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5.1.2 The main sources of

capital
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Learning outcomes

■ You will learn about the main sources of capital:

■ Internal sources and external sources with examples

■ Short-term and long-term sources with examples, e.g. debt or equity for
long-term finance
■ Importance of micro-finance in developing economies
■ The main factors considered in making the financial choice, e.g. size and
legal form of business, amount required, length of time, existing loans
■ Recommend and justify appropriate source(s) of finance in given
circumstances
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Discussion

■ Write down two to three reasons why you want or need money.

■ Write down two to three reasons why CASH might be important to

a business.
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Time Periods for Finance

Finance is generally considered to be either:

Short- Medium- Long-

term term term

1 to 3 years 3 to 10 years Over 10 years

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Short-term finance

■ Less than 1 year

■ Used to:
■ Bridge the finance gap
■ Payments that have to be made for purchases before the cash is received
from sales
■ Provide working capital for seasonal variations in sales
■ Pay for unexpected expenditure

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Medium-term finance

■ 2 – 5 years

■ Used to:
■ Finance the purchase of machinery, vehicles etc.
■ Provide initial start-up capital to invest in fixed assets
■ Replace an overdraft which is difficult to clear

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Long-term finance

■ Over 5 years

■ Used to:
■ Finance the purchase of land and buildings
■ Provide capital for major expansion
■ e.g. takeovers

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Types of finance
task■ Select the appropriate source of finance

Short term Medium term Long term

New lorry

Extra stock

New factory

New computer

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Sources of Finance

Sources of Finance can be either:

Internal External
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Sources of finance

Internal finance

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Internal Finance

■ Prepare a slide that summarizes the main points, advantages and

disadvantages of the given source of internal finance

■ Retained Profit

■ Working capital

■ Sales of assets

■ Reduce stocks

■ Owner's savings

■ You have 5 MINUTES

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Internal finance
retained profit
■ Profits are ploughed back into the business

■ Does not have to be repaid (unlike a loan)

■ Only available to profitable businesses!

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Internal finance
working capital
■ Using cash inflows (e.g. sales and payments from debtors) to pay for
cash outflows

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Internal finance
sale of assets
■ Sell surplus buildings etc.

■ Could lease them back (sale and lease back)

■ Makes better use of capital tied up in the business

■ May take some time to sell assets at a fair price

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Internal finance
reduce stocks
✓ Reduces the opportunity cost and storage cost of high stock levels

✓ May prevent the business from responding to an increase in demand

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Internal finance
owners’ savings
■ A sole trader or partnership may wish to increase their investment
■ (As unincorporated businesses are not separate from their owners, this is
internal finance)

■ Should be available quickly

■ Increases the owner’s risk

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Sources of finance

External finance
1. Long term finance
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External finance – long term

issue of shares (equity)
■ Only for incorporated businesses

■ A permanent source of finance

■ No interest is paid

■ Dividends will be expected

■ Ownership is diluted

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External finance – long term

bank loan
✓ Quick to arrange

✓ Length of loan can match the need

■ Golden rule: The length of the loan should be matched to the life of the
asset purchased

✓ Collateral (security) is usually needed

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External finance – long term

sell debentures
■ Long term loans issued by PLCs

■ Used for long term finance (e.g. 25 years)

■ The loan is repaid on the maturity date

■ Interest must be paid at a fixed interest rate

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External finance – long term

debt factoring
■ Debt factors are firms which ‘buy’ the debts of a business at a
discount for immediate cash

■ The risk of a bad debt is passed to the factor

■ The firm does not receive the full value of its debts

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External finance – long term

grants and subsidies

■ e.g. from the government or lottery commission

■ Often do not have to be repaid
■ Often have strings attached
▪ e.g. location

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External finance – long term

mortgage
■ A loan secured against a specific asset (collateral)

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External finance – long term

venture capital (private equity)
■ Venture capitalists are willing to risk large sums in exciting
projects for potentially high dividends

■ Venture capitalists usually demand a ‘shares + loan’ deal in

order to achieve an element of control whilst receiving
‘guaranteed’ interest
Shares + Loan

Guaranteed
Control
Interest
✓ Finance available for a high risk project
✓ Venture capitalist will expect high dividends from a
successful project
* ✓ Loss of control
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Sources of finance

External finance
2. Medium-term finance

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External finance – medium term

hire purchase
■ Allows a business to buy a fixed asset over a long period of time

■ Unlike leasing, the firm owns the asset once the final payment is
made

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External finance – medium term

leasing
■ The firm pays a monthly fee to borrow an asset without ever actually
owning it

■ The firm does not have to find a large sum to purchase an asset

■ The firm is not responsible for maintaining the asset

■ The total cost of leasing will be higher than outright purchase

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External finance – medium term

also…
■ Medium-term (2 – 5 years) loan

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Sources of finance

External finance
3. Short-term finance
– for day to day operations

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External finance – short term

overdraft
■ The bank gives the business the right to ‘overdraw’ its bank account

■ A flexible form of borrowing – interest is only paid on the overdrawn

amount each day

■ Interest is higher than a loan

■ Can be withdrawn by the bank at short notice

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External finance – short term

trade credit
■ Take advantage of credit offered by suppliers and reduce the credit
periods offered to customers

■ Effectively an interest free loan

■ Suppliers may refuse to give discounts/supply if delay is too long

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External finance – short term

also…
■ Short-term (less than 1 year) loan

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Importance of micro-finance in
developing economies
■ Micro-finance: Small amounts of capital loaned to entrepreneurs in
countries where business finance is often difficult to obtain. These
loans are usually repaid after a relatively short period of time. This
type of finance is important to people who come from poor
backgrounds and do not have savings, or lenders such as families or
friends to lend money. Banks would most likely not be willing to lend
money to them as they are considered as a high risk. So micro finance
is very useful to those in need
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The main factors considered in making
the financial choice
■ Size and legal form of business: Unincorporated business such as sole traders or
partnerships are unable to raise finance by issuing shares and banks are less
willing to lend them money as they are considered a risk. Even if unincorporated
businesses can get loans, they often charged at a higher interest rate

■ Amount required: If large capital amount is require then share issues and
debentures are more appropriate. A smaller amount might be financed through
bank loans, leasing or hire purchase

■ Length of time: The business needs to plan carefully to decide how long it will
need the finance for. If it is long term then debentures or share issues would be
most appropriate. If it is short-term, then overdrafts may be the most flexible
solution

■ Existing borrowing: If a business already has existing borrowing then they might
find it more difficult to borrow further amounts from banks and other lenders as it
will be seen as a greater risk.
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■ Complete Sources of Finance

■ You are ready for Sources of Finance Quiz