Sources of business finance

Introduction: Where Does the Money Come From?

Hi there! Imagine you have a brilliant idea for a new business—maybe a trendy vintage clothing shop or a high-tech app. You’ve done your research and you're ready to go. But there is one big question: How are you going to pay for it?

Every business, whether it is a tiny start-up or a well-known shop on the high street, needs finance (money) to survive and grow. In this guide, we will look at the different ways businesses get the cash they need. We call these Sources of Finance.

Don't worry if this seems tricky at first! You can think of it like this: if you wanted to buy a new bike, you might use your pocket money, borrow from a parent, or ask for a loan. Businesses do exactly the same thing, just on a bigger scale.

Short-Term Sources of Finance

Sometimes a business just needs a little bit of money for a short time—usually less than a year. This is often to pay for "day-to-day" things like electricity bills or buying extra stock for a busy weekend.

1. Overdraft

An overdraft is when a bank lets a business take more money out of its bank account than it actually has. It’s like having a "safety net" on your bank account.

• The Good: It is very quick to arrange and flexible. You only use it when you need it.
• The Bad: The bank charges high interest (a fee for borrowing the money). If you don't pay it back quickly, it gets very expensive!

2. Trade Credit

This is a "buy now, pay later" deal with suppliers. For example, a florist might receive a delivery of roses today but doesn't have to pay the supplier for 30 or 60 days.

• The Good: It helps with cash flow because you can sell the products to customers before you have to pay for them yourself.
• The Bad: If you pay late, the supplier might get angry and stop selling to you, or you might lose out on "early payment discounts."

Quick Review: Short-term finance is for small, everyday costs. Think of it like a quick "top-up" for the business wallet.

Long-Term Sources of Finance

If a business wants to buy something big, like a delivery van, a factory, or expensive computers, it needs long-term finance. This is money that is paid back over many years or might never be "paid back" at all.

1. Personal Savings

Many entrepreneurs use their own money to start a business. This is often the first place they look.

• The Good: There is no interest to pay, and the owner keeps full control of the business.
• The Bad: It is very risky! If the business fails, the owner loses all their hard-earned savings.

2. Retained Profit

This is money the business has made in the past and kept (or "retained") to spend later. It is like a business "savings account."

• The Good: It is "free" money—no interest and no debt.
• The Bad: A brand-new business won't have any profit yet! Also, shareholders might be unhappy if the business keeps the profit instead of giving it to them.

3. Bank Loans

The business borrows a fixed amount of money from the bank and pays it back in monthly chunks over a few years, plus interest.

• The Good: You know exactly how much you have to pay back each month, which makes planning easier.
• The Bad: You must pay it back even if the business isn't making money. Usually, you have to provide collateral (something valuable like a house that the bank can take if you don't pay).

4. Share Capital

This is only for companies (like a Private Limited Company). The business sells a "piece" of itself to investors. In return for their money, the investors become shareholders.

• The Good: You get a lot of money and never have to pay it back.
• The Bad: You lose some control. You now have to listen to the shareholders' opinions, and you have to share your future profits with them.

5. Venture Capital

Think of the TV show Dragons' Den! Venture capitalists are professional investors who put large amounts of money into small businesses that they think will grow very fast.

• The Good: They often provide expert advice and contacts, not just money.
• The Bad: They usually want a big share of the business and can be very demanding.

6. Crowd Funding

This is a modern way of raising money. A business puts its idea on a website (like Kickstarter) and asks hundreds of people to contribute a small amount of money.

• The Good: It’s a great way to see if people actually like your idea before you start.
• The Bad: If you don’t reach your money goal, you usually don’t get any of the money at all!

Memory Aid: The "Finance Map"

To help you remember which is which, try this simple trick:

• Short-term = O.T. (Overdraft & Trade Credit) — Think of Over-Time (short extra work).
• Long-term = P.R.L.S.V.C. — "People Really Like Spending Very Coolly"
  (Personal savings, Retained profit, Loans, Share capital, Venture capital, Crowd funding).

Important Considerations

When a business picks a source of finance, they usually think about these three things:

1. Cost: How much interest will we have to pay? (Loans and Overdrafts are expensive!)

2. Control: Will I have to give up a part of my business? (Share Capital and Venture Capital mean losing control.)

3. Risk: What happens if I can't pay it back? (Loans are high risk for the owner's assets.)

Quick Review Box

Key Terms to Remember:

Interest: The extra cost of borrowing money. Usually shown as a percentage, for example: \( Interest = Amount Borrowed \times \text{% rate} \).

Insolvency: A scary word that just means the business has run out of money and cannot pay its debts.

Collateral: An asset (like a building) that a bank can take if a loan isn't paid back.

Summary: Putting it into Practice

Choosing the right source of finance depends on the situation. If you need to buy a box of pens, use an overdraft. If you need to buy a whole new warehouse, get a bank loan or sell share capital. Picking the wrong one can lead to high costs or the business failing!

Top Tip for Exams: If a question asks about a brand-new start-up, they usually use personal savings or crowd funding because banks are often too scared to give them a loan yet!