Share capital the money raised from selling shares of the company. The main sources of finance for a limited liability company. This can provide lots of finance.
Selling Shares: private limited companies cannot sell their shares to the general public. If they want to they can ‘go public’ by floating their shares on the stock exchange. This is known as initial public offering (IPO). Existing companies can raise further finance by selling more shares in a share issue. However by issuing shares, ownership and control of the business becomes diluted.
Loan capital
Overdrafts: allows a business to temporarily overdraw on its bank account, i.e., to take out more money than it has in its account.
Debentures: the holder of a debenture is a creditor of the company, not an owner. This means that holders are entitled to an agreed fixed rate of return, but have no voting rights and the amount borrowed must be repaid by the expiry date.
Mortgages: only limited companies can raise funds from the sale of shares and debentures. Smaller firms need long-term finances to purchase the premises, a purpose which mortgages are designed for. It is usually a long-term loan from a financial institution (like a bank) and the lender must use land or property as security on the loan. (Note: Mortgages are specialised long-term loans only for the purchase of premises, not machinery for example)
Grants: governmental financial gifts to support business activities. These tend to be offered to eligible business in one-off payments.
Subsidies: governmental grant to reduce costs of production, generally to provide benefit to society. This tends to be done for essential products and services such as agricultural goods, public transport etc. Subsidies do not cut into profit margins of the producer.
Debt factoring: when a firm sells its products, it issues an invoice stating the amount due. Debt factoring involves a specialist company (called a factor) providing finance against these unpaid invoices. So, when a debtor fails to pay its bill in time, the company turns to the factor and asks for the return of these funds, which the factor does immediately. However, when a customer pays the bill in full, the factor would usually keep 20% of the value of the invoice.
Venture capital: high risk capital invested by venture capital firms usually at the beginning of a business idea. They find small businesses with high growth potential. These firms seek businesses with convincing and coherent plans to make the risk of investment worthwhile. They then receive profit in return from their investment.
Business angels: usually wealthy individuals who invest their money in businesses with high growth potential. They provide funding and in return tend to take a proactive role in the business and receive profits until the business can buy out the stake owned by the business angel.
Hire Purchase
Definition: Hire purchase is a financing arrangement where a business or individual agrees to buy a product through an initial deposit followed by regular payments over a period. Ownership of the product transfers to the buyer only after the final payment.
Advantages:
- Immediate Use: Allows businesses to use the asset immediately without paying the full amount upfront.
- Spread Costs: Payments are spread over time, easing cash flow management.
- Tax Benefits: Payments can often be deducted as business expenses.
Disadvantages:
- Higher Cost: Total payments typically exceed the asset’s cash purchase price due to interest charges.
- Asset Ownership: The buyer does not own the asset until the final payment is made, risking loss of the asset if payments are not maintained.
Industry Example: A small manufacturing firm may use hire purchase to acquire new machinery. This allows the firm to increase production capacity immediately without depleting cash reserves, although it will pay more over time due to interest charges.
Trade Credit
Definition: Trade credit is a financing arrangement where a supplier allows a business to purchase goods or services on account, paying for them at a later date.
Advantages:
- Improved Cash Flow: Businesses can sell goods before payment is due to the supplier, improving cash flow.
- No Interest: If paid within the credit period, trade credit is essentially an interest-free loan.
- Builds Supplier Relationships: Regular use of trade credit can strengthen relationships with suppliers.
Disadvantages:
- Overreliance Risk: Dependence on trade credit may lead to financial instability if credit terms are suddenly changed.
- Late Payment Penalties: Late payments can incur charges and damage supplier relationships.
- Creditworthiness: Typically available only to businesses with a good credit history.
Industry Example: A retail clothing store might use trade credit to stock inventory for the upcoming season, paying suppliers after sales have been made. This strategy improves the store’s liquidity but risks financial strain if sales do not meet expectations.
Leasing
Definition: Leasing is a financing arrangement where a business pays to use an asset owned by another party (the lessor) for a specified period, with payments made on a regular basis.
Advantages:
- No Large Initial Outlay: Access to expensive equipment without significant initial investment.
- Flexibility: Leases can be structured to meet the specific needs of the business, including upgrades to newer models.
- Tax Efficiency: Lease payments can often be deducted as business expenses.
Disadvantages:
- Higher Long-term Cost: Total lease payments may exceed the cost of purchasing the asset outright.
- No Ownership: The business never owns the asset and must return it at the end of the lease term unless a buyout option is exercised.
- Contractual Obligations: Early termination of the lease can result in penalties.
Industry Example: An IT company may lease servers and network infrastructure to support its operations. This allows the company to stay updated with the latest technology without large capital expenditures, though it may pay more over the long term and must negotiate lease renewals regularly.
Conclusion
Hire purchase, trade credit, and leasing each offer distinct financial advantages and challenges, catering to different business needs and strategic considerations. From acquiring new machinery through hire purchase, improving liquidity with trade credit, to accessing the latest technology through leasing, these financing options play critical roles in business operations and growth strategies. The examples provided illustrate practical applications across industries, emphasizing the importance of carefully weighing each option’s benefits and drawbacks. For IB Business & Management students, understanding these financing mechanisms is essential for effective financial decision-making and strategic planning in a business context.
