Choose a Finance Source

Who can afford which cost

You already know the sources and what each one charges: interest on a loan or an overdraft, a share of ownership when you issue shares, a say in decisions when you take somebody’s money, an asset you no longer have when you sell one. There is no free money. That is settled, and this module starts from it rather than repeating it. The question it leaves open is the one exam questions actually ask. If every source costs something, who is able to pay which cost? A business that has been trading for years has profit it kept, assets it owns and a record a lender can look at, so it can pay in interest and keep its ownership intact. A business that started last month has none of those things, so the only currency it has is a share of itself and the personal risk of the people running it. Once you see it that way, choosing a source stops being a matter of preference and becomes a matter of what this particular business actually has to offer. That is a judgement you can defend, and defending it is what the marks are for.

What each business has to offer

The same amount of money for the same purpose should often be raised differently by these two businesses, and it is not because one is better run. It is because they have different things to offer whoever provides the money.

Situation to the source that fits

Why a new business cannot use profit

A student recommends retained profit to a business that opened last month, saying it is the cheapest source. What is wrong with the recommendation?

• The business has not made any profit yet, so the source is not available to it whatever its merits
• Retained profit is actually expensive, because of the interest
• Retained profit is an external source, so a new business cannot access it
• Nothing is wrong; it is the correct recommendation

Match the money to the job

Stage tells you what a business can offer. Purpose tells you what shape the money needs to be, and the rule is simpler than it sounds: the finance should last about as long as the thing it pays for. A gap that closes in a few weeks, such as wages while you wait for customers to pay, wants finance that goes away just as quickly, which is why an overdraft or trade credit fits and a fifteen-year mortgage does not. Something the business will still be using in ten years, such as premises or a major machine, can reasonably be paid for over years, which is what a loan or a mortgage is for. Get this the wrong way round and you create a real problem rather than a theoretical one. Borrow long for a short need and you pay for money after you have stopped needing it. Borrow short for a long need and the repayment falls due while the thing you bought is still being paid off. So a good answer names two things about the business, not one: what stage it is at, which decides what it can offer, and what the money is for, which decides what shape it should take. An answer naming only the source has not made a judgement at all.

Which two justify the choice

Select the TWO sentences that make a justified recommendation rather than just a choice.

• A bank loan suits this established firm because it has a trading record and can pay in interest without giving up ownership
• An overdraft suits this need because the shortage lasts only until customers pay, so finance that ends quickly fits it
• A bank loan is the best source of finance for any business that needs money
• The business should issue shares, because share issues raise large amounts

The judgement in words

To recommend a source of finance you need two facts about the business, not one. Its _____ decides what it is able to offer, because a new business has no retained _____ and no trading record, while an established one does. What the money is _____ decides what shape the finance should take, since it ought to last about as long as the thing it pays for. A recommendation that names a source without giving a _____ drawn from those two facts has not made a _____ at all.

Questions to ask the business

Put the questions you would ask into the order that gets you to a justified recommendation fastest.

• How long has this business been trading, and has it made a profit yet?
• What can it offer: profit it kept, assets it owns, a record, or a share of itself?
• What is the money actually for, and how long will that thing last?
• Which sources are therefore available to this business at all?
• Of those, which cost suits it best: interest, ownership, control, or an asset given up?
• State the recommendation and the reason drawn from the answers above

The recommendation with no reason

Four sentences from an answer recommending finance to a newly opened business. Select the ONE that names a source without justifying it.

• Because the business has only just opened, it has no retained profit to reinvest.
• It should raise the money by issuing shares, since that is how businesses get finance.
• Money from family and friends may cost little in interest but can bring pressure into a relationship.
• Since the van will be used for several years, spreading its cost over time is reasonable.

A recommendation, worked

A question describes a business that opened three months ago, makes and sells furniture, and needs a machine it will use for years. It asks you to recommend a source of finance and justify your choice. Here is an answer that would score well. Because the business is new, retained profit is not available to it, as it has not yet accumulated any, and a bank may be reluctant to lend without a trading record. What it can offer instead is a share of ownership or the security of the machine itself. Since the machine will be used for several years, the finance can reasonably be spread over time rather than repaid quickly. Hire purchase would therefore suit this business, because the payments are spread across the machine’s useful life and the machine itself provides the security a new business otherwise lacks. The drawback is that the total paid will be more than the cash price, and the business does not own the machine until the final payment. On balance this is worth accepting, since the alternative of giving up ownership through a share issue is a permanent cost for a one-off purchase. Notice what that answer does. It names the stage and says what follows from it. It names the purpose and says what follows from that. It recommends, gives the drawback honestly, and then still reaches a decision. An answer that stops before the last sentence has explained rather than judged.

Make the recommendation

Assemble a recommendation for an established business that wants to buy premises it will use for many years.

Advise this business

A business that opened four months ago sells online and needs money to buy stock for a busy season. It expects to sell that stock within two months. Take the decisions in order.

• What should you establish first, before considering any source?
• What does the purpose tell you about the shape of the finance?
• Which recommendation fits both the stage and the purpose?
• What must your answer include to be a judgement rather than a description?

Advise the two businesses

Two businesses each need the same amount of money to buy a delivery van. One opened last month; the other has traded profitably for ten years. Recommend a source of finance for each, and justify both choices.

• State what the new business is able to offer, and what it cannot
• State what the established business is able to offer that the new one cannot
• Explain what the purpose tells you about how long the finance should last
• Recommend a source for the new business and give the reason
• Recommend a source for the established business and give the reason
• Give one drawback of each recommendation honestly
• Explain why the same money for the same purpose is raised differently by the two businesses
• Reach a clear judgement rather than stopping at the explanation