,000 for a full-length documentary
- Campaign succeeded due to engaged audience built in Step 1
Key Lesson: Starting small helps build an engaged audience before attempting larger funding targets.
Crowd-sourced funding (CSF)
Crowd-sourced funding was introduced in Australia in 2017 and is regulated by the Australian Securities and Investments Commission (ASIC). CSF is a financial service where eligible startups, small and medium-sized businesses raise funds from the public to start or grow their business or pay off debts.
CSF Eligibility Requirements:
- Must be a private company
- Less than $25 million in assets
- Less than $25 million in annual revenue
Investment Limits:
- Businesses can raise up to $5 million per year using CSF
- Individual investors can contribute up to $10,000 per annum
- In exchange, investors receive business shares
Key difference from crowdfunding:
- CSF offers equity (ownership shares) in return for investment
- Crowdfunding typically offers rewards or products rather than ownership
Worked Example: Zero Co's Record-Breaking CSF Campaign
Zero Co, an eco-startup reducing plastic waste, demonstrates the power of CSF:
The Business Model:
- Offers single-use plastic-free body care and cleaning products
- Uses refillable containers made from recycled plastic
- Addresses growing environmental concerns
The CSF Success:
- Raised $5 million in just 6 hours and 27 minutes
- Set an Australian CSF record
- Demonstrated strong market demand for sustainable products
The Impact: By 2021, Australian investors had contributed $71 million to crowd-sourced funding, with over 150 companies using CSF and attracting 68,000 investors. The most popular sectors have been financial services and food and beverage.
Suppliers (trade credit)
Trade credit is the credit extended by suppliers that allows businesses to delay payment for goods. For many businesses, this is essential for financing growth.
How trade credit works:
- Suppliers deliver goods or materials to the business
- Business receives and uses the goods immediately
- Payment is delayed for an agreed period
- Often offered interest-free for up to 90 days
Requirements:
- Suppliers typically offer trade credit only to businesses with established, reliable relationships
- Consistent payment history builds trust and may improve terms
Benefits:
- Helps manage cash flow
- No interest costs if paid within agreed terms
- Allows business to generate revenue from goods before paying for them
Stock market (initial public offering)
An initial public offering (IPO), also known as floating on the stock market, involves publicly offering shares to raise capital. This strategy may be followed by a business needing funds to support expansion or by a privately owned business that wishes its shares to be traded on the stock market.
Key characteristics:
- Shares are offered to the general public through a stock exchange
- Raises potentially large amounts of capital
- Business becomes publicly traded
Advantages:
- Access to substantial capital
- Increased business profile and credibility
- Shares become liquid assets (easily bought and sold)
Disadvantages:
- Expensive and complex process
- Extensive legal and regulatory requirements
- Risk of not raising the needed funds
- Ongoing disclosure and reporting obligations
- Loss of privacy regarding business operations
- Original owners' control becomes diluted
This option suits established businesses with strong growth potential rather than startups.
Sources of finance from financial institutions
Financial institutions such as banks, building societies and credit unions provide financial solutions for both short and long-term purposes. Businesses take out various loan types to fit their situations.
Types of products available:
- Business loans
- Lines of credit
- Overdraft facilities
- Invoice financing
- Equipment leases
- Asset financing
Loan characteristics vary:
- Amount borrowed
- Repayment period
- Interest rate
- Interest rate type (fixed or variable)
- Security required
- Fees and charges
Overdrafts:
An overdraft is a bank's authorization that allows a customer to withdraw cash exceeding their account balance, creating a negative balance up to a certain limit.
Requirements for overdraft:
- Business must provide security (such as stock or buildings)
- Favorable credit assessment showing business viability
- Agreement on overdraft limit
How overdrafts work:
- Functions like a loan but with more flexibility
- Should only be used to help cash flow
- Provides working capital before receiving customer payments
- Business pays higher interest rates compared to other finance forms
- Best suited for short-term borrowing needs
When to Use Overdrafts:
Appropriate uses:
- Covering temporary cash shortages
- Managing timing differences between expenses and revenue
- Emergency situations
Inappropriate uses (avoid these):
- Long-term financing needs
- Regular operational expenses
- Large equipment purchases
Loans tend to be more suitable for long-term borrowing needs due to lower interest rates and structured repayment plans.
Australia's major banks (ANZ, Commonwealth Bank of Australia, National Bank of Australia, and Westpac) offer comprehensive business banking services including loans and finance, cash flow solutions, equipment and car finance, and business accounts and cards.
Finance companies
Finance companies are direct lenders, similar to banks. Credit managers or analysts review loan applications and decide whether to approve them.
Key characteristics:
- Accept higher levels of risk than banks
- Charge higher interest rates as a result
- Often offer finance products through retailers
- Provide alternative options when bank financing isn't available
Examples of finance companies:
- Zurich Financial Services
- Capital Finance
- Latitude Financial Services
Finance companies fill a gap in the market by serving businesses that may not qualify for traditional bank loans, though at higher costs.
Commercial hire purchase
Under a hire-purchase contract, a business pays an initial deposit for goods such as machinery or vehicles, then uses those goods while paying off the remainder of the purchase price in installments plus interest.
How hire purchase works:
- Business pays an initial deposit
- Business receives and uses the goods immediately
- Regular installments are paid over an agreed period
- Interest is charged on the outstanding balance
- After the final installment, the business owns the goods
Key features:
- Goods may be repossessed if installments aren't paid
- Regular installments may be reduced if the final installment is much larger (called a "balloon payment")
- Ownership transfers to the purchaser only after all payments are made
Advantages:
- Business can generate revenue using the goods before fully paying for them
- Helps manage cash flow
- Fixed repayment schedule aids budgeting
- No need for large upfront capital
Disadvantages:
- Total cost is higher than purchasing outright due to interest
- Risk of losing goods if payments cannot be maintained
- Business doesn't own goods until final payment
Business support services
Successful businesses typically utilize available support services more than those that fail. Business operators should be aware of support services available and know how to access them.
Informal support services
Previous owners
When purchasing an existing business, negotiating a transition period is wise. This is a period where new owners operate the business alongside former owners before final handover occurs.
What previous owners can provide:
- Demonstration of established systems and procedures
- Information about clients, their tastes and buying habits
- Guidance on appropriate suppliers
- Advice on potential sources of support
- Insights into challenges and opportunities
- Introduction to key contacts and relationships
Previous owners represent valuable sources of information and assistance, helping smooth the transition to new ownership.
Networks
A network is an interconnected system of people or businesses. Networks can be informal friendship groups or more formalized groupings such as service clubs like Rotary. Networks may form among business operators with something in common, such as operating in the same geographic area or within the same industry.
What networks facilitate:
- Exchange of ideas, advice and support between like-minded individuals
- Personal satisfaction from meeting others looking to improve their business
- Establishment of connections with local businesses and community
- Contact with owners of complementary businesses
- Opportunities to address shared concerns together, potentially with greater influence
Benefits of networking with competitors:
- Identifying shared concerns that can be addressed collectively
- "Keeping an eye on the competition" to identify gaps in the market
- Understanding industry trends and challenges
- Benchmarking business practices
- Potential collaboration on common issues
Networks provide both practical business benefits and personal support for business owners.
Professional support services
Business operators should expect to pay for professional advice from specialist support services. These advisors assist with decision-making on legal matters, financial issues, and daily operational activities.
Legal support services
Many businesses require lawyer services to negotiate on their behalf, give advice and provide representation on legal issues. In general, ignorance is not accepted as an excuse for breaking any law, so business owners must ensure they follow specialist legal advice.
When lawyer services are crucial:
Business establishment and purchase:
- Advice on purchasing or establishing the business
- Acting on behalf of business owners during the purchase process
- Selection and establishment of the best legal ownership structure
- Franchise agreement review and negotiation
Legal documentation:
- Preparing contracts required for sale and purchase of business
- Drafting partnership agreements
- Creating employment contracts
- Preparing terms and conditions for customers
Intellectual property:
- Securing trademarks and patents
- Protecting copyrights
- Licensing agreements
Legislation compliance:
- Interpretation of legislation and its effects on the business
- Local government by-laws
- WorkCover requirements
- Employment law obligations
- Consumer protection law
- Company law compliance
Business changes:
- Dealing with takeovers and acquisitions
- Selling the business
- Restructuring ownership
A contract is a legally binding agreement that incorporates offer, acceptance, and the intention to enter into legal relations. Professional legal advice ensures contracts protect the business's interests.
Financial support services
A successful business needs an accountant to provide initial financial assistance during the establishment phase, as well as regular and ongoing services throughout the business's life.
When accountant expertise is required:
Business valuation and setup:
- Giving accurate valuation of a business intended for purchase, including goodwill
- Establishing a financial recording system
- Recommending appropriate computer software
Ongoing financial management:
- Preparing quarterly financial statements
- Creating monthly cash flow summaries
- Developing and monitoring budgets
- Auditing financial records
Taxation:
- Preparing tax returns
- Tax planning and advice
- Ensuring compliance with tax obligations
- Liaison with the Australian Taxation Office (ATO)
Important Qualifications to Verify:
- Accountant must be a qualified tax agent to deal with taxation matters
- Australian Financial Services Licence required to give financial advice
- Check memberships with professional bodies like CPA Australia or Chartered Accountants Australia and New Zealand
Bank managers provide another valuable source of financial advice and assistance:
- Processing loans
- Supervising business bank accounts
- Advising on feasibility of business expansion
- Providing investment advice
- Acting as a source of finance
- Providing EFTPOS facilities
Good record-keeping processes reduce the work required by an accountant, helping minimize costs.
Technology support services
Given the complexity and expertise required in information technology (IT), businesses often seek external IT support services. This frees time for owners and employees to focus on other business areas.
What IT support services provide:
System management:
- Installing computer systems and infrastructure
- Maintaining systems for smooth, continuous operations
- Regular updates and upgrades
- Technical troubleshooting and problem-solving
Security:
- Protecting computer infrastructure from cyber threats
- Installing and updating security programs
- Monitoring for security breaches
- Protecting sensitive data
- Preventing erosion of stakeholder confidence
Specific IT services offered:
- Business internet setup and management
- Cloud service implementation
- Network security
- Business email systems
- Software development
- Customer relationship management software
- Location-based tools
Why IT services are valuable:
- Business efficiency is not compromised
- Operations continue without interruption
- Professional expertise ensures systems work properly
- Reduces risk of costly downtime
- Protects against data breaches
Worked Example: Bunnings Cyber Security Incident
This case illustrates the critical importance of IT security measures:
The Incident:
- December 2021: Approximately 3.7 million Bunnings customers affected
- Customers using contactless pickup services had their names and email addresses compromised
- Third-party booking provider Flexbooker experienced a cyber security attack
The Consequences:
- Incident referred to the Office of Australian Information Commission
- Customer trust potentially damaged
- Highlighted vulnerability in third-party service providers
Key Lesson: Robust IT security measures are essential not just for your own systems, but also for vetting and monitoring third-party service providers who handle customer data.
Remember!
Key Points to Remember:
Finance is critical for business success - needed for establishment costs, operating expenses, and capital resources.
Four key factors guide finance choices (RCCT):
- Risk - potential consequences if unable to meet commitments
- Cost - minimizing expenses while maximizing profit opportunities
- Control - whether ownership becomes diluted
- Time - long-term versus short-term borrowing
Many finance sources exist - from bootstrapping and personal savings to external investors, crowdfunding, institutional loans, and stock market offerings. Each has different advantages, disadvantages, costs, and impacts on control.
Support services improve success rates - both informal support (previous owners, networks) and professional services (legal, financial, technology) help businesses navigate challenges and make informed decisions.
Match finance to purpose - use short-term finance (like overdrafts or trade credit) for temporary cash flow needs, and long-term finance (like bank loans or hire purchase) for permanent assets like equipment or buildings.
Key Terms to Remember:
- Finance: Management of money belonging to a person, group, or organisation
- Bootstrapping: Self-funding approach keeping costs low and using revenue for growth
- Business angel: Individual providing startup capital plus mentorship
- Venture capital: Large investments in high-growth potential businesses
- Crowdfunding: Public donations for specific projects without equity exchange
- Crowd-sourced funding (CSF): ASIC-regulated equity fundraising (up to $5 million annually)
- IPO: Floating shares on the stock market to raise capital
- Overdraft: Bank authorization to withdraw beyond account balance (short-term only)
- Trade credit: Supplier credit allowing delayed payment (often 90 days interest-free)
- Hire purchase: Deposit plus installments while using goods; ownership transfers after final payment
- Specialist support services: Professional advisors including lawyers, accountants, and IT experts