CHAPTER 9

Sources of Finance
Finance

Finance is the money required in the business

Why do businesses need finance?

• To startup the business – Businesses need money to buy land and

equipment

• Expanding the business – Businesses need money to expand (e.g.

buying more land to expand factory, upgrading machines)

• For working capital - ‘lifeblood’ of business as they will constantly

need working capital for business activities. Businesses need this
money to pay for day to day expenses such as employee wages and
salaries, purchasing raw material etc..
Capital Expenditure and revenue
expenditure

In all three cases above, businesses may need finance to pay for
either capital expenditure or revenue expenditure. It is important to
understand the difference

•Capital Expenditure: money spent on non-current assets which will last

more than one year. These non-current assets are needed at the start of a
business and as it expands, for example land, building, machinery, fixtures,
equipment and so one

•Revenue Expenditure: money spent on day-to-day expenses which do not

involve the purchase of a long-term asset, for example wages and rent.
Internal
Sources
of
Finance External
INTERNAL SOURCES

These are sources of funds that are

obtained from the business itself.
Interna
l
Retained Profit
This is profit that is kept back in the business after the owners have
taken their share of the profits. Also known as ploughed back profit.

 Retained profit does not have to A new business will not

be repaid. have retained profit.
 There is no interest to pay – the Many new businesses will find
capital is raised from within the that their retained profit is
 business too small for plans they have
(like expansion).
Keeping more profits to be
used as capital will reduce
owner’s share of profit and
they may resist the decision.
Interna
l
Selling Fixed Assets
Existing assets which are no longer needed by the business can be sold,
for example redundant buildings or surplus vehicles or equipment.

 Makes better use of the capital It may take time to sell the assets.
tied up in the business. It is not available to new
 it does not increase debt for businesses since they have no
the business unlike loan surplus assets.
Interna
l
Sale of inventories
sell finished goods or unwanted components in inventory.

 Reduces the opportunity cost and If not enough inventory is kept,

unexpected increase demand
and cost of holding high inventory form customers cannot be
levels. fulfilled
Interna
l
Owners’` Savings
A sole trader or members of a partnership may put up more of their savings
into their unincorporated businesses. Since these owners are not separate
from their businesses, this type of finance is internal.

 It should be available to the firm Savings may be too low.

quickly. It increases the risk taken by
 No interest is paid. the owners.
EXTERNAL SOURCES

These are sources of funds that are

obtained from individuals or institutions
outside of the business.
Externa
l
Issue
_ _ _ _ _ of
_
__ _____

Shares
Selling shares to the public; only possible for limited
companies.
 Permanent source of capital Dividends are paid to
which does not need to be repaid the shareholders.
to the shareholders.
 No interest is paid. Dilution of control due to
the new owners.. If many
shares are bought, the
ownership of the business
will change hands. (The
ownership is decided by
who has the highest
percentage of shares in the
company)
Externa
l
_
Bank_ _Loans
_____ _____

Money borrowed from the bank that is returned with

interest.
 Usually quick to arrange. Has to be repaid.
 Can be for varying length of time. Interest must be paid.
 Large companies benefit from the Security or collateral is often
financial economies of scale, required. This is a guarantee to the
getting lower interest rates for bank to ensure the bank that the
borrowing large sums. amount loaned will be paid back.

For a sole trader, his house might be collateral.

So there is a risk of losing highly valuable
assets
Externa
l
_
Debentures
_____ __ _____

Long-term loan certificates issued by limited companies. . Like shares, debentures

will be issued, people will buy them and the business can raise money. But this
finance acts as a loan- it will have to be repaid after a specified period of time and
interest will have to be paid for it as well.

As with loans, these must be

 Debentures can be used to raise
repaid and interest must be paid.
very long-term finance, for
example, 25 years.
Externa
l
Factoring
_ _ _ _ _ _ _ of_ _ Debts
_
___

Debt factors are specialist agencies that ‘buy’ the debts of firms for immediate
cash.

They may offer 90% of the value of an existing debt and collect it from the
debtor for the full amount, hence making a profit.

 Immediate cash is made available. The firm doesn’t receive 100% of

 The risk of collecting the debts the value of its debts.
will no longer be for business ,
but will be the factor’s.
Externa
l
Grants & Subsidies
_____ __ _____
_from Outside
Agencies
Outside agencies like the government or not-for-profit institutions can
support businesses by giving funds in the form of grants or subsidies.

 They do not have to be repaid. They are often given with

conditions that the business has
to comply with. For example,
location choices, employment
preferences, etc.
Externa
l
_Micro-Financing
____ __ _____
_
In many low-income developing countries, traditional commercial banks have been very
unwilling to lend to poor people because the small size of the loan means that the business
will not make a profit and that the poorer groups in society cannot afford a collateral.
The institutions that lend the poorer people money can include postal savings bank, finance
cooperatives, credit unions and development banks.

 Specialist institutions have been set up The profit generated is very low
in most developing countries to meet to the micro-financers because
the financial needs of poor people – the
especially poor entrepreneurs. This size of the investment is very low.
lowers unemployment and helps in
raising the standards of living of the There is a risk on non-payment by
people. the borrowers since the chances of
failure are higher than most.
Crowdfunding

Crowdfunding: raises capital by asking small funds from a large pool

of people, e.g. via Kickstarter. These funds are voluntary ‘donations’
and don’t have to be return or paid a dividend.

Crowdfunding Benefits x Crowdfunding Proposal Rejection

 No initial fees for the platform. Poorly thought-out proposal may be
 Allows public reaction to new rejected.
business ventures (feedback on x Total required funding must be
business idea) repaid.
 Provides a fast way to raise x Media interest and publicity are
substantial sums. needed for success.
 Often used by entrepreneurs x Publicizing new business idea
when other 'traditional' sources could allow competitors to'steal'
are unavailable the idea.
Retained
Profits

Sale of Fixed
Assets
Internal Selling Stocks
– Reducing
Stock
levels
Owners’

Sources of Savings
Issue of

Finance Shares

Bank Loans

Selling
Debentures
External Factoring of
Debts
Grants and
Subsidies

Micro-
financing

crowdfunding
SPLITTING FUNDS IN TERMS OF
LONGEVITY

We split funds in terms of short-term and long-

term finance.
SHORT-TERM FUNDS

Provides the working capital needed by businesses

for day-to-day operations. It is finance needed for
one to three years.
Short-
term
OVERDRAFTS

Arranged by the bank.

 The bank gives the business the Interest rates are variable, unlike
right to ‘overdraw’ its bank most loans which have fixed
account (spend more than what is rates.
currently in it).
The bank can ask for the
 The firm can use this finance to
overdraft to be paid at very short
pay expenses but cannot do
this indefinitely. notice.
 It’s ‘flexible’ because you can
overdraft every month a different
amount.
 Interest will be paid on only the
overdrawn amount.
 Cheaper than loans.
Short-
term
TRADE CREDIT

This is when a business delays paying off its suppliers, which leaves
the business in a better cash position.

 It is almost an interest-free loan The supplier may refuse to give

to the business for the length of discounts or even refuse to supply
time that payment is delayed for. any more goods if payment is
not made quickly.
Short-
term
FACTORING OF DEBTS

Debt factors are specialist agencies that ‘buy’ the debts of firms for immediate
cash.

They may offer 90% of the value of an existing debt and collect it from the
debtor for the full amount, hence making a profit.

 Immediate cash is made available. The firm doesn’t receive 100% of

 The risk of collecting the debts the value of its debts.
will no longer be ours, but will
be the factor’s.
LONG-TERM FUNDS

Finance that is available for over three years. This

purchases long-term fixed assets, update or expand
the business or finance a takeover of another firm.
Long-term

BANK LOANS

Money borrowed from the bank that is returned with

interest.

 Usually quick to arrange. Has to be repaid.

 Can be for varying length of time. Interest must be paid.
 Large companies benefit from the Security or collateral is often
financial economies of scale, required. This is a guarantee to the
getting lower interest rates for bank to ensure the bank that the
borrowing large sums. amount loaned will be paid back.
Long-term

HIRE PURCHASE

This allows a business to buy a non-current asset over a long period of

time with monthly payments which include an interest charge.

 The firm does not have to find a A cash deposit is paid at the
large cash sum to purchase the start of the period.
asset. Interest payments can be quite
high.
Long-term

LEASIN
G
Leasing an asset allows the firm to use an asset but it does not have to purchase it.
Monthly leasing payments are made. The business could decide to purchase the
asset at the end of the leasing period. Some businesses decide to sell off some
non-current assets for cash and lease them back from a leasing company. This is
called sale and lease back.

 The firm does not have to find a The total cost of the leasing
large cash sum to purchase the charges will be higher than
asset to start with. purchasing the asset.
 The care and maintenance of the
asset are carried out by the
leasing company.
Long-term

ISSUE OF SHARES

Selling shares to the public; only possible for limited

companies.

 Permanent source of capital Dividends are paid to the

shareholders.
which does not need to be repaid
Dilution of control due to the new
to the shareholders. owners.
 No interest is paid. Dividends are paid after tax,
whereas interest on loans is paid
before tax is deducted.
The balance of ownership can be
affected by a large share issue.
Long-term

DEBEN TURES

Long-term loan certificates issued by limited

companies.
 Debentures can be used to raise As with loans, these must be
very long-term finance, for repaid and interest must be paid.
example, 25 years.
Overdraft
s
Short Trade
- Credi
t
term Factorin
Sources of g of
Debts
Finance Bank
Loans
Hire
Purchase
Long- Leasing
term Issue of
Shares

Debentur
es
HOW DO BUSINESSES CHOOSE
THE TYPE OF FINANCE NEEDED?

Purpose and time period

Amount needed
Status and size
Control
Risk and
gearing