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Overview of Sources of
Finance
SHORT TERM ■ The major sources of finance for companies are:

FINANCE – Internal funds – The firms’ accumulated earnings

■ Company’s net profit after paying dividends to the
stockholders.
Chapter 6
– External funds – These include borrowings and the
issuance of shares and bonds.

Internally generated Internal

(Retained earnings) funds
Equity
(Long Term)
Retained earnings (Internal funds)
Ordinary shares,
Preference shares
 The amount of net income left over for the business after it has paid out
dividends to its shareholders.
Sources of  A business generates earnings that can be positive (profits) or negative
Finance Long term debt External
(losses).
(Bonds) funds
 Positive profits give a lot of room to the business owners or the company’s
management to utilise the surplus money earned.
Debt Medium term debt  Often this profit is paid out to shareholders, but it can also be re-invested
(Short, Medium & Long (Leasing, Hire back into the company for growth purposes.
Term) purchase)
 The money not paid to shareholders is considered as retained earnings.

Short term debt

(Trade Credit,
Overdraft)

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Internally generated
(Retained earnings)
Sources of Finance
Equity
(Long Term)
Sources of
Ordinary shares, long term
Preference shares
finance (1) Short term finance
■ Usually in the form of short-term bank loan, overdraft facility,
Sources of
Finance Long term debt trade credit, etc.
(Bonds)
■ Used by business as a form of working capital to aid in its day-
to-day business operation.
Debt Medium term debt Sources of
(Leasing, Hire medium term
■ Also includes some money market instruments (covered in
(Short, Medium & Long
Term) purchase) Chapter 10). For example, treasury bills, commercial paper, etc.
finance
■ Financing requirement is usually for less than 1 year.
Short term debt Sources of
(Trade Credit, short term
Overdraft) finance

Sources of Finance Sources of Finance

(2) Medium term finance (3) Long term finance

■ Usually in the form medium term bank loan, hire purchase, ■ Usually in the form of ordinary shares, preference shares,
leasing, etc. bonds, retained earnings.

■ Provided largely by banks usually in the form of loan with
repayment targets.
■ Bank lending may be a volatile* source of finance i.e. interest
is sensitive to the state of the economy.
*Volatile: change suddenly and unexpectedly.
■ Financing requirement is usually for between 2 to 5 years.
■ Firm can issue shares and bonds to raise financing.
■ Issuance of shares will require the shareholders to pump in
additional capital or else their shareholdings will be diluted.
(covered in Chapter 7b – Equity)
■ Issuance of bonds means the issuer are borrowing money
from the investor. These securities are usually fixed interest
loans to firms. (covered in Chapter 7a – Bonds)
■ Financing requirement is usually for between 6 years and
beyond.

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Internally generated
(Retained earnings) Classification of Sources of
Equity
(Long Term)
Permanent
Sources of Finance
(Shares) long term
finance (1) Spontaneous source of finance
• It consists of trade credit and other accounts payable (accruals)
Sources of Permanent (Bonds) that arise in firm’s day-to-day operations.
Finance
• Has following characteristics:
Sources of  Arise from the normal course of business
Permanent (Hire
purchase, leasing) medium term  Normally no explicit cost attached
Debt finance  Unsecured
(Short, Medium &
Long Term) • For example, as the firm acquires materials for its inventories,
Temporary
(Overdraft, bank trade credit is often made available spontaneously or on demand
loan) Sources of from the firm’s suppliers.
short term
• Accrued wages and salaries, accrued interest and taxes also
Spontaneous finance provide valuable sources of spontaneous financing.
(Trade credit,
accruals) • These expenses accrue throughout the period until they are paid.

Classification of Sources of Classification of Sources of

Finance Finance
(2) Temporary source of finance (3) Permanent source of finance
• It is another form of current liabilities. Usually in the form of • Sources of financing that do not mature or come due within
short term bank loan or overdraft facility. the year.
• Used by business as a form of working capital to aid in its day- • Including intermediate term loans, long-term debt, bonds,
to-day business operation. preferred stock and common equity.

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Common Types of Short Term Common Types of Short Term

Finance Finance
(1) OVERDRAFT
Overdraft ■ A deficit in a bank account caused by drawing more money than
the account holds.
■ When payments from a bank current account exceed income to the
Short term bank loan account for a temporary period, the bank finances the deficit by
means of an overdraft.
Accounts payable (Trade credit) ■ It is a form of short-term lending.
■ By providing an overdraft facility to a customer, the bank is
Factoring committing itself to provide an overdraft to the customer whenever
the customer wants it, up to the agreed limit.

Common Types of Short Term Advantages of

Overdraft
Disadvantages
of Overdraft
Finance
Overdraft is subject to annual reviewed by
An overdraft can do the same job as a
(1) OVERDRAFT the bank. The bank has the absolute right
medium term loan: a facility can simply be to withdraw the facility or charge higher
renewed every time it comes up for review. interest.
■ The bank will earn interest on the lending, but only to the extent
that the customer uses the facility and goes into overdraft. The bank has the flexibility to review the
Overdraft is repayable on demand.
customers’ overdraft facility periodically
■ The bank will generally charge a commitment fee when a customer and perhaps agrees to grant additional Customer must repay in full if the bank
is granted an overdraft facility. decides to withdraw the facility granted.
facilities.

■ The commitment fee is charged on the unutilised portion of The customer only pays interest when the
overdraft. account is overdrawn. If customer does not Generally the overdraft interest rate is
utilise the overdraft facility, he does not higher than a loan.
need to pay interest.

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Common Types of Short Term Common Types of Short Term

Finance Finance
(2) SHORT TERM BANK LOAN OVERDRAFT TERM LOAN
■ Short term loan is a contract under which a borrower agrees to It is usually used to finance working It is suitable to finance purchase of
make a series of interest and principal payments on specific dates capital. non-current asset. Eg. plant and
to the lender. machinery.
■ It is a loan made by a financial institution to business and having It is repayable on demand ie. The bank If the periodic installments are
an initial maturity of less than 1 year. reserves the right not to renew the adhered to, the borrower does not
■ Commercial banks, whose loans generally appear on firm’s facility. have to worry whether the bank will
Statement of Financial Position (Balance Sheet) as notes payable, renew the facility or not.
are second in importance to trade credit as a source of short-term
financing for non-financial corporation. There is no periodic payment of There are periodic payments of
installments, so long as the overdraft installment, eg. monthly, quarterly,
limit is not exceeded. semiannually, or annually, that cover
both interest and principal.

Common Types of Short Term Common Types of Short Term

Finance
(3) ACCOUNTS PAYABLE (TRADE CREDIT)
■ Firms generally make purchases from other firms on credit,
recording the debt as an account payable. Account payable is the
major source or percentage of unsecured short-term financing for
business.
■ The percentage is somewhat larger for smaller firms. This is
because small companies often do not qualify for financing from
other sources, they rely especially heavily on trade credit.
Finance
(3) ACCOUNTS PAYABLE (TRADE CREDIT)
■ Trade credit is sometimes considered as one of the best forms of
short-term credit because:
– Trade credit does not carry any interest charges. To the trader,
it has zero opportunity cost.
– Trade credit need not be negotiated regularly. As long as it is
within the limit, any increase in trade credit is automatic.
– The amount of trade credit will increase as business expands.
It grows in line with the business. In that sense, there is no
fear of insufficient credit.

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Common Types of Short Term
Finance
(4) FACTORING
■ Factoring is an arrangement to have debts (accounts
receivables) collected by a factor which advances a proportion of
the money it is due to collect, instead of the company having to
wait for cash from its credit customers.
■ Factoring enables companies to overcome the problem of
insufficient cash.
Advantages of Factoring
■ Relieved from collection of accounts receivable which can be very
time consuming. More resources to devote to sales activities.
■ Relieved of the risk of default by purchasers.
■ Smoother cash flow and financial planning.
■ Factors will credit check your customers and can help your
business trade with better quality customers and improve debtor
spread.
■ No need a credit department and does not have to incur the
administrative and clerical cost of credit investigation and
collection or the losses on uncollected accounts.
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Process of Factoring
*After deducting certain fees
and interests on the financing
Disadvantages of Factoring
■ There is usually a stigma attached to debt factoring. Customers
may perceive the business is in financial difficulties.
■ May reduce the scope for other borrowing – book debts will not
be available as security.
■ It is an expensive source of finance. The costs of debt factoring
include factoring commission and interest on the amounts
advance.
■ May be difficult to end an arrangement with a factor as the firm
will have to pay off any money they have advanced you on
invoices if the customer has not paid them yet.
■ Some customers may prefer to deal directly with the firm.
■ How the factor deals with the firm’s customers will affect what
the customers think of the firm.
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Security in Financing
■ Secured loans
- A loan backed by collateral.
- The principal sources of collateral include accounts receivable, inventories,
property, etc.
- In the event of default, lender can seize the pledged assets and sell them to
settle the debt.
- It normally has lower interest rate and is easier to obtain.
- E.g. housing loan.
■ Unsecured loans
- Financing obtained without pledging specific assets as collateral.
- The loan is granted based on creditworthiness of borrower (the extent to
which a person or company is considered suitable to receive financial credit,
often based on their reliability in paying money back in the past).
- It normally has higher interest rate and is more difficult to obtain.
- E.g. credit card.
Advantages of Short-Term
Financing
■ Speed
– A short-term loan can be obtained much faster than a long-
term loan. Lenders will insist on a more thorough financial
examination before extending long-term credit, and the loan
agreement will have to be spelled out in considerable detail.
■ Flexibility
– If it needs funds for seasonal or cyclical use, a firm may not
want to commit itself to long-term debt.
■ Cost of Long-term debts versus short-term debt
– The yield curve is normally upward sloping, indicating that
interest rates are generally lower on short-term debt.

Disadvantages of Short-Term
Financing
■ Risk
– Short-term credit is riskier for two reasons:

a. If a firm borrows on a long-term basis, its interest costs will be

relatively stable over time, but if it uses short-term credit, its
interest expense will fluctuate widely at time going quite high.
b. If a firm borrows heavily on a short-term basis, a temporary
recession may make it impossible to repay the debt on schedule. If
the borrower is in a weak financial position, the lender may not
extend the loan, which could force the firm into bankruptcy.