Sources of Small Business Finance

18: Topic 1.3 Putting a business idea into practice

Sources of short-term finance

Bank overdrafts: a bank grants the business the ability to take more money from its bank account than it has in return for charging a fee and interest until it is repaid.

• A benefit of an overdraft is that it is flexible.
• No payments are required on a regular basis and the business can pay the �overdraft back partially or in full when there are enough funds.
• A drawback is the bank can demand payment in full within 24 hours.

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Trade credit: where a supplier provides goods to a business and allows time for payment, e.g. 30 days.

• A benefit of trade credit is that it helps the business with cash flow, i.e. payment to suppliers can be made once the business has been paid for products.
• A drawback is that small businesses often struggle to get credit.

Sources of long-term finance

Personal savings: business owners often use their own savings to show outside investors they are willing to take a risk with the new venture.

Retained profit: this is the profit that the business keeps aside

• A benefit of retained profit is that there are no extra costs to financing the business, such as interest charges.
• A problem with retained profit is that it is unavailable to new businesses.

Venture capital: this is where another business or individual will provide finance in a risky business in exchange for shares in the business and profits.

• A benefit of venture capital is it is more likely to be granted to new businesses.
• A drawback is the business must share in its ownership and/or profits.

Sources of long-term finance

Loans: loans are usually borrowed from a bank. They will last a certain period of time, and interest must be paid on them till they are repaid. Loans are normally secured against some assets owned by the business.

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Crowdfunding: this means getting an investment from a wide range of small investors. This is done on the internet, via sites like Funding Circle. This spreads risk for the investor, though many businesses do not achieve the desired funding. There are different types of crowdfunding - sometimes investors give to the business through donations, sometimes it’s as a loan, and sometimes it’s in exchange for a small stake in the business. In the exam, you could discuss any of these, but use your ‘this is because’ to clarify which type you’re talking about.

Sources of long-term finance - share capital

• Shares are an individual part of a business.
• Ordinary shares give a buyer part ownership of a business, along with voting rights at the annual general meeting, and a share of the business profits, called a dividend.
• A benefit of share capital is once shares have been bought they can only be sold to someone else. The business cannot be forced to give money back.
• A drawback is that the owner loses some control over the business depending on how many shares are owned by shareholders.

Short term v long term finance

The general rule is simple - short term needs should be met by short term finance, and long term needs by long term finance.

Short-term finance can be used to:

• Get through periods when cash flow is poor for seasonal reasons
• Bridge gaps when large customers delay payments, leaving no cash to pay bills in the short-term
• Provide cash when a sudden large order means raw materials have to be bought

Short term v long term finance

Long-term finance can be used to:

• Provide start-up capital to finance the business
• Finance the purchase of assets such as factories and machinery
• Provide capital for expansion - perhaps new premises, a bigger factory, or for buying another business

Sources of finance