Class 2 – Sources of Finance, Advantages & Disadvantages

Contents
Implications of Choices and Choosing a Source

Learning Objectives

1) Sources of Short-term financing

2) How do the three basic legal forms of organizing firms (sole proprietorship,
partnership and corporation) go about raising large amounts of money under
each form?

2) Legal, financial and dilution of control implications

3) Advantages and disadvantages of different sources

4) Suitability for purpose e.g. matching of term of finance to term of project

 Sources of Short-Term
Financing
• Trade Credit from Suppliers
• Bank Loans
• Commercial Paper (Promissory Notes)
• Bankers’ Acceptances
• Foreign Borrowing
• Loans Against Receivables and Inventory
 Trade Credit

• Largest source of short-term financing for a firm

• Trade payables are a spontaneous source of funds
• Usually a 30-60 day grace period before a bill is due
 Trade Credit
Often, suppliers will offer a discount if you pay your bills
early instead of delaying payment.
• Cash discount allows for a reduction in price if payment is made within a
specified time
• ex: 2/10 net 30 means you a 2% discount if pay within 10 days
• On a $100 billing, we could pay $98 up to the 10th day or wait 20 more days
and pay $100.

$98 $100

10 days 20 days
If you don’t pay in 10 days, we get to ‘use’ (or borrow) $98 for a $2 fee (or interest rate)
 Net Credit Position

Net Credit Position = A/R ─ A/P

Accounts Accounts
Receivable Payable

• If A/R greater than A/P, the firm is a net provider of

trade credit (positive number)
• If A/P greater than A/R, it is a net user of trade credit
(negative number)
Larger firms tend to be net providers of trade credit, while smaller
firms are net users
 Bank Credit

A self-liquidating loan generates cash flows that form a built-in

or automatic repayment scheme.

• A borrower takes out a loan that is used to finance business

activities that generate revenue.

• Then the borrower takes the revenue generated from those

business activities and uses it to repay the money that was
borrowed to finance the activities.
Example:
• During the busy season the company needs to borrow money to finance
inventory and accounts receivable.
• When the company has generated profits from the busy season, it will to
use those profits to repay the loans
 Bank Credit
Short-term loans take on the nature of longer-term financing
through renewing arrangements.
• A line of credit is an ongoing availability to borrow money
using your property or the business as collateral.
• A balloon mortgage is a short-term loan with a long-term
repayment schedule. For example, you make payments as if
the loan would be paid in 25 years, but the actual maturity is
10 years. After ten years the loan needs to be ‘renewed.’
Renewal:
• Your lender will review the renewal as if it is a new loan.
• The bank will want to ensure that the value of your collateral equals or
exceeds the loan amount.
 Bank Credit

Demand loans are payable (or can be

advanced) as desired and the interest
rate fluctuates with prime.
• Similar to a line of credit (LOC) but
the lending bank can demand the
repayment of the loan at any time.
• At the same time, the borrower
may repay the loan all at once
without prepayment penalties.
 Types of Bank Loans

Discounted Loan:
– when a bank deducts the interest on the loan in advance and lends
the balance

Instalment Loan:
– calls for a series of equal payments over the life of the loan
– e.g. most car loans and home mortgages

Compensating Balance Loan:

– when a compensating balance is required as part of the loan
 Corporate Borrowing

Commercial Paper:
• A short-term unsecured promissory note in minimum units of $50,000
• Sold (at a discount) by finance companies, other large corporations
• Rates paid are lower than the rate a bank would charge for loan
• Total amount of commercial paper outstanding has increased greatly in
recent years
Bankers’ Acceptances:
• Used to finance inventory of finished goods in transit (e.g. imports)
• Marketable money market instrument
• Sold at a discount
 Comparison of commercial paper rate to
bank prime rate*
20

18 90 day commercial paper

Prime
16

14

12
Yield (%)

10

* Average interest rate at December 31

 Foreign Borrowing

Foreign Borrowing:
• An increasing source of funds for Canadian firms is the large
Eurocurrency market.
• Loans from foreign banks denominated in U.S. dollars are
called “Eurodollar” loans.
• Foreign interest rates may be more favorable. The company
then converts the borrowed foreign currency to Canadian
dollars.
• There is a foreign exchange exposure risk associated with
these loans.
 Accounts Receivable Financing

A/R financing includes 3 choices:

1. Pledging accounts receivable as collateral
2. An outright sale of a company’s accounts receivables to
a factoring company.
3. Asset-backed Securities: Sale of receivables by large
corporations in public offerings.

Tends to be a relatively expensive source of financing

 Inventory Financing

• Inventory may be assigned as collateral security against an operating

loan

• For example, in a Trust Receipt or Floor Planning

• loan is based upon serial numbers on product
• when goods are sold, loan is repaid
• used by auto dealers, industrial equipment dealers,
television and home appliance dealers
Hire purchase (HP) or leasing

This a type of asset finance that allows firms or individuals to possess and control
an asset during an agreed term, while paying rent or instalments covering
depreciation of the asset.

The use of HP or leasing is particularly common in industries where expensive

machinery is required, such as construction, manufacturing, plant hire, printing,
road freight, transport, engineering and professional services.

It is also used to finance other capital requirements of a business, for example:

smaller items
• cars
• photocopiers.
Elements of Working Capital Management

The working capital ratio, calculated as current assets divided by current liabilities, is
considered a key indicator of a company's fundamental financial health since it
indicates the company's ability to successfully meet all of its short-term financial
obligations.

Although numbers vary by industry, a working capital ratio below 1.0 is generally
indicative of a company having trouble meeting short-term obligations, usually due
to insufficient cash flow. Working capital ratios of 1.2 to 2.0 are considered
desirable, but a ratio higher than 2.0 may indicate a company is not making the
most effective use of its assets to increase revenues.
How Factoring can improve Cash Flow

Factoring is a process by which a business sells its invoices to a specialist factoring

company (a factor) and receives quick payment in return as a cash advance. For a
small fee, the factoring company chases the debt and deals with any non-payment
issues, removing all the hassles associated with invoice administration. 

Factoring can dramatically improve cash flow and boost company growth as it

guarantees income and releases monetary assets that would otherwise be tied up in
invoices (essentially providing instant access to money belonging to the business but
which hasn’t yet been paid by debtors).

Therefore, it is perfectly suited to start-ups and small companies, service based

industries that rely on invoicing and businesses that wish to fund periods of rapid
growth.
 Sole Proprietorships

• Business is owned by an individual who holds title to all assets and is

personally responsible for all debts

• Widely used in service industries (ie: Lawyers, Doctors, Vets)

• Easily established

• Proprietor has unlimited liability

How would a sole proprietor raise capital?

How would a sole proprietor raise capital?
• Borrow from friends/family

• Take our a loan from the bank (may not be as attractive to

a lender since there is only one person)
 Partnerships

• More than one owner of the business

• Greater amounts of capital can be raised

How would a partnership raise capital?

How would a sole partnership raise capital?
• More than one owner to put in personal capital

• Borrow from friends/family

• Take our a loan from the bank (may be more agreeable

given a larger investment base)
 Corporations

• Exist legally separate and apart from its owners

• An owner’s liability is limited to his/her investment

• Personal assets cannot be seized in claims against the

corporation

How can a corporation raise capital?

How would a corporation raise capital?

• Ability to raise capital apart from its owners

• Equity financing - Common/preferred shares

• Debt financing

• Retained earnings
Sources of Finance

Sources of finance can be classified into:

• Internal sources (raised from within the organization)

• External (raised from an outside source)

Internal Sources

• There are five internal sources of finance:

• Owner’s investment (start up or additional capital)

• Retained profits/earnings (the profit kept in the company rather
than being paid out to shareholders as a dividend)
• Sale of stock
• Sale of fixed assets
• Debt collection
Internal Sources(cont.)

Owner’s investment Advantages

• Doesn’t have to be repaid
• This is money which comes from
the owner/s own savings • No interest is payable
• It may be in the form of start up
capital - used when the business is Disadvantages
setting up • There is a limit to the amount an
owner can invest
• It may be in the form of additional
capital – perhaps used for
expansion
• This is a long-term source of finance
Internal Sources(cont.)

Retained Earnings Advantages

• This source of finance is only • Doesn’t have to be repaid

available for a business which has • No interest is payable
had enough time to earn funds

• It is when the profits made are Disadvantages

ploughed back into the business
• Not available to a new business
• This is a medium or long-term • Business may not make enough
source of finance profit to plough back
Internal Sources(cont.)

Sale of Inventory (stock) Advantages

• This money comes in from selling • Quick way of raising money

off unsold inventory • By selling off inventory it reduces
the costs associated with holding
• This is what happens in January them
when items go on sale

• It is when the profits made are Disadvantages

ploughed back into the business
• Business will have to take a
• This is a short-term source of reduced price for the stock
finance
Internal Sources(cont.)

Sale of Fixed Assets

• This money comes in from selling
off fixed assets, such as:

• a piece of machinery that is no

longer needed

• Businesses do not always have

surplus fixed assets which they
can sell off

• There is also a limit to the number

of fixed assets a firm can sell off

• This is a medium-term source of

finance
ollection

Internal Sources
External Sources

There are eight external sources of finance:

• Bank Loan or Overdraft

• Additional Partners
• Share Issue
• Leasing
• Hire Purchase
• Mortgage
• Trade Credit
• Government Grants
External Sources(cont.)

Bank Loan

• This is money borrowed at an

agreed rate of interest over a set
period of time

• This is a medium or long-term

source of finance
External Sources(cont.)

Bank Overdraft

• This is where the business is

allowed to be overdrawn on its
account

• This means they can still write

cheques, even if they do not have
enough money in the account

• This is a short-term source of

finance
External Sources(cont.)

Additional Partners

• This is sources of finance suitable

for a partnership business

• The new partner/s can contribute

extra capital
Issue

External Sources(cont.)
sing

External Sources(cont.)
External Sources(cont.)
Hire Purchase
• This method allows a business to
obtain assets without the need to
pay a large lump sum up front
• Involves paying an initial deposit
and regular payments for a set
period of time
• The main difference between hire
purchase and leasing is that with
hire purchase after all repayments
have been made the business
owns the asset
• This is a medium-term source of
finance
Advantages
• Businesses can have the use of
up-to-date equipment immediately
• Payments are spread over a
period of time which is good for
budgeting
• Once all repayments are made the
business will own the asset
Disadvantages
• This is an expensive method
compared to buying with cash
External Sources(cont.)
Mortgage
• This is a loan secured on
property
• Repaid in instalments over a
period of time typically 25 years
• The business will own the
property once the final payment
has been made
• This is a long-term source of
finance
Advantages
• Business has the use of the property
• Payments are spread over a period of
time which is good for budgeting
• Once all repayments are made the
business will own the asset
Disadvantages
• This is an expensive method compared
to buying with cash
• If business does not keep up with
repayments the property could be
repossessed
External Sources(cont.)

Trade Credit Advantages

• Trade credit is summed up by the • Business can sell the goods first
phrase: and pay for them later
• Good for cash flow
Buy now pay later • No interest charged if money is
paid within agreed time
• Typical trade credit period is 30 Disadvantages
days • Discount given for cash payment
would be lost (expensive source of
• This is a short-term source of funds)
finance • Businesses need to carefully
manage their cash flow to ensure
they will have money available
when the debt is due to be paid
ent Grants

External Sources(cont.)

Advantages
• Don’t have to be repaid
Disadvantages

• Certain conditions may apply such

as location

• Not all businesses may be eligible

for a grant
Factors Affecting Choice of Source of Finance

• The source of finance chosen will depend on a number of

factors:

• Purpose – what the finance is to be used for

• Time Period – how long the finance will be needed for

• Amount – how much money the business needs

• Ownership and Size of the business

Terms we need to know

Depreciation
• Is the systematic allocation of the cost of a capital assets over a
period of time for financial purposes, tax purposes or both

• Depreciation deductions taken on a firm’s tax returns are

treated as expense items, therefore, depreciation lowers
taxable income

• Everything else being equal, the greater the depreciation

charges, the lower the taxes
A few accounting terms we need to know

There are a number of alternative procedures for depreciating capital

assets for tax and financial reporting:

Straight-Line Depreciation
• A method of depreciation that allocates expenses evenly over the
depreciable life of the asset

Accelerated Depreciation
• Methods of depreciation that write off the cost of a capital asset faster than
under straight-line depreciation

Declining-Balance Depreciation
• Methods of depreciation calling for an annual charge based on a fixed
percentage of the asset’s depreciated book value at the beginning of the
year for which the depreciation charge applies
THANK YOU