Sources of Finance (Leaving Cert Business): Revision Notes

Sources of Finance

Understanding finance needs

Both businesses and households regularly face situations where their available money is insufficient to meet their operational requirements and expenses. This creates a need to seek external funding from various available sources.

Financial requirements for businesses and households

Businesses require funding at different stages of their lifecycle. New enterprises need initial capital for premises, equipment and stock, while ongoing operations demand money for overheads and day-to-day expenses. Established companies may seek expansion funding for product development, international markets or additional locations.

Households similarly need finance for major purchases such as property and vehicles, as well as significant expenses like education costs. The scope of household financial management extends beyond immediate purchases to include long-term planning for insurance, mortgages, savings and retirement.

Categories of finance by time period

Financial sources are typically categorised based on their repayment timeframes:

Some financing options are exclusively available to businesses, while others serve both businesses and households.

Short-term finance options

Short-term financing plays a crucial role in maintaining smooth operations for both businesses and households. Understanding the various options available helps in making informed decisions about immediate funding needs.

Bank overdraft

A bank overdraft facility allows account holders to withdraw amounts exceeding their current balance, up to an agreed limit. Financial institutions charge interest on the overdrawn amount calculated daily.

Households utilise overdrafts to manage cash flow gaps, such as paying bills before salary payments arrive. Businesses employ overdraft facilities for purchasing inventory or covering part-time staff wages during busy periods.

Advantages:

• Interest charges apply only to the amount overdrawn
• Available immediately with no security requirements
• Flexible amounts and timeframes
• Ensures bills are paid punctually without late fees
• No need to track multiple payment dates

Disadvantages:

• Higher interest rates compared to longer-term borrowing options
• Limited borrowing capacity
• Deposited funds automatically reduce overdraft amounts, affecting cash flow
• Can encourage financial complacency and over-reliance on credit facilities

Accrued expenses

This approach involves postponing bill payments to allocate funds to more pressing expenses. Service providers allow continued usage while invoicing at period end.

Advantages:

• Improves immediate cash flow availability
• No interest charges or fees
• Minimal risk as no security is required

Disadvantages:

• Not universally offered by service providers
• Risk of service disconnection for unpaid accounts
• Full payment still required eventually, requiring careful budgeting

Credit purchases and trade credit

Credit purchases allow households to acquire goods immediately and pay within one to two months upon receiving invoices. Trade credit operates similarly for businesses, enabling stock purchases on a "buy now, pay later" basis.

The available credit amount often depends on the buyer's reputation and previous payment history.

Advantages:

• No interest charges when paid within agreed timeframes
• Enhances cash flow by enabling fund reallocation for priority expenses
• Immediate access to goods and services

Disadvantages:

• Loss of cash payment discounts
• Risk of bad debt for credit providers
• Potential damage to credit reputation for late payments

Credit cards

Credit cards are payment instruments issued by financial institutions, allowing purchases up to predetermined credit limits. Monthly payments can be made in full or at minimum percentages, with interest charged on outstanding balances.

Advantages:

• No interest charges when full monthly payments are made on time
• Protection against merchant failures or non-delivery
• Global acceptance and secure online payment method

Disadvantages:

• High interest rates (currently 13.8-22.9% for AIB cards) when full payments aren't made
• Easy to overspend, leading to substantial debt accumulation
• Security risks with online transactions and potential card details theft

Invoice discounting (business only)

This financing method allows businesses to receive loans based on percentages of money owed by their customers. For example, AIB Invoice Finance provides up to 85% of invoiced debt amounts.

Advantages:

• Rapid cash flow improvement upon invoice generation
• No impact on business reputation
• No asset security requirements

Disadvantages:

• Fixed monthly service fees can be substantial
• Limited to commercial invoices only
• Regular account statement provision required

Factoring (business only)

Factoring companies assume responsibility for collecting invoice payments and return portions of total amounts owed to businesses. Non-recourse factoring transfers all collection risks, while recourse factoring requires businesses to repurchase unpaid invoices.

Advantages:

• Immediate cash flow enhancement
• No impact on business ownership or control
• Protection from bad debts (non-recourse arrangements)

Disadvantages:

• Factoring companies retain percentages as fees
• Potential reputation damage suggesting cash flow difficulties
• Loss of debt collection control and credit term negotiation ability

Medium-term finance options

Medium-term financing addresses expenditure requirements over one to five year periods and bridges the gap between short-term operational funding and long-term strategic investments.

Medium-term loans and personal loans

Medium-term business loans support equipment, computer and vehicle purchases over one to five year repayment periods. Interest rates and conditions vary between financial institutions, with security or personal guarantees sometimes required.

Personal loans (also called signature or unsecured loans) rely solely on borrower repayment promises. Households commonly use personal loans for holidays, vehicles or special events like weddings.

Advantages:

• Smaller amounts may not require security
• Lower interest rates than hire purchase options
• Tax-deductible interest payments for business loans
• Immediate access to expensive items

Disadvantages:

• Security or personal guarantees may be necessary
• Asset repossession risk for unpaid loans
• Total cost exceeds outright purchase prices when interest is included

Leasing and renting

Leasing involves agreements between lessees (users) and lessors (owners) for asset usage over one to five year periods. Common leased assets include premises, vehicles and equipment that may depreciate significantly or become obsolete quickly.

Advantages:

• Immediate access to expensive items
• No collateral requirements as lessors retain legal ownership
• Access to current technology and equipment
• Lease payments can offset business profits for tax purposes

Disadvantages:

• Users never gain ownership (unless specific purchase options exist)
• Care requirements to avoid penalties for damage or excessive use
• Asset repossession risk for unpaid amounts
• Potentially more expensive than outright purchase over extended periods

Hire purchase

Hire purchase arrangements allow asset usage while making fixed instalments, with legal ownership transferring upon final payments.

Advantages:

• Immediate asset availability for single instalment
• Legal protection after one-third payment prevents repossession without court proceedings
• No collateral requirements protecting other assets
• No asset care obligations unlike leasing

Disadvantages:

• Additional fees and penalty risks for missed payments
• Repossession charges around €300 if payments lapse
• "Half rule" means half the total hire purchase price is owed for early returns
• More expensive than outright purchases due to depreciation over time

Personal contract plans (PCPs)

PCPs resemble hire purchase agreements but typically feature lower monthly payments and higher final payments than traditional hire purchase arrangements. Car dealers frequently offer PCPs requiring initial deposits of 10-30% of vehicle cash prices, usually over three-year terms.

Long-term finance options

Long-term financing supports expenditure over periods exceeding five years and is essential for major strategic investments, property purchases, and business expansion initiatives.

Equity capital and debt capital

Understanding the distinction between equity and debt capital is crucial for making informed long-term financing decisions.

Equity vs debt capital comparison:

Control aspects: Share sales grant voting rights to shareholders, while debt capital doesn't affect business control.

Risk factors: Equity capital presents lower risk as shareholders await dividends until profit generation. Debt capital requires fixed repayments regardless of profitability, increasing bankruptcy risks.

Security requirements: Equity capital needs no security, while debt capital typically requires collateral.

Tax implications: Dividend payments aren't tax-deductible, but interest payments are tax-deductible.

Businesses typically combine debt and equity capital for long-term financing, with the ratio referred to as gearing.

Retained earnings and savings

Retained earnings represent business profits reinvested as additional capital rather than distributed as dividends, supporting expansion and asset purchases.

Similarly, households and individuals often maintain savings in deposit accounts with financial institutions to earn interest or invest for potentially higher returns.

Debentures and mortgages

Long-term loans or debentures involve borrowing for five-year or longer periods, forming part of debt capital. Security or collateral is required, typically property or fixed assets, with banks specifying interest rates and repayment schedules.

Households obtain long-term loans as mortgages on properties, usually over 30-year periods depending on retirement age timing.

Grants

Government and EU funding can provide significant financial support without repayment obligations.

European Regional Fund, European Social Fund and European Cohesion Fund offer grant assistance for various economic initiatives including infrastructure development, training programmes, market research, job creation and enterprise development.

In Ireland, Local Enterprise Offices provide business start-up grants (priming grants) to micro-enterprises within their first 18 months, with average awards of €35,000.

Advantages:

• No repayment requirements or security needs
• Can target specific geographical areas or high-unemployment regions
• No loss of business ownership or control

Disadvantages:

• Complex application processes requiring time and expertise
• Specific conditions and reporting requirements
• Narrow focus can limit approval chances

Subsidies (business only)

Subsidies are monetary grants from state or public bodies helping local or national industries maintain low prices for goods or services. They're designed to increase production or reduce prices for socially desirable items, such as Dublin Bus subsidies.

Advantages:

• Free financing source without debt creation
• No security requirements or control loss

Disadvantages:

• May be better to borrow at low rates for higher-return operations
• Might discourage investors due to uncertain dividend payments

Sale and leaseback (business only)

This arrangement involves property owners selling assets and then leasing them back from buyers. For example, businesses might sell premises to banks and rent them back.

Advantages:

• Maintains property usage while accessing important capital
• Rent payments are tax-deductible expenses

Disadvantages:

• Ownership loss with some agreements preventing property repurchase
• No control over rental amount increases and uncertain future costs

Choosing sources of finance

Selecting the most appropriate financing requires careful evaluation of multiple interconnected factors. The decision-making process should be systematic and thorough.

When selecting financing options, several factors require careful consideration:

1. Purpose and longevity: Financing sources must match their intended use timeframes. Long-term business expansion shouldn't rely on credit cards, while assets lasting extended periods need long-term financing. Daily expenses suit short-term funding.

2. Cost considerations: Obtaining the most affordable financing is crucial. Interest rates significantly impact total costs. All loan advertisements must display Annual Percentage Rates (APR), with fine print details requiring careful examination.

3. Control implications: For businesses, selling shares provides finance but issues new voting shares, potentially shifting power balances. Loan capital doesn't affect internal control. Lenders often require collateral security, and businesses may lose assets if repayments aren't maintained.

4. Risk assessment: Businesses with low profit-making probabilities are considered high-risk and may struggle finding lenders. Loan finance represents higher risk than ordinary shareholdings since lenders must wait for repayment until funds become available.

5. Amount requirements: Some sources don't offer large amounts while others lack flexibility for smaller amounts.

Factors affecting finance availability

The ability to secure financing depends on various internal and external factors that have evolved significantly in recent years.

Business status impact: Private limited companies and public limited companies find financing easier than sole traders, though they must prepare more detailed financial information to assist banks. PLCs can also sell public shares.

Current finance availability: Recent trends show increased rejection rates for SME loans and overdrafts in Ireland compared to similar countries. The 2008-2014 recession effects continue impacting availability. While banks advertise normal operations, many businesses and households seeking finance or arrangement renewals report disagreement. Additional conditions may attach to borrowings with increased difficulty renegotiating existing loans.

Key takeaways