The appropriateness, advantages and disadvantages of sources of finance
for a given situation AO2
AO2 You need to be able to: Demonstrate application and analysis of knowledge and understanding Command Terms: These terms require students to use their knowledge and skills to break down ideas into simpler parts and to see how the parts relate: Analyse, Apply, Comment, Demonstrate, Distinguish, Explain, Interpret, Suggest
Firms need money. They need money to pay wages, to buy raw materials, to pay for promotional activities, to fund research and development and to enable them to invest in new machinery and equipment. All these different activities require different sources of finance. Some will be internal (from within the firm), and some external (from outside the firm).
Selecting the source
Choosing an appropriate source of finance is vital. Considerations when selecting a source of finance include:
- Cost: Business obviously prefer sources that are cheaper - administration or interest charges add to the cost e.g. share issue carry high administration charges but no interest.
- Use of funds: Revenue expenditure tends to be financed by short term finance, e.g. raw material purchases are financed by trade credit or overdraft. However, the purchase of property should be financed with long term sources such as share capital or a mortgage.
- Status and size: Small firms may be limited in their sources as they lack sufficient security. Large firms have access to many sources including a flotation on a stock market.
- Financial situation: Firms suffering from liquidity problems, or firms that already have significant loans, may face reluctance from lenders to provide funds. If lenders do agree to the loan, it is likely to be at higher interest rates.
- The external environment: Firms will need to aware of market trends and forecasts and research available sources of finance.
- Organisational goals: Is the business wishing to grow, and if so how? For example, expansion overseas may require substantial funds.
- Existing financial structure: Additional loans may have a negative effect on the balance sheet and financial ratios.
- Risk: The riskier the use of the funds the harder it will be to find a lender.
- Availability of security: Small firms may find it difficult to borrow large sums for long periods as they do not have sufficient assets of value to offer as security.
When answering an examination question about finance, the most important question when choosing a source is:
Does the source of finance match the need e.g. term?
If the need is long-term e.g. buying a property, then the source should be long-term e.g. a mortgage .... Not short term like an overdraft.
Do not mix up short-term needs with long-term sources or vice-versa
Capital expenditure is incurred when a business spends money either to buy fixed assets or to add to the value of an existing fixed asset.
Fixed assets are assets not intended for resale. They represent the productive capacity of the business and determine the scale of the business operations and provide the opportunity for the business to make profits or losses. Purchases of fixed assets are shown on the balance sheet and increase the value of the business.
Included in capital expenditures is spending on:
- acquiring fixed assets such as equipment, buildings, machinery and vehicles
- improving existing assets
- preparing an asset to be used in business
- restoring property or adapting it to a new or different use
- starting a new business
As fixed assets tend to be expensive, the finance used will be of a medium- to long-term nature. Capital spending is not usually charged to just one year's accounts, but is spread out of the life of the asset in the form of a depreciation charge to the profit and loss account.
Revenue expenditure refers to an operating expense incurred from the daily running of the organisation, such as staff wages, purchase of trading stock, rent of business premises, advertising and so on. It does not add to the value to the business. The expenditure needs to be matched against revenue in the same period as the revenue is earned. Revenue and expenditure are matched in the profit and loss account, but because it is short-term it will only affect one accounting period.
There are three categories of revenue expenditure:
- Single use consumables such as stationery, petrol for vehicles
- Purchase of items that will be used up within the current financial year e.g. raw materials
- Items that are used before they are paid for, e.g. marketing expenditure
Revenue expenditure is sometimes described as circulating capital. This description reflects the fact that the capital in question leaves the owner's possession to produce profit or loss. The capital may be considered as being 'turned over'. In the process of turning over, profit or loss ensues.