1.4.3Types and sources of credit and the impact of credit within the economy

Credit – a contractual agreement in which a borrower receives money and agrees to repay         the lender at some date in the future with interest.

The importance of credit

  • Businesses need loans for upfront costs, before they can set up or get money from buyers.
  • For exporters who must pay for production costs first.
  • For working capital (finance for day to day expenses like buying stock) e.g. overdraft.
  • So people can buy houses (mortgages).
  • So businesses can expand.
  • To help the government of it has a deficit – income from tax is less than expenditure.

Internal Finance – money that is sourced from inside the business.

This includes retained capital, sale of assets and working capital (day to day funds in the business)

External finance – money that comes from outside the business

This includes bank loans, overdrafts, share capital, trade credit and venture capital.

METHOD OF FINANCE DEFINITION BENEFITS DRAWBACKS INTERNAL/ EXTERNAL
(BANK) LOAN The use of someone else’s money which involves repayment and payment of interest. Greater certainty of funding provided terms of loan are complied with.

Lower interest rates than overdraft.

Appropriate method of financing fixed costs.

Requires security (collateral).

Interest is paid on full amount withstanding not amount used.

Regular repayments must be made regardless of cash flow.

Total interest can be high if loan is paid over long period of time

Hard to get for smaller businesses

External
OVERDRAFT Facility that allows borrowing of up to a certain limit. Flexible/ useful way of dealing with cash flow problems

Interest paid only on amount used

Relatively easy to obtain/arrange

Interest rates usually higher than for loans.

Short-term so unsuited for large amounts.

Banks can demand payment at any time.

Interest rate varies with change in base rate

External
TRADE CREDIT Time allowed by a supplier before a business must make payment for goods provided. No interest

Effectively ‘free’ finance

Commonly available

Helps with cash flow

Limited amounts provided and is short term

Delaying payment for too long will lead to withdrawn credit

Can also lead to extra fees

Suppliers can commence insolvency proceedings (take you to court)

External
RETAINED PROFIT Profit collected from years of business No interest to pay

No loss of control

Profits could be earning interest for the company

Loss of security – less funds to help if in trouble

Internal
VENTURE CAPITAL Investment provided in turn for a proportion of shares/ profits Immediate cash injection (given in exchange for shares)

Does not require repayment

Can also receive advice

 

Loss of control through the selling of shares

Requires a dividend to be paid

External
OWNERS CAPITAL Money put in by the owner of the business No interest to pay

No loss of control

Shows confidence as own funds are put at risk (may attract other investors)

Opportunity cost is saving money and gaining interest

Also big purchases lost e.g. holiday etc.

May not have large amounts of funds

Internal
SHARE CAPITAL The money retained from selling shares to investors Immediate cash injection

Does not require repayments

Loss of control as shares are sold

Need to pay dividends

External
SALE OF ASSETS Selling off old/unused property No interest to pay

No money owed

Assets could have been useful in the future

Second hand value of items is usually very low

 

Internal
PEER TO PEER LENDING/ ONLINE COLLABORATIVE FUNDING Unsecured loans organised from b2b

Investors can buy shares in many business projects

Better access to credit/loans and a higher return on interest (5-10%)

Cuts out bureaucracy and lenders know where their money is going

Risk of non-payment is higher

No guarantee that people will get their money back – not protected under the Financial Services Compensation Scheme

External
LEASING Long term rental agreement that allows businesses to use assets without having to pay upfront Maintenance is often included and new models regularly updated

Much lower outlay on equipment

More expensive in long term

Cannot own the item

Regular monthly payments must be made

External
DEBENTURE Loan from one PLC to another with fixed rate of interest not secured by physical assets No assets are at risk

Provides long-term funds

Rate of interest is usually lower than dividends or loans

Fixed interest rate and set repayment date

Interest payments must be made by the company

During depression, the profits of the company declines and will find it hard to pay interest.

Competitors can gain profit from them

External

 

Challenges in obtaining credit

  • New and small firms are unlikely to get bank loans which inhibits the growth of small firms in the economy.
  • It takes a long time to build up a strong credit rating/history. Poor credit history will mean only high interest loans are available. This excludes potentially good entrepreneurs from setting up.