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Delaying payment for too long will lead to withdrawn credit Can also lead to extra fees Suppliers can commence insolvency proceedings (take you to court) |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.