Sources of Finance (Junior Cert Business Studies): Revision Notes
Sources of Finance
Understanding how businesses raise money is crucial for any enterprise. Companies need funding for different purposes and time periods, and choosing the right source of finance can make the difference between business success and failure.
What influences the choice of finance source?
When businesses need money, they cannot simply pick any source of finance. Several important factors shape their decision:
- Purpose of the funds - Companies must clearly identify why they need the money. Are they starting up, purchasing equipment, expanding operations, or managing daily expenses? Different purposes often require different financing approaches.
- Cost considerations - Businesses should carefully evaluate how much it will cost to access the money. This includes interest rates, fees, and any additional charges. Generally, lower costs benefit the business more, but the cheapest option is not always the most suitable.
- Control implications - Some financing options may require business owners to share control or ownership of their company. For instance, bringing in investors might mean giving up some decision-making power. Entrepreneurs must consider how much control they want to maintain.
- Repayment obligations - Different sources have varying repayment requirements. Some might demand quick repayment, whilst others allow longer terms. Businesses need to ensure they can meet these obligations without damaging their cash flow.
The four key factors that influence finance source selection are: Use (purpose), Cost (interest and fees), Control (ownership implications), and Repayments (terms and timing). Remember these as "UCCR" for easy recall.
Household vs business finance - similarities and differences
Both households and businesses need to manage money carefully, but there are important distinctions:
Similarities:
- Both require finance to meet their needs and obligations
- Both must make smart financial decisions and regularly review their situation
- Both need to plan ahead with budgets (household budgets vs cash flow forecasts)
- Both may need to borrow money or find ways to reduce spending when facing financial shortfalls
Key differences:
- Scale: Businesses typically handle much larger amounts of money than households
- Time investment: Companies spend considerably more time managing their finances than typical households
- Record keeping: Businesses must maintain detailed financial accounts when applying for funding
- Options available: Companies have access to a wider range of financing sources than households
While households and businesses share basic financial management principles, businesses operate at a larger scale with more complex requirements and greater financing options available to them.
Understanding timeframes for business finance
Timeframes determine how finance sources are classified. Short-term means repayment within one year, medium-term covers one to five years, and long-term extends beyond five years or may not require repayment at all.
Business financial needs fall into three main categories:
- Short-term requirements include purchasing stock, paying suppliers for raw materials, and covering wages.
- Medium-term needs involve buying delivery vehicles, IT equipment, and office furniture.
- Long-term necessities encompass acquiring premises, developing export markets, and purchasing factory machinery.
Short-term sources of finance
These funding options must be repaid within twelve months and help businesses manage immediate cash flow needs.
Bank overdraft
This facility allows companies to withdraw more money from their current account than they actually have deposited, up to an agreed limit. Banks charge interest on the overdrawn amount, and this interest rate is typically higher than other loan types.
Worked Example: Bank Overdraft
Galway Bay Seafood might arrange a €15,000 overdraft to help manage cash flow during quieter winter months when restaurant orders decrease. If they use €10,000 of this facility for two months at 8% annual interest, they would pay approximately €133 in interest charges.
Trade creditors
Companies can purchase supplies on credit and pay for them at an agreed future date, usually within 30 days. This arrangement allows businesses to use the money for other expenses or invest it to earn interest whilst they wait. However, companies miss out on any early payment discounts by using this approach.
Worked Example: Trade Creditors
Dublin Coffee Roasters might purchase coffee beans worth €5,000 in January but not pay until February. This frees up €5,000 cash for other immediate needs, such as paying wages or rent, whilst still receiving the coffee beans for their operations.
Expenses due (accruals)
Accruals are expenses that have been incurred but not yet paid, allowing businesses to use that money temporarily for other purposes.
Certain bills like electricity or tax don't require immediate payment, so companies can use this money temporarily to finance other business activities. The funds can even be deposited in a bank account to earn interest. However, businesses must ensure they have the money available when the bill becomes due - for example, electricity could be disconnected if bills remain unpaid.
Worked Example: Accruals
Cork Manufacturing Ltd might receive an electricity bill of €2,000 in March but not need to pay it until April. They can deposit this €2,000 in a savings account earning 2% annual interest for one month, earning approximately €3 in additional income while waiting to pay the bill.
Medium-term sources of finance
These financing options require repayment within one to five years and are typically used for purchasing equipment or assets.
Term loan
A term loan involves borrowing money from a financial institution over a period of one to five years. Companies repay the loan through regular instalments that include both the original amount borrowed and interest charges. The repayment schedule can be tailored to suit business needs - companies might choose weekly, fortnightly, or monthly payments and can decide on the loan duration within the one to five-year range.
Worked Example: Term Loan
Limerick Tech Solutions might take out a three-year term loan of €40,000 to purchase new computer servers. At 6% annual interest, they would pay approximately €1,216 monthly, totaling €43,776 over the three-year period (€3,776 in interest charges).
Leasing
Leasing allows businesses to rent assets like vehicles or equipment whilst never actually owning them, but having full use during the agreement period.
This arrangement lets companies lease (essentially rent) assets such as vehicles or equipment from a leasing company. Businesses pay an agreed amount over a set period for full use of the asset but never become the owner. At the agreement's end, assets can often be updated to newer models.
Leasing works well for preserving cash flow or when equipment becomes outdated quickly, as purchasing outright would be very expensive.
Worked Example: Leasing
Waterford Delivery Services might lease five delivery vans for €800 per van per month over three years. This costs €144,000 total but allows them to upgrade to newer, more efficient models every three years whilst maintaining predictable monthly costs of €4,000.
Hire purchase
Hire purchase enables businesses to use assets like equipment or vehicles immediately whilst paying for them through instalments. The key difference from leasing is that ownership transfers to the business once the final payment is made. This arrangement involves three parties: the buyer (business), the seller, and the finance company.
The finance company pays the seller for the asset upfront, then collects regular instalments from the buyer that include interest and fees. This makes hire purchase more expensive than outright purchase, but it's suitable for businesses that need assets quickly but lack the full purchase price.
Worked Example: Hire Purchase
Sligo Restaurant Equipment might hire purchase a €20,000 commercial oven at 7% annual interest over four years. They would pay approximately €479 monthly, totalling €22,992 (€2,992 in additional costs compared to outright purchase), but gain immediate use of the oven whilst spreading the cost.
Long-term sources of finance
These funding sources either require repayment over more than five years or may not need repayment at all.
Retained earnings
Retained earnings represent profits that businesses choose to reinvest back into the company rather than distribute to owners or shareholders.
This involves using company profits to finance business growth and expansion. When a business makes profit, it can choose to reinvest some or all of it back into the company rather than taking it out as personal income or dividends.
Retained earnings are considered 'free' finance because there are no repayment obligations or interest charges. However, businesses must generate sufficient profits to use this financing method effectively.
Worked Example: Retained Earnings
If Kerry Food Products made €500,000 profit in 2023, they might retain €300,000 to fund new product development whilst distributing €200,000 to shareholders. The retained €300,000 provides growth capital without any borrowing costs or repayment requirements.
Grants
Government bodies and the European Union provide grants - money that doesn't require repayment - to support business start-ups and expansion. Enterprise Ireland, for instance, invested €23 million in new Irish businesses during 2018.
Companies may need to meet specific criteria to qualify for grants, such as creating a certain number of jobs or operating in particular sectors. Local Enterprise Offices (LEOs) also provide grants to local businesses with viable business plans.
Worked Example: Grants
Donegal Wind Energy might receive a €100,000 EU grant to develop renewable energy technology. This provides growth capital without any repayment obligations, interest charges, or loss of business control, making it an extremely attractive financing option when available.
Ordinary share capital
Ordinary share capital involves raising finance by selling shares in the company, where each share represents partial ownership and voting rights.
Companies can raise money by selling shares to investors. The funds generated don't require repayment, but shareholders receive dividends (a percentage of profits) and voting rights. Each share equals one vote, so selling shares means giving up some control. To maintain control, business owners must retain at least 51% of shares.
Worked Example: Share Capital
Cork Software Solutions needs €200,000 for expansion. They might sell 40% of their shares to investors at €5 per share (40,000 shares), raising the required funds whilst keeping 60% ownership and control. The new shareholders would receive 40% of any dividends paid.
Long-term loan
These loans extend over five years or more (such as mortgages) and are repaid through instalments plus interest. Payment structures can be tailored to suit business needs and circumstances.
Before approving long-term loans, lenders typically require detailed information including the loan amount and purpose, business financial performance and cash flow forecasts, details of existing borrowings, and collateral (security) for the loan.
Worked Example: Long-term Loan
Mayo Manufacturing might secure a 10-year loan of €500,000 at 5% annual interest to purchase a new factory, providing their existing premises as collateral. Monthly payments would be approximately €5,303, totaling €636,360 over ten years.
Sale and leaseback
Sale and leaseback involves selling a valuable business asset to raise money, then leasing it back to continue using it whilst no longer owning it.
This arrangement allows companies to sell valuable assets like buildings or land to investment companies, then lease them back over time. The business releases money tied up in the asset for other purposes whilst maintaining full use of the asset. However, the company no longer owns the asset, and the new owners may increase rent over time.
Worked Example: Sale and Leaseback
Dublin Hotel Group might sell their city centre property for €2 million to fund expansion into rural areas, then lease it back at €15,000 monthly. This provides immediate capital for growth whilst allowing continued operation at the same location.
Key Points to Remember:
- Choose finance based on timeframe: Short-term (under 1 year), medium-term (1-5 years), or long-term (over 5 years)
- Consider four key factors: Use, cost, control, and repayment terms when selecting finance sources
- Retained earnings are 'free' money: Using profits avoids interest charges and repayment obligations, but requires sufficient profitability
- Ownership vs control trade-off: Sources like shares and investors provide funds without repayment but reduce business owner control
- Match finance to purpose: Use short-term sources for immediate needs, medium-term for equipment, and long-term for major investments like premises