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

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    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    Delaying payment for too long will lead to withdrawn credit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.

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