Sources of Finance

Purpose of Finance
• Capital expenditure is the finance spent on fixed Assets
（non-current assets) .
- Fixed assets: Items of monetary value that have a long term
function for businesses, so can be used repeatedly for the
purpose of production.
- e.g. spending on land, buildings, equipment, machinery and
vehicles.

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• Revenue expenditure refers to payments for the daily running
of a business,
- e.g. spending on wages, raw materials, rent and electricity.
Capital expenditure

Reasons for capital expenditure (investment expenditure)

- To add extra production capacity as the business grows
- To improve efficiency by utilizing the latest
technologies , such as IT system and production
technology
- To replace worn-out, damaged and/or obsolete
(outdated) capital equipment and machinery

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- To comply with changing legislation and regulations,
such as green technologies
Capital expenditure vs Revenue expenditure
Capital expenditure Revenue expenditure
Nature Spending on fixed assets Spending on daily operations

Impact on financial Balance sheet- increase Income statement-recorded as

statements value of assets and expense and reduce the profit
depreciate overtime
Useful life More than one year Consumed within the same
financial period when they were
incurred

Amount Usually more significant

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Value generation
than revenue expenditure
In the future In current financial period
Frequency Incurred more frequently than
capital expenditure
Capital expenditure vs Revenue expenditure
Capital Revenue expenditure
expenditure

Challenges - High initial - Cost control

investment cost - Cash flow
- High uncertainty management
- Opportunity cost

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Sources of Finance

Sources of finance is the

general term used to refer to
where or how businesses
obtain their funds.
Sources of Finance
Internal External
➢ Personal funds (for sole ➢ Share capital
traders) ➢ Loan capital
➢ Retained profits ➢ Overdrafts
➢ Sale of assets ➢ Trade credit/ Hire
purchase
➢ Crowdfunding
➢ Leasing
➢ Microfinance providers
➢ Business angels
Internal Sources of Finance
Internal sources of Finance
(i) Personal funds (Owner’s capital)
- It refers to the use of an entrepreneur’s own savings.
- Main source of finance for sole traders and for partnerships
(ii) Retained profits
- It is the value of the surplus that a business keeps to use
within the business aſter paying corporate taxes on its profits

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to the government and dividend payments to its
shareholders.
- Mainly used for capital expenditure or contingency fund
Internal sources of Finance

(iii) Sale of assets

- It means selling existing items of value that the business
owns, such as dormant assets (unused assets) and obsolete
assets (outdated assets).
- E.g. obsolete machinery, land, buildings or even subsidiaries.

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External Sources of Finance
(i) Share capital

Share capital is the money raised from selling shares in a limited

liability company.

- Privately held company

➢ Privately held companies can sell shares to existing
shareholders or friends, families or accredited investors.

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➢ The shares cannot be sold to the general public
(i) Share capital

- Publicly held company

➢ The shares can be sold to general public through IPO(refers
to going public by floating their shares on a stock exchange
for the first time)
➢ Listed companies can raise further finance by selling more
shares in a share issue (existing companies raising further
finance by selling more shares)
(i) Share capital
Evaluation of share capital:
- No repayment obligation
- No interest payment
- Access to large amount of capital, as investors can purchase large
number of shares
- Shareholders share the risks and return of the company’s
performance, align the interest of shareholders and management
BUT
- Dilution of control and loss of autonomy
- Dividend payments, limit the ability to reinvest profits in expansion
- Regulatory requirements and costs such as legalities and
administrative procedures in flotation
(ii) Loan capital
Loan capital refers to medium to long-term sources of finance
obtained from commercial lenders such as banks.
Fixed or variable interest is charged, the amount borrowed is
paid back in instalments over a predetermined period of time.

Examples of loan capital:

- Mortgages
- Business development loans
- Debentures
(ii) Loan capital
✓ Mortgage is a secured loan for the purchase of property such
as land or buildings.
- If the borrower default on the loan , the lender can repossess
(take back) the property.
✓ Business development loan
- flexible loan to meet the development needs of a company
✓ Debentures
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- long-term loans issued by a business
- Debenture holders ( individuals, government or business
organizations) receive interests, no voting rights
(ii) Loan capital
Evaluation of loan capital:
- No dilution of ownership, lenders have no voting rights
- Tax deduction since interest charges are an expense
BUT
- Loan capital and interest have to be repaid, regardless of
company’s performance
- Interest payment can add up over time, making loan capital
more expensive than other sources
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- Regular interest payment will affect company’s profit and
liquidity position
- Higher percentage of borrowing will make the firm more
vulnerable
(iii) Overdrafts
Overdraſts are a financial service that allows a business to
temporarily overdraw on its bank account, i.e. to take out more
money than it has in the account.

- Used when businesses have minor cash flow problems e.g.

business sold items on credit and are awaiting payments from
their customers

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- Most flexible form of borrowing
BUT
- Short term source of finance with relatively high interest rate
- Repayable on demand from the lender
(iv) Trade credit
Trade credit allows a business to postpone payments or to ‘buy
now and pay later’. The credit provider does not receive any
cash from the buyer until a later date (usually allow between
30-60 days).
- Creditors ( credit holder) refers to suppliers who allow
businesses to purchase products on trade credit, usually
recorded as current liability on balance sheet

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- Debtors refers to customers who purchase products from the
business and has not yet paid, usually recorded as current
asset on balance sheet
(iv) Trade credit
- Credit cards are issued by a financial institution such as
commercial banks that allow holders to purchase G&S on
credit.
➢ The creditor is a financial institution such as banks
➢ It is a vital external sources of finance for sole traders and
partnership
- No cash required upfront, in effect, become a source of finance
and alleviate liquidity problem
BUT
- Penalties and interest payment
- Negative impact on credit rating
(v) Crowdfunding

Crowdfunding is a way of raising finance from a large number

of individuals for a small amount of money to finance a
new business venture or project.

- Usually relies on social media platforms which will charge

service fee and traditional networks such as families and

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friends
(v) Crowdfunding
- Access to large pool of potential investors
- Cost-effective
- Increase exposure to public
BUT
- Heavily regulated in some countries
- May result in loss of ownership and control
- Risk of failure, resulting wasted time and efforts
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- Intellectual property concerns, sharing details will increase the
risk of intellectual property theft or infringement
(vi) Leasing
Leasing is a form of hiring whereby a contract is agreed between
a leasing company (the lessor) and the customer (the lessee).The
lessee pays rental income to hire assets from the lessor, who is the
legal owner of the assets.
- Cheaper to lease assets especially in short to medium term
- Repairs and maintenance are the responsibility of the lessor
- Tax deduction, since spending on leased asset is an expense
BUT

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- More expensive in the long term
• Sale-and-Ieaseback involves a business selling a particular fixed
asset (to raise finance) and immediately leasing the property
back.
(vii) Microfinance providers
Microfinance is a type of financial service aimed at entrepreneurs
of small businesses, especially females and those on low incomes.

- As a for profit social enterprise, it enable disadvantaged

members to gain access to finance to help eradicate poverty
(vii) Microfinance providers

- Access to capital for individuals and businesses that excluded

from traditional financial services （for business)
- Support for entrepreneurship, job creation (for society)
- Social wellbeing (for society)
BUT
- Limited loan size (for business)
- Limited eligibility (for business)
- Immorality due to gain from the poor (for microfinance
provider)
(viii) Business angels
Business angels refers to extremely wealthy individuals who
choose to invest their own money in businesses that offer high
growth potential, i.e. high-risk, high-return business ventures.

- For firms that are unable to secure loans from banks and/or
too small to attract the attention of other investors
- Experience, expertise and networking provided
BUT
- Loss of control
- May demand high rate of return
- Need to buy out the stake at higher cost
(ix) Hire purchase

Hire purchase allows a business to pay its creditors in

instalments, perhaps over 12 or 24months.

- a deposit(or downpayment) is required to secure a HP

deal from the lender
- Interest is charged by the lender
Sources of Finance
Sources of Finance

• Short term
Less than one year

• Long term
More than 12 months
Factors influencing financing decision
Factors influencing Significance
financing (SPACED)
Size and status of a firm - Large companies or MNC are easier to raise funds from wide range of
sources than sole traders
- Large companies can enjoy financial economies of scale and offer high
levels of collateral
Purpose of finance - Revenue expenditure → short term sources of finance
- Capital expenditure → long term sources of finance
Amount required - Share capital and loan capital would be used for large capital sums
- Retained profit/ overdraft would be used for small amount of finance
Cost of finance - Internal finance is the cheapest source of finance
- Loans might be expensive during a period of rising interest rate
- Flotation can cost millions of dollars in fees and promotion of share
sale, dividends may add more cost
External factors - State of economy/ Interest rate/ stock market volatility will affect
business investment
Duration - Short term finance should be used to finance short term needs. E.g. pay
creditors or buy stock.
- Long term capital may be needed for long term expansion/ investment.
Practice
DEFINITION

The day-to-day spending required for the running of a business,

e.g. rent, raw materials, wages and utility bills.

Revenue expenditure
DEFINITION

A long-term source of finance that requires the borrower to

provide property and land as collateral (security guarantee) to the
lender in case the borrower defaults on the loan.

Mortgage
DEFINITION

Source of credit finance that allows firms the chance to use assets
without having to pay for them in one lump sum. Once the final
repayment (instalment) has been made, the asset legally belongs
to the business.

Hire purchase
DIFFERENCE

capital expenditure and revenue expenditure.

Capital expenditure (investment) is spending on fixed assets for

the long term, e.g. buildings and machinery. By contrast, revenue
expenditure is spending on items needed for the daily running of
a business, e.g. raw materials and wages.
revenue
DIFFERENCE

an overdraft and a bank loan.

An overdraft is a short-term source of finance whereas bank loans

are medium to long term; overdrafts are technically repayable ‘on
demand’; customers have to bank with the particular organization
to qualify for an overdraft but customers do not have to be a bank
customer to qualify for its loans; the interest rate charged on bank
loans tends to be lower, although collateral (security) is often
required.
DIFFERENCE

ordinary shares and debentures.

Owners of ordinary shares have voting rights, whereas debenture

holders do not;
Shareholders are the owners of a company, whereas debenture
holders are not (debentures are a form of long-term loan);
debenture holders are guaranteed their return (interest payments)
whereas shareholders are not;
Share capital vs Loan capital
Share capital Loan capital

Time Long term source of Long term source of

finance finance

Amount Large capital sums Large capital sums

Return to investors - Dividends (making - Regular interest

profit) and capital payment and
gain (sale of shares) principal
- Voting rights - No voting rights
Risks to investors High Low
TRUE or FALSE

Personal finance is the cheapest source of finance.

T
TRUE or FALSE

Directors own the money of incorporated companies and use

these on behalf of their shareholders.

F
TRUE or FALSE

Relying on loan capital means the business is likely to suffer

during times of rising interest rates.

T
M C Q

Which of the following is the most suitable reason for using

personal finance?
A. Insufficient internal sources of finance
B. Insufficient external sources of finance
C. There is no interest obligation
D. To please the owners (shareholders) of a company
M C Q

Advantages of internal finance do not include

A. Greater flexibility in the use of finance
B. Greater choice of finance
C. No need to go through administrative procedures
D. Tax concessions for the use of internal profit
M C Q

Advantages of funding growth through a share issue include all

those listed below except
A. An extra source of finance
B. Less financial risks due to the spreading of risks amongst
shareholders
C. Control of the company is diluted
D. It acts as a form of motivation for employees who own shares
in the company
M C Q

Which of the following is a drawback to a business that issues

debentures?
A. Lenders do not have any voting rights
B. There is dilution of control
C. There is a dilution of ownership
D. The value of liabilities increases
M C Q

Debenture holders
A. Own a part of the company in which they hold debentures
B. Are paid a return from the profits of the company
C. Receive payments from companies before any shareholders
D. Are represented as current liabilities on the company’s balance
sheet
M C Q

Which of the following best describes hire purchase?

A. Hiring of equipment for a period of time
B. Repaying loans by making fixed regular payments
C. Hiring out equipment as a source of finance
D. Differs from leasing in that ownership occurs with the last
instalment
M C Q

Which of the following is a disadvantage of leasing capital

equipment?
A. It is cheaper in the long run to buy capital equipment
B. The firm might not have sufficient funds to purchase the
equipment
C. Capital equipment needs replacing if technology is changing
rapidly
D. The management of cash flow is easier with regular
repayments