BM Topic 3.2: Sources of Finance

Define ‘sources of finance’

Define ‘sources of finance’

the general term used to refer to where or how businesses obtain their funds. these can be categorised as internal or external.

Define ‘internal sources of finance’

finance that comes from within an organisation, from its own resources & assets, without the help of a third party. these do not have to be repaid to to anyone as they belong to the owner of the organisation

3 Internal sources of finance

1. Personal funds

2. Retained profit

3. The sale of assets

‘Personal funds (for sole traders)’ as an internal source of finance

funds employed by the owners at their personal level (e.g. savings)

Advantages of using ‘personal funds' as a source of finance

• do not need to be repaid

• no interest charges incurred (unlike external finance)

• by investing personal funds, sole traders & partners have a better chance of borrowing money if they need to do so as it shows greater commitment to the business venture

• cheaper than external sources

Disadvantages of using ‘personal funds' as a source of finance

** as sole traders represent relatively high risk, they are less likely to be able to secure external sources of finance, so need to rely on PF

• personal funds are rarely sufficient for most small businesses

• many entrepreneurs risk their entire life savings in a business venture. in particular, sole traders & partners risk losing all their personal funds if the venture fails

‘Retained profit’ as an internal source of finance

profits that are left after the payment of dividends (shareholders) & taxes (government). generally used for expansion and other future activities related to the growth of the business. it is considered a permanent source of finance as it doesn’t have to be repaid & belongs to the business.

Advantages of using ‘retained profit' as a source of finance

• does not incur any interest charges

• as the money belongs to the business, it is considered a permanent source of finance, because it doesn’t have to be repaid

• if a business project fails, the use of retained profit does not necessarily pull the organisation into debt

• business has great flexibility in the use of retained profit

Disadvantages of using ‘retained profit' as a source of finance

• start-ups don’t have any retained profit, so it is not a possible source of finance for creating a new business

• retained profit is rarely enough as a sole source of finance for most businesses in their pursuit of growth and evolution

• using the funds as retained profits for use to grow the business means there is less dividends paid to shareholders & owners of the business

‘The sale of assets’ as an internal source of finance

selling of (existing) dormant (unused assets) and obsolete (outdated) assets (liquidation) of value (usually non-current assets)

Advantages of using ‘the sale of assets' as a source of finance

• a large sum of money can be raised (e.g. selling a fleet of old vehicles)

• the sale of excess resources, redundant assets or obsolete belongings is a sensible way for a business to raise finance

  • the alternative is that these resources would tie up much needed working capital for the organisation

• no cost of borrowing or interest payments

Disdvantages of using ‘the sale of assets' as a source of finance

• sale of certain fixed assets can hinder a firm’s productive capacity (e.g. farm land, factories)

• can be very time-consuming to find a suitable buyer for second-hand assets (especially if they are obsolete)

  • even if a buyer can be found, purchase price is likely to be very low as the business is in a weaker bargaining position (especially if desperate for $$)

• the option of asset sales is only available to established businesses; new businesses unlikely to be in such a position

Define ‘external sources of finance’

those that come from outside the organization, usually with the help of a third party provider. Due to the higher costs, external finance is only used when a business is unable to get enough funds from internal sources

8 external sources of finance

1. Share Capital

2. Loan Capital

3. Overdrafts

4. Trade Credit

5. Crowdfunding

6. Leasing

7. Microfinance Providers

8. Business Angels

‘Share capital’ as an internal source of finance

- finance raised through the issuing of shares via stock exchange
- a long-term finance source for limited liability companies (selling shares)
- when a limited liability company sells its shares for the very first time on the stock exchange, it is known as an IPO (Initial Public Offering)

• main source of finance for most limited liability companies & is recorded in the company’s balance sheet

Advantages of using ‘share capital' as a source of finance

• permanent capital as it does not need to be repaid
  - generated from the initial sale of shares to investors. does not include shares traded in the secondary market after issuing -shareholders sell their shareholdings to other buyers via stock ex.

• unlike loan capital, share capital does not involve debt or incur interest repayments → reduces the expenses of the company and helps to improve its cash flow position

• any publicly held company can raise further finance by selling additional shares (a process known as a share issue)

• improves the company's gearing (its debt to equity ratio). a relatively degree of debt makes the company more attractive to commercial lenders and can enhance the firm’s ability to obtain future debt financing on more favourable terms

Disdvantages of using ‘share capital' as a source of finance

• shareholders need to be paid dividends at some point if the company earns profit → can be a financial burden & limit the available funds that can be retained for investment purposes

• although share capital can raise a lot of money for a company, the ownership and control of existing shareholders may be diluted.

• costs of issuing shares can be expensive, especially through an IPO, which includes professional fees, legal expenses, and marketing costs.

• only publicly held companies can trade their shares using the stock market. Publicly held companies must comply with stringent regulatory requirements, including financial disclosures and annual reporting standards, which can be costly and time-consuming for these businesses.

  • shares in privately held companies cannot be traded on a stock exchange, as their shares are not sold to the public. for them, share capital is typically raised by selling shares to pre-approved family members, relatives, and close friends.

‘Loan capital’ as an internal source of finance

- borrowed funds from commercial lenders, such as banks
- typically a long-term source of finance (medium to long)
- interest charges are imposed & can be fixed or variable, depending on the agreement between the borrower and lender
- the amount borrowed is paid back in instalments over a predetermined period of time (e.g. 5, 10, 25 years)
- appears as part of a firm’s non-current liabilities in the balance sheet
- typically used to purchase non-current assets (e.g. machinery & property)

3 examples of ‘loan capital’

1. Mortgages

2. Business development loans

3. Debentures

‘Mortgage’ as a loan capital source of finance

secured loans for the purchase of property (real estate) such as land or buildings.
- if the borrower defaults on the loan (fails to repay) then the lender can repossess (reclaim or take back) the property

‘Business development loans’ as a loan capital source of finance

highly flexible loans catered to meet the specific needs of the borrower to develop aspects of their business.
-can be used for a range of purposes, such as to start or expand their business, purchase specialist equipment & other assets or to improve an organisation’s cash flow position

‘Debentures’ as a loan capital source of finance

long-term loans issued by a business. debenture holders (individuals, governments, or other businesses) receive interest payments even if the business makes a loss & before shareholders are paid any dividends. the interest payment can be fixed or variable depending on the type of the debenture.
*unlike shareholders, debenture holders do not have ownership or voting rights
- provides a long-term source of finance without the business losing any control
- issuing debentures increases a firm’s gearing ratio → means the business has more borrowing as a percentage of its total capital employed, so this makes the firm more vulnerable to risks if interest rates increase

‘Corporate bonds’ as a loan capital source of finance

debt securities (guarantees) sold to investors. Bonds represent a debt obligation that the issuer (or borrower) must repay with interest over a specified period. Bondholders are the investors who purchase corporate bonds, providing the company with the necessary loan capital. Unlike shareholders, bondholders do not have a share of ownership in the company.

Advantages of using ‘loan capital' as a source of finance

• enables the borrower to pay in regular instalments, making it more accessible & affordable for many businesses

  • not burdened to pay a large sum of money at once

• large businesses are often able to negotiate a lower rate of interest on their loans (financial economies of scale)

• loan capital is suitable if the owners need to raise finance but do not want to dilute their ownership or potentially lose control through issuing shares

Disadvantages of using ‘loan capital' as a source of finance

• interest is charged on the amount of borrowed funds interest rate can be a fixed or variable

• in many cases, businesses have to offer collateral (security) before loans can be approved. failure to repay the loan: lender able to legally seize the firm’s assets to pay for the outstanding amount borrowed

• firms that borrow loan capital on variable interest rates may suffer from liquidity problems if the rate of interest increases, because their debt repayment burden will increase

‘Overdrafts’ as an external source of finance

a banking service that enables customers to withdraw more money from their account than exists (going into the negatives)
- can help businesses meet their short-term liquidity needs, especially in emergency situations
- ***overdraft has to be pre-approved to avoid expensive bank charges, as does the maximum amount that can be withdrawn

Advantages of using ‘overdrafts' as a source of finance

• quite easy to obtain → important source of finance for small businesses

• provides businesses with emergency funds to finance their operations e.g. paying suppliers or staff wages during a time where liquidity is a problem

• provides great flexibility for businesses as overdrafts are only used as & when needed

Disadvantages of using ‘overdrafts' as a source of finance

• interest is charged on the amount overdrawn, usually at rates higher than those charged for ordinary bank loans

• banks usually only lend a small amount of money, in order to keep a business operation

  • not a suitable source of finance for purchasing non-current assets

• banks can ask for overdrafts to be repaid at very short notice

• essentially a high-cost, short-term loan for businesses

‘Trade credit’ as an external source of finance

financial agreement between businesses where one business allows another business to purchase and obtain goods or services but to pay for them at a later date (on credit), typically with agreed-upon term
- typical trade credit period is between 30 to 60 days
- a method of short-term financing
- helps the purchaser’s cash flow as they can obtain supplies without having to pay for it immediately

*does not incur any interest charges if amount owed is payed in full within trade credit period (making this relatively attractive compared to overdrafts)

Advantages of using ‘trade credit' as a source of finance

• flexible

• offers affordable financing: can be seen as an interest-free loan, allowing businesses to retain cash within their operations

• facilitates start-up businesses: allows start-ups to quickly acquire stock & materials necessary

Disadvantages of using ‘trade credit' as a source of finance

for the client:

• challenging for start-ups as suppliers may be hesitant to offer trade credits to businesses without established track record or consistent trading history

• missed repayments can result in penalties and accrued interest

• falling behind on repayment can cause legal action against buyer & damage buyers’ credit rating

for the supplier:

• inconvenience & cash flow disruptions due to late repayments from client

• administrative burden of paperwork

‘Crowdfunding’ as an external source of finance

raising small amount of money from a large number of people to fund a particular business product or venture typically done via online platforms
- supporters collectively known as the ‘crowd’ & the business entity known as the ‘fundraiser’

1. equity crowdfunding - the sale of a stake in a business to several investors in the crowd

2. donation-based crowdfunding - individuals donate small amounts of money to help fund a specific charitable project while receiving no financial stake or return for doing so

Advantages of using ‘crowdfunding' as a source of finance

• as each individual lends a relatively small amount of money, this limits the risks and impacts should the business project fail to succeed

• avoids need for business owners or entrepreneurs to deal with commercial banks, which is often time-consuming & bureaucratic process

• many people can invest, individuals of the crowd do not take any controlling interest in the organisation

• usually less costly than being listed on a public stock exchange

Disadvantages of using ‘crowdfunding' as a source of finance

• legal challenges & considerations e.g. transparent disclosure of legal documents, holding annual general meetings with investors & publication of annual reports which adds to the costs of the business

• needs to be due diligence (investigation & exercise of care prior to entering into a contractual agreement with another entity). investors have the option to ask for additional information from the fundraiser, this can delay decision-making & incur additional costs for the business

• theft of intellectual property is commonplace, entrepreneurs are vulnerable to others stealing their business ideas, largely due to the absence of IP protection in terms of the lack of knowledge & finance to defend these rights

• there are a lot of crowdfunding scams, loose regulatory requirement for crowdfunding exposes investors to fraud

‘Leasing’ as an external source of finance

involves the business or the customer (lessee) drawing up a contract with the leasing company (lessor) to use particular non-current assets for an agreed fee.

• enables a business to use these assets without having to purchase them outright (may be unnecessary or too expensive)
  - common option for businesses to access non-current assets without the high costs of capital expenditure
  - e.g. computers, photocopiers, tools, equipment, buildings
  *usually lessor allows a long-term lessee (usually lasting 3 or more years) the option to buy the asset at the end of the lease agreement
  *lessor is responsible for maintaining leased equipment

Advantages of using ‘leasing' as a source of finance

• lessee does not have to purchase the expensive equipment, machinery, vehicles, or other type of capital, instead, its money can be used for revenue expenditure purposes

• lessor takes responsibility for the maintenance of the capital equipment & other leased property → helps to cut operating costs of the lessee

• leasing is particularly advantageous if the business only needs to use the fixed capital for a short period of time, or if it does not want to deal with the hassles and costs of repairs and maintenance

Disadvantages of using ‘leasing' as a source of finance

• lessee never owns the asset, ownership remains with the lessor before, during & after leasing contract

• over a long period of time, leasing can be more expensive than buying the asset outright due to the accumulated costs of leasing the asset over time

** extension: combining the sale of assets & leasing → known as sale & leaseback. hybrid financial strategy that involves a business divesting its tangible non-current assets (by selling the assets) and subsequently entering into a lease agreement to regain access to and use of same assets. gives the business immediate liquidity without losing the asset (although ownership of asset changes)

‘Microfinance providers’ as an external source of finance

for-profit social enterprises that offer a financial service to those without a job or on very low incomes who would not ordinarily be able to secure bank loans
- aim of microfinance is to help entrepreneurs, especially women, struggling to finance their business start-ups to gain access to loans of a small amount.

• can give borrowers the opportunity to become self-sufficient & empower them to run their businesses

• interest is charged on the amount borrowed, although typically lower than what commercial banks would charge

Advantages of using ‘microfinance providers' as a source of finance

• can help many people to get out of poverty by making them become financially independent

• can help provide property relief

• help to empower entrepreneurs of small businesses, especially women & the underprivileged working & living in low-income countries

• can create benefits for the wider community, such as improved healthcare, education & employment opportunities

• microfinance providers act in a socially responsible way by helping the poorest & most vulnerable adults in society

• can help to build & foster a culture of entrepreneurialship & economic independence

Disadvantages of using ‘microfinance providers' as a source of finance

• some people regard the practice of microfinance providers as being unethical as they earn profits from low-income individuals & households

• only provides finance on a small scale, so is unlikely to be sufficient to make a real difference to society as a whole

• microfinance loans incur interest charges, so can be rather expensive for small business owners who find it difficult to earn enough revenue to keep up with their loan repayments

• microfinances increases the debts of entrepreneurs who may subsequently struggle in their business venture

• due to relatively low profitability, microfinance providers may struggle to attract and/or retain employees & managers, given that their remuneration packages are unlikely to be matched by larger for-profit financial companies such as commercial banks & insurance companies

‘Business angels (or angel investors)’ as an external source of finance

wealthy & successful private individuals who risk their own money in a business venture that has high growth potential. the finance from business angels is their own (personal investors). represents a high degree of risk

• angel investors come from private equity firms → specialist finance companies that provide funding in exchange for equity ownership or a share of future profits in the businesses seeking capital.

• involves a hands-on approach from the private equity firm in managing & growing the partner business

Advantages of using ‘business angels' as a source of finance

• provide an essential source of finance for start-ups and small businesses that are unable to secure finance from conventional providers of finance, such as commercial banks & other financial institutions

• businesses can benefit from the expertise & experiences of the business angels, who are likely to provide their input in order to secure a significant return on their investment (ROI)

• it is particularly useful for small businesses & inexperienced entrepreneurs who are unable to raise sufficient finance on their own, such as those which are unable to secure loan capital or those that are not permitted to sell shares on a public stock exchange

Disadvantages of using ‘business angels' as a source of finance

• for the business angels, such business ventures are extremely high risk, especially as they risk losing their personal money. hence, the amount of finance available is often not easily available for start-ups and small businesses

• no guarantees that angel investors will earn a satisfactory ROI, despite high potential returns

• such finance is difficult to come by, not only due to the risks involved but also due to the large number of entrepreneurs competing for such funds

• use of business angels will dilute the firm’s control & ownership as the angel investors will want a share & say in the organisation

Explain what an ‘IPO’ is

An IPO , or Initial Public Offering, the process undertaken when a private company offers its shares to the public for the first time. This marks the transition from a private company to a publicly traded company through the sale of shares on a stock exchange in order to raise capital.

What is ‘short-term finance’?

refers to sources of finance needed for the day-to-day running of a business, i.e. its revenue expenditure. also often used to solve cash flow (working capital) problems. short-term sources of finance are funds that do not last longer than one year from the balance sheet date

• personal savings

• sale of assets

• overdrafts

• trade credit

What is ‘long-term finance’?

refers to sources of finance of more than one year from the balance sheet date & is used mainly to pay for fixed assets i.e. capital expenditure (such as the purchase of capital equipment, machinery, and motor vehicles). used to purchase long-term fixed assets (e.g. property) or to fund the growth of a business in overseas markets (e.g. setting up factories or production facilities in other countries)

• share capital

• loan capital, such as mortgages

• leasing

• business angels

• microfinance providers

• crowdfunding

4 main reasons businesses are charged a different RATE of interest

R - Risk → the greater the risk of a business defaulting on a loan (failing to repay the borrowed money), the higher the interest rate tends to be, large multinationals offer less risk so are able to borrow more money at a relatively lower rate of interest

A - Administration costs → the higher the administration costs involved in lending money to a business, the higher the interest rate tends to be. for example, lending a total of $100m to 100 different customers is more administratively costly than lending the same amount to a single customer

T - Time → the longer the period of a loan (short, medium vs long-term finance), the higher the interest rate tends to be in order to compensate lenders for the opportunity cost of money being lent out for long periods of time

E - Expectations → if the economy is expected to do well (with increases spending, investment & export earnings) then it is likely interest rates will rise to dampen the effects on inflation

Factors that determine the appropriateness of different sources of finance (acronym)

S - Size of business

P - Purpose (use) of funds

A - Amount required

C - Cost

E - External environment

D - Duration

Factors that determine the appropriateness of different sources of finance (S)

S - Size of the business

• the larger the size of a business, the greater the choice of finance there tends to be. e.g. public limited companies can obtain finance from selling share, whereas sole traders cannot. a larger business is also likely to have more retained profit + easier for a large business to obtain bank loans & mortgages to finance its growth, especially as it has more collateral that can be used to qualify for lower interest rates (financial economies of scale)

Factors that determine the appropriateness of different sources of finance (P)

P - Purpose of funds

• refers to what the finance is specifically to be used for, e.g. if finance is needed for the purchase of a new factory or office building, then long-term sources of finance are more appropriate e.g. mortgages. the sale of assets, such as computer equipment, would be suitable if a business wished to upgrade its obsolete assets

• for short-term day-to-day running costs of the business, trade credit would be more appropriate.

• loan capital might be more appropriate if the organization faces a major liquidity issue so needs access to a large amount of cash, especially if it cannot immediately get the money owed by its debtors

Factors that determine the appropriateness of different sources of finance (A)

A - Amount required

• if a business only needs a small amount of finance, it is likely to consider short-term sources of finance, such as bank overdrafts

• for larger amounts, the business is likely to use long-term sources such as loan capital from commercial banks, mortgages, or even a share issue

Factors that determine the appropriateness of different sources of finance (C)

C - Cost

• businesses need to consider the costs associated with obtaining a certain source of finance. for example, an IPO will be relatively expensive, whereas using personal funds or retained profits will not be

• in the long term, leasing (hiring) assts is more expensive than an outright purchase. mortgage costs include administration costs & interest payment over the duration of the loan → add a significant amount of costs for businesses in the long term

Factors that determine the appropriateness of different sources of finance (E)

E - External environment

• factors that affect a business bit which it has no control of. e.g. central bank or monetary authority is responsible for interest rates in the economy. higher interest rates make loan capital (e.g. overdraft, bank loans, mortgages) more expensive → likely to reduce the demand for loan capital to finance business expenditure

• governments set up their own criteria for subsidies & grants. economic factors might also affect the amount of finance business angels and venture capitalists are willing to make available to investment purposes

Factors that determine the appropriateness of different sources of finance (D)

D - Duration

• the longer the finance is needed, the more likely the firm will need to provide a guarantee (collateral or security) to the lender, in case the borrower defaults on the loan e.g. mortgage is secured on the commercial property for which the borrowinf is used for - in the case of defaulting on the loan, lender can liquidate the commercial property to get as much of its money back as possible

• overdraft would be more suitable for firms needing a small amount of money for only a short time period, usually to deal with short-term liquidity issues

What is the ‘stock exchange’

a highly regulated marketplace where individuals & businesses can buy & sell shares in public limited companies