Module – Introduction to Business Studies

(IBS).
Short Title – IBS.

DATE:

Lecturer:
Week 10 lecture 2 : Sources of Finance

▪ Module code – FY021

▪ Level 3
▪ Week 10 lecture
▪ Email:
▪ Office hour:
▪ Pat hour:
Learning outcomes:

▪ Sources of finance
▪ Short-term financing
▪ Long-term financing
▪ Debt factoring
▪ Preference shares
▪ Stock Market floatation
▪ Right issues vs Bonus
▪ Venture capital, Bond, Debenture and Convertible
▪ Role of finance within organisation
Sources of Finance
▪ Sources of Finance
 Short-Term Financing

• Short-term finance options for businesses can include overdrafts, loans, from friends and credit from suppliers.

• These finance options should all be used as a short-term option only and then repaid as quickly as possible.

• This type of financing is often termed as working capital financing, and is very important part of business funding.

Need for Shot-term Finance

• Is needed in order to pay creditors such as suppliers.

• The amount needed will vary from business to business, and can vary from month to month.

• Calculating how much working capital needed should be an initial business task.

• Businesses will calculate the minimum needed by averaging the amount of sales over a month, then multiplying by how many
months before receiving payment.
Short-term Financing

Working Capital

• It is usually defined as the money businesses need to pay all their activities.

• This means the money needed to pay bills, wages and materials.

• Current assets such as money in the bank, stock, and debts from those that owe the business money are viewed as working
capital.

• Against this are the current liabilities, which is money owed by the business such as VAT, PAYE, and money owed to
suppliers.

• It is vital that a business has enough working capital to pay their current liabilities.

• One of the reasons that many businesses fail is a lack of adequate working
capital from the start of the business life.
Benefits and issues with short-term finance

• They are excellent as a short-term finance option

• They are easily arranged, flexible, and there is not usually a charge if you wish to repay the
overdraft early.

• On the downside, overdrafts are often abused leaving the borrower open to hefty fees if the
overdraft limit is exceeded.

• Another negative is that O/D can be taken away just as easily as they are given if they are
abused regularly.

• Overdrafts should also not be used as a long term finance option;

• Unsecured loans are much less expensive in the long term.

Bank overdraft

Advantages:
• Easy to arrange and relatively cheap.
• Useful as method of easing cash flow strains during peak periods
• Interest charges are only incurred whilst the facility is overdrawn and only
the exact amount of funding required is utilised.

Disadvantages:
• Security may be required.
• Can be withdrawn by the bank at any time or may not be renewed when it is
required in future.
• Banks may required management figures at regular intervals in order to
monitor progress.
Sources of Short-term Finance

▪ Bank loan:
• Bank loans are very flexible.
• They can vary in the length of time that loan has to be repaid.
• Loans arranged with a bank that are less than one year are
regarded as short term finance.
• As with any other loan there are interest payments to be made and
this can be expensive and also can vary.
• The repayment is done by instalments normally monthly.
Bank loan
Advantages
• Can be structured so that repayments can be met out of future income deriving from
a project.
• Cannot technically be withdrawn as long as the borrower honours all of the terms of
the facility.
• Repayments can be structured to meet the needs of the business.
Disadvantages
• Security will generally be required which adds to the initial costs and puts the
business at a degree of risk.
• Management figures may be required at regular intervals.
• An agreed sum of money is lent and this may be more than is actually needed at the
time.
• Can be expensive for small company
Sources of Short-term finance

Obtaining Trade Credit

• Trade credit is a short term financing option widely used in business.
• Basically, it means you are using credit from suppliers to fund part of your
business.
• By so doing you will not usually be charged any interest on the credit
obtained.
• It is important that creditors are paid on time and in full as set out in the
credit agreements.
• If businesses do not adhere to the credit agreements terms and conditions
then creditors are well within their rights to apply charges and interest
penalties.
• Ultimately, they can stop this credit service altogether.
Sources of short-term finance
Debt factoring and Invoice discounting
• They are ways of selling your outstanding debtor payments to a third party
so you do not have to wait for payment.
• There are a number of different financial institutions and stand alone
companies that provide this service and they will charge a fee.
• In Many cases, these options will not be suitable for small start-up
businesses.
• For instance most companies will only deal with businesses that have an
annual turnover of £50,000.
• There are some debt factoring and invoicing companies that will provide this
service for smaller companies but charges for the service can be high.
Long –term financing
Debt factoring and Invoice discounting
• They are ways of selling your outstanding debtor payments to a
third party so you do not have to wait for payment.
• There are a number of different financial institutions and stand alone
companies that provide this service and they will charge a fee.
• In Many cases, these options will not be suitable for small start-up
businesses.
• For instance most companies will only deal with businesses that
have an annual turnover of £50,000.
• There are some debt factoring and invoicing companies that will
provide this service for smaller companies but charges for the
service can be high.
Preference Shares
• Preference shares also constitute part of the shareholders’ fund.
• Preference shares usually offer their owners a fixed rate of dividend each year.
• However, if a firm has insufficient profits the amount paid will be reduced, sometimes
to zero.
• Thus there is no guarantee that an annual income will be received, unlike with debt
capital.
• Dividend to preference shares is paid before anything is paid out to ordinary
shareholders – indeed there may be nothing left after obligation to preference
shareholders.
• They are attractive to some investors as they provide regular income at higher rate of
interest.
• They are considered part of the shareholder fund but not equity share capital.
Types of Preference Shares

• Convertible preference shares: means that preference shares can

be converted into ordinary shares at some future date.

• Cumulative preference shares: means that if dividends is missed

in a year the right to eventually receive a dividend is carried forward.
These prior year dividends has to be paid before any payout to
ordinary shareholders.
• Redeemable preference shares: these have a finite life, at the end
of which the initial capital investment will be repaid.
• Irredeemable preference shares: these have no fixed redemption
date.
Preference Shares
Advantages
• Dividends ‘optional’: preference can be omitted for one or more years. This can give
the directors more flexibility and greater chance of surviving a downturn in trading.
• Influence over management: preference shares are an additional source of capital,
which because they do not (usually) confer voting rights, do not dilute the influence of
ordinary shareholders on the firm’s direction.
• Extraordinary profits: the limits placed on the return to preference shareholders
mean that the ordinary shareholders profits when the firm is doing well.
• Financial gearing consideration: there are limits to safe levels of borrowing.
Preference shares are alternative, if less effective, shock absorber to ordinary shares
because of the possibility of avoiding the annual cash outflow due on dividends.
Preference Shares

Disadvantages
• High cost of capital: higher risk attached to the return
and capital cause preference shareholder to demand
higher level of return than debt holders.
• Dividends are not tax deductible unlike interest on debts.
Stock Market floatation

• Enough – in terms of size and turnover,

• they may want to become quoted on a stock market, giving investors a clear
market-determined price for the company’s shares, at which they can easily
both buy and sell the company shares.
• Stock Exchange Placing: shares are only sold/ ‘‘placed’’ with a few big
institutional investors, such as pension funds.
• Initial Public Offer (IPO): shares are sold to the public – and not just to a
select group of institutional investors.
• A Tender Offer: a very unusual – and unpopular – floatation method, which
are normally only used to float companies with unique businesses – difficult
to determine the price at which the shares are to be sold.
Stock Market Floatation

Advantages of Stock Market Floatation

• Much easier to raise equity finance. The shares are now ‘tradable’ and therefore
liquid)
• Allows the owner to release some of their capital/wealth that is tied up in the
company.
• It provides business angels and venture capitalists with an ‘‘exit route’’ from their
investments.

Disadvantages of Stock Market Floatation

• Loss of control by the original owner
• Cost of the initial floatation and the annual audit and stock exchange membership
costs.
• Increased level of financial information disclosure.
Activity: Please listen attentively
▪ https://www.youtube.com/watch?v=sfcZOl6f-Dg
Right issues vs Bonus issues

Right issue
• The new shares are offered for sale, at a small discount on the current market price,
• to all the company’s shareholders, in proportion to their existing shareholdings.
• Shareholders may then decide either to take up their rights,
• (i.e. buy the new shares to which they are entitled), or sell-on the rights to other
investors.

Bonus issue
• New shares are offered for sale but at no cost to existing shareholders.
• It is usually offered to shareholders in place of dividends being given.
• It is therefore internally generated source of finance
Right issues
• What if a shareholder does not want to take up the rights?
• As owners of firm all shareholders must be treated in the same way.
• To make sure that some shareholders do not lose out because they
are unwilling or unable to buy more shares,
• the law requires that shareholders have a third choice, other than
buy or not to buy the new shares.
• This is to sell the rights on to someone else on the stock market (the
right nil paid)
Right issues
Nana Plc has 20 million shares in issue and their current
market price is £2.24 per share. The company wishes to
raise an extra £8m of new equity capital and proposes to
make a 1 for 5 rights issue at £2 per share. You are a
shareholder in Nana that currently holds 5,000 shares.
Solution:
This situation can now be analysed as follows:
i) Amount of new shares sold:
20m shares / 5 shares = 4m new shares.

ii) Amount of finance raised:

4m new shares x £2 per share = £8 million
Venture Capitalist
• There are a number of different types of venture capital
providers.
• They can be firms, funds or investment trusts, either
quoted or private, which have raised their capital from
more than one source.
• The main sources are pension and insurance funds, but
banks, corporate investors and private individuals also
put money into these venture capital funds.
Venture capital/ private equity
• Venture capital funds provide finance for unquoted firms with high growth
potential
• VC is funding mainly for the development of existing companies with sound
management and,
• high growth potential, but sometimes for especially attractive start-ups.
• Funds are usually provided in large packages (typically over £250,000 and
can go up to £5 million) of debt and
• equity to offer a degree of security and to allow VC companies to participate
in any major success.
• VC companies often provide managerial assistance.
• Venture capitalists expect to get a return of between five and ten times their
initial investment in about five to seven years.
• This is due to the fact that and as we know high risk goes with high return.
Venture capital/ private equity
• Venture capital funds provide finance for unquoted firms with high growth
potential
• VC is funding mainly for the development of existing companies with sound
management and,
• high growth potential, but sometimes for especially attractive start-ups.
• Funds are usually provided in large packages (typically over £250,000 and
can go up to £5 million) of debt and
• equity to offer a degree of security and to allow VC companies to participate
in any major success.
• VC companies often provide managerial assistance.
• Venture capitalists expect to get a return of between five and ten times their
initial investment in about five to seven years.
• This is due to the fact that and as we know high risk goes with high return.
Debt Financing
• Debentures and long term debts are alternative to equity in
financing an entity’s long term finance requirements.
• Debt finance is less risky than equity finance to the investor as is
always assured of interest and capital repayment ahead of
shareholders.
• From the view of the company it is less expensive than equity
finance because the risks are less;
• the investor is satisfied with the lower expected rate of return.
• The interest expense is also an allowable expense for tax purpose.
Bond
• A bond is a long-term contract in which the bondholder lends money to a
company.
• In return the company (usually) promises to pay the bond owners a series of
interest payments, known as coupons, until the bond matures.
• At maturity the bondholder receives a specified principal sum called the par
(face or nominal) value of the bond.
• This is usually £100 in the UK and $1000 in the USA.
• The maturity time is generally seven to thirty years.
• Bonds are traded in the secondary market.
• However, there is very small secondary market compared to shares as
investors hold on rather than trade in and out.
Types of Bond
• with regular income (usually semi-annual) and with a specified redemption date. They
are also known as plain, straight or vanilla bonds.
• Other bonds are a variation on this. Some pay coupon every three months, some pay
no coupons at all (called zero coupon bonds) – these are sold at a larger discount
to the par value and the investor makes capital gain by holding the bond.
• Some bonds do not pay a fixed coupon but one which values depending upon the
level of short term interest rates (floating rate or variable rate bonds).
• Some latest bonds allows the issuer to link interest rate and principal amount to a
wide variety of economic events. These bonds were designed to let companies adjust
their interest and principal payments to manageable levels in the event of the firm
being adversely affected by some economic variable changes.
Activity: Listen attentively
▪ https://www.youtube.com/watch?v=Qh-M3_L4xYk
Debenture
• The most secured type of bond is called a Debenture.
• They are usually secured by either a fixed or floating charge against the firm’s assets.
• A fixed charge means that specific assets are used as a security which, in the event
of default, can be sold at the insistence of the debenture holders and the proceeds
used to pay the debt.
• A floating charge means that the loan is secured by a general charge on all the
assets of the corporation.
• It has a high degree of freedom in this case to in the used its assets until committing
a default ‘crystallises’ the charge.
• If this happens, a receiver will be appointed with powers to dispose of the assets and
to distribute the proceeds to the creditors.
• Fixed charge debenture holders rank above floating charge debenture holders in the
payout after insolvency.
Debenture
• Advantages:
Cash can be raised for long periods.
Large sums can be sourced against specific assets, leaving other assets
free for use as security for other facilities.

• Disadvantages:
Money cannot usually be repaid if the project generates cash more quickly
than envisaged.
It may not be possible to arrange an extension at the redemption date if the
cash flow of the business is poor,
A high ratio of borrowing in this form may deter investors when they
compare fixed-interest securities with equity capital
Convertible
• Convertible begins life as a form of debt, but carries the right, at the
holder’s option
• to convert it into ordinary shares (equity) at some specified date in
future and on specified terms,
• E.g. how many new ordinary shares can be obtained on conversion
per unit of convertible stock.
• Convertibles are particularly suitable for companies facing relatively
high business risks
• but strong potential growth because they offer investors the
possibility of participating in future prosperity.
Bank Borrowing
• Borrowings directly from banks is another way of long term finance.
• Following are advantages of bank loans:
1. Administrative and legal costs are low: because bank loan
arises from direct negotiations.
2. Quick: bank loan can work out speedily and funding facility can be
in place within matter of hours.
3. Flexibility: in case of unfavourable economic circumstances,
negotiating with a single lender has a distinct advantage.
4. Available to small firms: available to firms of almost every size.
Debt Finance
• Advantages:
• Lower cost than equity
• No dilution of voting powers
• Interest payments is tax deductible
• May contain options for early settlement.
• Disadvantages:
• Interest and principal payments are set by contract and must be met, regardless of
the economic position of the firm
• Agreement may place burdensome restrictions on the firm, such as maintenance of
working capital at a given level, limits on future debt offerings, and guidelines for
dividend policy.
• Utilised beyond a given point, debt may serve as a depressant on outstanding
ordinary share value.
Role of finance within organisation

▪ Finance supports organisation in cash flow management.

▪ Profit planning and cost control
▪ Strategic planning and budgeting
▪ Managing unavoidable risk
▪ Equity or loan
▪ Finance supports and motivates the development of skills and
knowledge required within organisation.
▪ Finance creates an avenue for: technical, analytical, technology and
interpersonal skills organisation requires.
Conclusion
▪ Finance is at the very centre of business and
management; it is also the life wire of any
business.
▪ This module has covered sources of finance or
other ways of raising fund/borrowing.
Self evaluation

▪ Do you understand the main subject area in this

module?
▪ Ask questions?
Thank You!!