Explain long term sources of finance and its advantages and disadvantages?

Answer 1

Sources of long term finance

Sources and uses of finance

There are a number of ways of raising finance for a business. The type of finance chosen depends on the nature of the business. Large organisations are able to use a wider variety of finance sources than are smaller ones. Savings are an obvious way of putting money into a business. A small business can also borrow from families and friends. In contrast, companies raise finance by issuing shares. Large companies often have thousands of different shareholders.

Sources of financeUses of finance

ShareholdersFinance to set up and expand a business

Bank Loans to finance capital projects .Overdrafts to manage cash flow

Creditors Short term credit until goods have been sold

To gain extra finance, a business can take out a loan from a bank or other or other financial institution. A loan is a sum of money lent for a given period of time. Repayment is made with interest. The lender of money needs to know all the business opportunities and risks involved and will therefore want to see a detailed business plan. The lender may also want some form of security should the business run into financial difficulty, and may therefore prefer to provide a secured loan.

Another way of raising short-term finance is through an overdraft facility with a bank. The borrower is given permission to take out more from their account than they have put in. The bank fixes a maximum limit for the overdraft. Interest is charged on the overdraft daily.

A further way of raising funds that has become popular is through venture capital. Merchant banks and investment specialists may be willing to provide finance for a promising and fast-growing smaller business. This usually involves a package that is a mix of share and loan capital.

Businesses may also qualify for grants. Government (or EU) assistance and funding is sometimes made available to businesses that meet certain conditions. For example, grants and loans may be available to firms setting up in rural areas or where there is high unemployment.

Once a business is up and running there are various ways of financing its expenditures. Expensive items of equipment can be leased. Rather than buying the equipment the business hires it from a leasing company. This saves having to lay out sums of money and the business does not have to worry about having to carry out major repairs itself. Motor vehicles, machines and office equipment are often leased.

Hire Purchase is an alternative way of purchasing items of equipment. With a leased item you use and pay for the item but never own it. With hire-purchase you put down a deposit on an item and then pay off the rest in installments. When the last installment has been paid you become the owner of the item.

Another common way in which firms can finance their business in the short term is through trade credit. In business it is common practice to purchase items and pay for them later. The supplier will normally send the purchaser a statement at the end of each month saying how much is owed. The buyer is then given a period of time in which to

pay.

There are different sources of long term finance which can be used to generate the finance for the business for long period of time. One of the most commonly used is Equity Shares, the issuing of equity shares is the most important source for raising the long term capital by the company. These shares are the best source because they are only paid back on winding up of company. Equity shareholders are the real owners of the company. Equity shareholders get dividend when the company is earning profits. A company can now issue different classes and kinds of shares to raise its owned capital. The kind of shares will be issued according to the needs of the company and preferences of the investors. There are two types of shares one is right shares. A public company may increase its subscribed capital by issue of right shares. Right shares are offered to the shareholders in proportion to their present holding often at a price which is less than the currently quoted price on the stock exchange.

The other source is debentures a company also raises long term finance through borrowing. These loans are raised by the issue of debentures. A debenture is an instrument issued by a company to acknowledge the loan taken by the company under its common seal.
· Secured and unsecured notes
· Convertible notes
· Fixed deposit loans
· Mortgages
· Eurobonds
· Interest rates swaps
· Forward rate agreements (FRA's)
· Interest only futures
· Option on future contracts.
· Convertible notes
· Subordinated debt

equity capital

Invested

money

that, in contrast to

debt capital, is not repaid to the

investors

in the normal

course of business. It

represents

the

risk capital

staked by the

owners

through

purchase

of a

company's

common stock

(ordinary shares).

The

value

of

equity capital

is computed by

estimating

the

current market value

of everything owned by the

company

from which the

total

of

all

liabilities

is subtracted. On the

balance sheet

of the company,

equity

capital

is

listed

as

stockholders' equity

or

owners' equity. Also called

equity financing

or

share capital.

preference shares

Capital stock

which

provides

a specific

dividend

that is

paid

before any

dividends

are paid to

common stock

holders

, and which

takes

precedence

over common

stock

in the event of a

liquidation

. Like common stock,

preference shares

represent

partial

ownership

in a

company

, although

preferred stock

shareholders

do not enjoy any of the

voting rights

of common

stockholders

. Also unlike common stock, preference shares pay a fixed dividend that does not

fluctuate

, although the company does not have to pay this dividend if it

lacks

the

financial

ability to do so. The

main

benefit

to owning preference shares are that the

investor

has a greater

claim

on the

company's

assets

than common stockholders. Preferred shareholders always

receive

their dividends

first

and, in the event the company goes

bankrupt

, preferred shareholders are paid off before common stockholders. In

general

, there are four different

types

of preferred stock:

cumulative preferred

stock,

non-cumulative preferred

stock,

participating preferred

stock, and

convertible preferred stock

.

also called

preferred stock.

term loan

• Asset based

  short-term

  (usually for one to five years) loan payable in a fixed number of equal installments over the term of the loan. Term loans are generally provided as working capital for acquiring income producing assets (machinery, equipment,

  and inventory

  ) that generate the

  cash flows

  for repayment of the loan.

Advantages & Disadvantages of Different Sources of Finance

One of the ongoing challenges of operating a business is maintaining a steady flow of finance to pay for new projects and fund growth. Securing finance is also extremely important during the startup process, as a company without enough money to operate until it can establish a revenue stream won't last long.

·

Types

o

Business Finance typically comes from one of three types of sources. The first is internal sources, which include savings or money from the sale of assets. The second is ownership capital, which refers to offering stock to investors who pay cash for their shares and take an ownership stake in the company. Finally, finance can come from non ownership capital, which refers to grants, loans, lines of credit and investment from venture capitalists, who don't take an ownership role in the business.

Benefits

o

Some sources of finance offer special benefits. Selling stock is among the fastest ways to get access to a large amount of cash, and it's money you'll never need to pay back directly. Internal sources of finance keep control within the company and don't subject you to interest payments on loans. Finally, non ownership capital is a vote of confidence from the investor or agency that issues a loan or grant. Grants are especially valuable because they don't require repayment, and might be available on a recurring basis.

Drawbacks

o

Each source of finance also has its own limitations. Ownership capital makes you responsible to a group of shareholders who have partial ownership rights. Loans cost interest, which the lender will demand back on schedule whether you've turned a profit or not. Internal sources are limited and once you sell off your assets or spend your savings, you'll need to turn to a new source of external finance anyway.

Time Frame

o

The amount of money your business needs, along with how soon you need it and how long you expect to need before you can pay it back, will impact which sources of finance work best. For example, a bank loan comes with a fixed repayment schedule, but you'll need to begin making payments relatively soon. Ownership capital gives your company a sudden influx of cash, but you can only take advantage of it once before you need to give up even more control by selling your own shares. If you need a long-term investment that might not show returns any time soon, selling assets or dipping into savings are likely better alternatives.

Effects

The methods you use to secure finance for your business can directly affect how your business grows and operates. If you choose to have an initial public offering, or IPO, by selling stock, you'll distribute control of your business to shareholders who will be able to vote for board members and have a say in the company's direction. Selling assets usually involves giving up a portion of your security or production capacity, which may involve a l