Accounts and Finance

Sources of Finance

Or where can we get

money from?
SOURCES OF FINANCE
 All businesses require funding for their
activities.
 For example – a loan to purchase a new
computer system or a bank overdraft to pay
suppliers before the receipt of customers
cash.
 Just like people, organizations require a
variety of funding for a range of purposes.
Why do we need finance?
1. Setting up a business
2. Need to finance our day-to-day
activities
3. Expansion
4. Research into new products
5. Special situations such as a fall in sales
 Finance is required
for many activities
 Setting up a business will require start-
up capital of cash injections from the
owner(s) to purchase essential capital
equipment and, possibly, premises.
 Finance is required
for many activities
 Businesses need to finance their working
capital –
• the day-to-day finance needed to pay bills and
expenses and to build up stocks
 Finance is required
for many activities
 Business expansion needs finance to
increase the capital assets held by the
firm – and, often, expansion will involve
higher working capital needs.
 Finance is required
for many activities
 Expansion can be achieved by taking
over other businesses. Finance is then
needed to buy out the owners of the
other firm.
 Finance is required
for many activities
 Special situations will often lead to a
need for greater finance. A decline in
sales, possibly as a result of economic
recession, could lead to cash needs to
keep the business stable; or a large
customer could fail to pay for goods, and
finance is quickly needed to pay for
essential expenses.
 Finance is required
for many activities
 Apart from purchasing fixed assets,
finance is often used to pay for research
and development into new products or to
invest in new marketing strategies, such
as opening up overseas markets.
 Finance is required
for many activities
 Note:
• Some of these situations will need investment in
the business for many years. Others will need only
short-term funding (for around one year or less).
• Some finance requirements of the business are for
between one and five years (medium term
financed).
• All of the situations will need different types of
finance. No one source or type of finance is likely
to be suitable in all cases.
Key Terms
 Start-up capital – capital needed by an
entrepreneur to set up a business
 Working capital – the capital needed to
pay for raw materials, day-to-day running
costs and credit offered to customers. In
accounting terms:
• working capital = current assets – current
liabilities
Working Capital (Balance Sheet)
Capital and Revenue
Expenditures
 Capital Expenditure – is the finance
spent on purchasing fixed assets that
are expected to last for more than one
year, such as land, buildings, equipment
and machinery.
 Revenue Expenditure – is spending on
all costs and assets other than fixed
assets and includes wages, raw
materials, rent and electricity.
 Factors to consider when
choosing finance:
 A business should match the source of finance
to its specific use – in practice this means that
a business should secure long-term sources
of finance for long term uses or needs and for
more short term finance immediate needs.
 The cost of the source.
 The organization’s objectives.
 The flexibility and availability of the finance, for
example, how easy it is to switch from one
form of funding to another, or whether a
particular form of finance is available for a new
business with no trading record.
Factors to consider when
choosing finance:
 The impact the new funding would have
on the organizations current financial
structure, for example, its balance sheet.
 The state of the external environment,
for example the economy and consumer
trends.
 The type of business structure it is, for
example a sole trader or partnership can
raise funds from the stock market.
Sources of Finance
 Internal Sources
of Finance

Funds that come from within the

business, such as profits that have been
retained for business use or from the
sale of goods and services that earn
money for the business.
Personal Funds
 Main source of finance for sole traders
and partnerships
• Sole traders – a business in which one person
provides the permanent finance and in return
has full control of the business and is able to
keep all the profits
• Partnerships – a business formed by 2 or
more people to carry on a business together,
with shared capital investment and usually
shared responsibilities
Profits retained in the business
 This is one of the most important sources of
business finance.
 If a company is trading profitably, some of these
profits will be taken in tax by the gov’t (corporate tax)
and some is nearly always paid out to the owners or
shareholders (dividends). If any of the profit
remains, it is kept in the business and this retained
profit becomes a source of finance for future
activities.
INTERNAL SOURCES OF FINANCE
Retained Profit

Advantages of using Retained Profit

 The advantages of retained profit are
that there are no associated borrowing
costs and that businesses do not see a
rise in debt levels (gearing).
 The owners control is not diluted and
decisions are not vetted by lenders
(banks)
INTERNAL SOURCES OF FINANCE
Retained Profit
The Disadvantage of using Retained Profit
 The disadvantages are that the owners may take
out all the organization’s spare cash and there
will be no buffer if the business suddenly needs
cash or another market opportunity arises.
 Equally some businesses are more focused on
investment decisions when borrowing money,
but are more lax when using retained profits.
 There may no outsiders to be accountable to –
especially small and family run businesses with
no outside shareholders.
Sale of Assets
 Many large retail businesses that own lots of
property have decided to sell off their property
portfolio and raise fresh expansion capital or cash.
 Businesses could sell assets that are no longer fully
employed to raise cash.
 Some businesses will sell assets that they still intend
to use, but which they do not need to own. Assets
might be sold to a leasing specialist and leased back
by the company. This will raise capital but there will
be an additional fixed cost in the leasing and rental
payment.
Evaluation: Advantages
 No direct cost to the business although
there may be opportunity cost
 Does not increase liabilities or debts
 There’s no risk of loss of control by the
original owners as no shares are sold
Evaluation: Disadvantages
 Is not available for all companies
 Can slow down business growth as the
pace of development will be limited by
the annual profits or the value of the
assets to be sold
 Working Capital-
Manufacturing Case Study
 The first part of the cycle starts with cash being spent on
raw materials.
 These materials become our stock, so the cash is now
tied up as unsold stock items.
 When the finished items of stock are finally sold to
customers, (on credit) these customers owe us money.
 They in effect become the debtors of the business.
 When paid, the debtors cash is returned to the business
and the cycle carries on in funding new stock or paying
the expenses the business (eg: paying suppliers or
reducing our bank deficit.
 If the business is making a profit some of this cash may
be kept in the business as retained profit and not spent
in the short term.
Reducing our Working Capital
Needs
 A possible source of finance is
squeezing or reducing our own working
capital needs.
 Therefore the cash we need is more
efficiently used.
 Eg: IF we minimize our stock levels we
reduce the amount of money tied up in
stock.
Just in Time Production (JIT)
Reducing Working Capital Needs
 In modern customer manufacturing the concept of
producing just in time (JIT) and only to a specific order
has grown dramatically.
 Eg: When a customers orders a bed or dining table they
may in some cases have to be wait 2 to 4 weeks for
delivery.
 This is because some items are not held in stock by the
retailer or manufacturer – they are both minimizing their
working capital needs and the amount of money tied up in
the unsold stock.
 The consumer therefore pays upfront to the retailer and is
effect funding the retailing and manufacturing of the
product.
Early Payments Incentives
Reducing Working Capital Needs

 A business can ask its customers who

purchase goods on credit to pay more
promptly, by offering a financial
incentive.
 Eg: A 5% discount for payment in 14
days and this helps to reduce the
funding needs from the bank or
shareholders.
Delaying Payments to
Creditors
Reducing Working Capital Needs
 A business can slow down payment to it
suppliers or creditors.
 Therefore a business can use resources
for longer without having paid for them.
 Suppliers or creditors are being asked to
fund more of our operation.
MRP & MRP2
Reducing Working Capital Needs
 Better management of stock can be done
internally and without always affecting
delivery dates.
 Better MRP (Material Resource Planning)
and MRP2 (Manufacturing Resource
Planning) systems are making the ordering
of stock materials more efficient.
 These systems reduce the time that stock is
left unused and therefore reduce the
amount of money tied up in stock.
The Advantages of
Reducing Working Capital Needs
 The advantage of squeezing working
capital as a source of finance is that you
do not have to ask a bank or
shareholders to give you more money
and on terms that may be expensive.
The Disadvantages of
Reducing Working Capital Needs
 The disadvantage is that suppliers and
customers may not be happy waiting for
money or paying upfront for goods,
especially when competitors may be able to
offer a better delivery schedule for
customers or better payment terms to their
suppliers.
 Caution has to be exercised and
communication with these two stakeholders
is paramount.
External Sources of
Finance

Long-term Financing:

To purchase fixed assets that will be

used for many years, or to fund a take-
over.
Issue New Shares
(Share Capital)
Available to limited companies (PLC’s and
LTD’s).
 Advantages:
• A permanent source of finance that does not
have to be repaid.
• No interest is charged.
• Large sums can be raised.
Issue New Shares
 Disadvantages:
• Shareholders will expect dividends to be paid.
• Original owners may lose control of the company if
new shareholders are created (exception – a Rights
Issue allows existing shareholders in plc’s to maintain
their % shareholding).
• Can be expensive to organize (fees paid to advisors
etc).
• May take some time to arrange.
• Dividends paid after tax, so less money available to
shareholders.
Long-term Bank Loan
(Loan Capital)
A loan for 10 years or more.
Example: Mortgages and Business Dev. Loans
 Advantages:
• Quick to arrange (money immediately
available).
• Flexibility over repayment term (eg 10 years-
25 years).
• Discount rates often available if large sums
borrowed.
• Interest is paid before the profits are taxed.
Long-term Bank Loan
(Loan Capital)
 Disadvantages:
• Loans must be repaid.
• Interest is charged and must be paid, even if
the firm makes a loss.
• Interest rates may be variable which adds
risk.
• Collateral or security is often required.
Debentures (long-term loan
certificates)
 Debentures are a type of long-term loan
with the promise of fixed annual interest
payments to the debenture holders and
are repayable on maturity.
Debentures (long-term loan
certificates)
 Advantages:
• Debenture holders can re-sell the debenture
(increased liquidity is an attraction for
investors).
• Interest rate is fixed. This reduces risk for the
business.
• Enables very long-term financing (eg. 25
years).
Debentures (long-term loan
certificates)
 Disadvantages:
• Must be repaid in full on the maturity date.
• A fixed rate of interest is charged throughout
the loan period.
Exam Tip!
 Students often write that a fall in a
company’s share price affects its
level of profits as the firm has less
money. It is more likely to be the
other way around; the poor
performance of a company will lead
to a fall in its value so its share price
declines.
 When share holders sell their
shares, the company does not
receive any of this money as these
shares are traded on the secondary
market of the stock exchange; no
new shares have been issued by the
company.
 Define the term initial public
offering (IPO).
• An initial public offering (IPO) occurs when a
company floats its shares on a stock exchange for
the very first time. For example, ABC floated its
shares in both Shanghai and Hong Kong. In doing
so, ABC became a public limited company.
 Comment on why ABC might have
decided to float its shares on the
stock market.
• The main benefit of issuing shares in a company is the
potential to raise a huge amount of share capital. In
the case of ABC, it was able to raise $22.1 billion,
significantly improving its cash flow and sources of
finance.
• The extra source of finance would allow ABC to
compete against more established global banks such as
Citibank, HSBC, Bank of China and ICBC, especially as
it would be able to expand its operations within and
beyond China.
 Comment on why ABC might have
decided to float its shares on the
stock market.
• Expansion (funded by the IPO) allows ABC to have a
greater market presence, thereby enhancing its
corporate image.

• In addition, ‘going public’ allows a business to have the

protection of limited liability.
 Explain why investors might have been
so keen to buy shares in ABC, despite
the weak market sentiment in Asian
stock markets at the time.

• Investors in the stock market tend to buy for the

medium to long term. Given that ABC is China’s third
biggest lender, with more than 325 million customers,
this may have provided sufficient reason (i.e. a sense
of security) for investors to pour money into the
company.
External Sources of
Finance

Medium-term Financing:

To purchase fixed assets that will be

used for 2 - 5 years (eg. equipment &
vehicles).
Medium-term Bank Loan
 Advantages:
• Quick to arrange (money immediately
available).
• Flexibility over repayment term (eg 2 - 5
years).
• Discount rates often available if large sums
borrowed.
• Interest is paid before the profits are taxed.
Medium-term Bank Loan
 Disadvantages:
• Loans must be repaid.
• Interest is charged and must be paid, even if
the firm makes a loss.
• Interest rates may be variable which adds
risk.
• Collateral or security may be required
(especially for smaller and higher risk
businesses).
 Hire Purchase
The business pays monthly installments to a finance company.
When the final installment is paid the asset becomes the
business’.
 Advantages

• Enables businesses to buy assets when they have

little cash available, or when they do not want to
commit large amounts of cash to acquire assets.
• No collateral required (the asset being purchased is
the collateral).
• Useful for businesses that have limited finance
options.
Hire Purchase
 Disadvantages
• A large cash deposit may be required.
• Interest rates are generally higher than for
bank loans.
• Failure to make a payment may result in the
asset being taken back by the HP company.
 Leasing
Businesses sign a contract with a leasing firm. They
effectively rent the assets they need from that firm
for an agreed period of time.
 Advantages:
• Firms can make use of assets without the need for large
sums of money.
• Frees money to be used elsewhere in the business (helps
cash flows).
• Gives the firm flexibility. It can lease assets only when it
needs to use them (reduces costs).
• The care and maintenance of the asset is the responsibility
of the leasing company.
• Assets are kept up to date (ideal for computers and other
equipment that become obsolete quickly).
Leasing
 Disadvantages:
• In the long run, total costs will be higher than
buying the asset outright.
• Businesses are committed to lease the asset
for the length of the lease agreement.
Sell and Lease-back
Businesses raise money by selling assets
that they need, then lease them back.
 Advantages:
• Frees money tied up in assets for use by the
business.
• The business is still able to make use of the
assets in return for monthly payments to the
leasing company.
Sell and Lease-back
 Disadvantages:
• The firm will have fewer assets to provide as
collateral for loans in the future.
• Day to day costs will be higher as there will be
an extra monthly payment for using the asset.
• The firm will be committed to lease the asset
for the length of the lease agreement.
External Sources of
Finance

Short-term Financing:
Provides the working capital needed for
the day-to-day expenses of the
business.
Covers the period from a few days to
12 months.
Bank Overdraft
The bank allows the current account of the
business to become ‘overdrawn’. This means
that it will have a negative balance. A facility to
become overdrawn should be arranged with
the bank before the money is required.
 Advantages:
• The most flexible form of financing as the amount of
money needed can change day-to-day.
• Interest is only payable on the amount overdrawn.
• Can be cheaper than a loan if overdrawn period is
kept short.
Bank Overdraft
 Disadvantages:
• Interest rates are generally higher than for a
loan.
• A fee is often charged for having the facility.
• Not generally available for a long period of time.
• The bank can ask for repayment at any time
which could cause the business to be made
bankrupt.
• There will be an upper limit to the facility. The
firm cannot be overdrawn more than this.
Trade Credit
When a business delays paying its
suppliers for an agreed period of time
(usually 30 or 60 days).
 Advantage:
• Is like the business receiving an interest-free
loan for a month or two.
• Allows the business to sell goods before
paying for them.
Trade Credit
 Disadvantages:
• Suppliers may refuse to send more supplies if
payments are left too long.
• The firm cannot usually obtain a discount for
paying the supplier quickly.
• Is generally limited to a period no longer than
60 days.
Debt Factoring
Debt Factors buy the debts of firms for
cash.
 Advantages:
• The business receives most of the money
owed to it (around 80-85%) immediately.
• Helps businesses that give their customers
long trade credit periods.
• The risk of non-payment is taken on by the
Factor.
Debt Factoring
 Disadvantage:
• The firm only receives a % of the money
owed to it (around 80-85%).
External Sources of
Finance

Grants & Subsidies

Grants
Money usually given by the government to
assist firms with important expenditures.
Advantages:
• Enables businesses to fund important projects
like training, or the purchase of new
equipment / technology.
• Encourages businesses to adopt new
methods / technologies eg. alternative energy
generators.
Grants
 Disadvantages:
• There are often ‘strings’ attached, eg firms
must locate in a certain area, create a certain
number of jobs, or purchase a specific item.
Subsidies
Payments made by governments in order
to keep businesses operational.
 Advantages:
• Money does not have to be returned.
• No interest is charged.
 Disadvantage:
• Only available to businesses in certain
industries.
Venture Capital
vs.
Business Angels

Sources of Finance
Venture Capital (VC)
 Is a high-risk capital invested by venture
capital firms, usually at the start of a
business idea. The finance is usually in
the form of loans and/or shares in the
business venture.
 Venture capitalists seek to invest in
small to medium-sized businesses that
have high growth potential.
Business Angels (BA)
 Are wealthy entrepreneurs who risk their
own money by investing in small to
medium-sized businesses that have high
growth potential.
 They take proactive role in the setting up
or running of the business venture –
owner loses some control to the BA
 By contrast, venture capital is typically a
pool of professionally managed funds.
 Criteria for VC and BA
 Return on investment – business has to
have good potential to be highly profitable.
 The business plan – should outline the LT
aim and purpose of the business venture.
 People – must have good team of people.
 Track record – Investors will assess the past
track record of the business and its
management before investing any capital.
Managers consider a number of
interlinked factors when
examining the strategic choice
between alternative sources of
finance

STAGE PC
Size and status of firm
 A well-known and large MNC will find it
much easier to raise finance from a
wider range of sources than a sole
trader.
 Large organizations are also able to
obtain cheap finance due to financial
economies of scale.
Timeframe
 If finance is needed for a long period of
time, then long-term loans such as
mortgages or debentures are suitable.
 If finance is needed to help fund working
capital, then short-term sources such as
trade credit and overdrafts are more
appropriate.
Amount required
 Large amounts of finance might be
raised through IPO or through secured
long-term loan from banks.
 If only a small amount is needed then
retained profit or an overdraft might be
sufficient.
Gearing
 Lenders assess a firm’s existing gearing
(LT external borrowing of a firm as a %
of its capital employed) before approving
any finance.
 Firms with high gearing are relatively
high risk as they have existing debt
commitments and more vulnerable to
any increase in interest rates.
External factors
 Factors beyond the control of a business
can have a huge impact on the strategic
choice of finance.
 Businesses will be affected by the state
of the economy and consumer
confidence levels.
Purpose of finance
 The choice of finance depends on
whether it is intended for the daily
running of the business (ST purposes) or
for the replacement of fixed assets over
a longer time period.
Cost of finance
 Managers need to consider the purchase
cost of assets and the associated costs,
such as administrative fees and
maintenance charges.
 Higher costs tend to require longer term
sources of finance.
 FINAL COMMENTS –
EXTERNAL SOURCES OF FINANCE
 Using external financing brings in much needed
funding for expansion, but it has its problems or
costs.
 Gearing ratios, rises as loans become a larger share
of the total capital of the business, also interest
cover ratios may worsen, unless profit rises
proportionally as well.
 Equally more long term debt will dilute the owners
stake in the business and that of the lenders will
rise, affecting to some extent business decision
making.
 It is important to consider a variety of funding
sources and not to become overly dependent on
one.