3.2 Sources of Finance

What are all the Internal Sources of Finance

• Personal Funds

• Retained Profits

• Sale of Assets

Personal Funds

A source of finance for sole traders that comes mostly from their own personal savings.

Advantages of Personal Funds

• Sole trader knows exactly how much money is available to run the business

• It provides the sole trader with much more control over the finances than other finance options. It also means that the sole trader does not need to pay the funds back or rely on outside investors or lenders, who could decide to withdraw their support at any time

Disadvantages of Personal Funds

• Large risk to the owners or sole traders because they could be investing their life’s savings, hence putting a strain on family or personal life.

Retained Profit (Ploughed-back Profits)

Profits that remains after a business has paid out dividends to its shareholders.

Advantages of Retained Profits

• It is cheap because it does not incur interest charges.

• Permanent source of finance as it does not have to be repaid.

• Flexible as it can be used in any way the business deems fit.

Disadvantages of Retained Profits

• Start-up businesses will not have any retained profit as they are new ventures

• If retained profit is too low, it may not be sufficient for business growth or expansion

• A high retained profit may mean that either very little or nothing was paid out to shareholders as dividends. This could be less attractive to stock buyers than a similar profitable business that distributes dividends generously to its shareholders.

Sale of Assets

When a business sells off its unwanted or unused assets to raise funds.

Advantages of Sale of Assets

• This is a good way to raise cash from capital that is tied up in assets which are not being used.

• NO interest or borrowing costs are incurred.

Disadvantages of Sale of Assets

• This option is only available to established businesses as new businesses may lack excess assets to sell.

• It can be time-consuming to find a buyer for the assets, especially for obsolete machinery.

What are the External Sources of Finance

• Share Capital

• Loan Capital

• Overdrafts

• Trade Credit

• Crowdfunding

• Leasing

• Microfinance Providers

• Business Angels

Share Capital

Money raised from the sale of shares of a limited company

Authorized Share Capital

The maximum amount the shareholders of a company intend to raise.

Stock Exchange

The share of a public limited company are sold in a special share market known as the stock exchanged. Here shares are bought and sold to willing investors.

Advantages of Share Capital

• It is a permanent source of capital as it willl not need to be redeemed. If shareholders want to get their money back they have to find a buyer for their shares.

• There are no interest payments and this relieves the business from additional expenses.

Disadvantages of Share Capital

• Shareholders will expect to be paid dividends when the business makes a profit

• For public limited companies, the ownership of the company may be diluted or change hands from the original shareholders to new ones via the stock exchange.

Loan Capital (Debt Capital)

Money sourced from financial institutions such as banks, with interest charged on the loan to be repaid.

Advantages of Loan Capital

• Loan capital is accessible and can be arranged quickly for a firm’s specific purpose

• Its repayment is spread out over a predetermined period of time, reducing the burden to the business of having to pay it in a lump sum.

• Large organization can negotiate for lower interest charges depending on teh amount they want to borrow.

Disadvantages of Loan Capital

• The capital will have to be redeemed even if the business is making a loss.

• In some cases, collateral (security) will be required before any funds are lent.

• Failure to repay the loan may lead to the seizure of a firm’s assets.

• If variable interest rates increase, a firm' that has a variable rate loan may be faced with high debt repayment burden.

Overdrafts

When a lending institution allows a firm to withdraw more money than it currently has in its account.

Advantages of Overdrafts

• It provides an opportunity for firms to spend more money than they have in their account.

• It is a flexible form of finance its demand will depend on the needs of the business at a particular point in time.

• Charging interest only on the amount overdrawn can make it a cheaper option than loan capital.

Disadvantages of Overdrafts

• Banks can request for the overdraft to be paid back at very short notice.

• Due to the variable nature of an overdraft, the bank can at times charge higher interest rates.

Trade Credit

An agreement between businesses that allows the buyer of goods or services to pay the seller at a later date.

Advantages of Trade Credit

• By delaying payments to suppliers, businesses are left in a better cash flow position than if they paid cash immediately.

• It is an interest-free means of raising funds for the length of the credit period.

Disadvantages of Trade Credit

• Debtors lose out on the possibility of getting discounts had they purchased by paying cash.

• Delaying payments to creditors or suppliers after the agreed period may lead to poor relation between the debtors and suppliers, with the latter refusing to engage in future transaction with th eformer.

Crowdfunding

When a business venture or project is funded by large number of people each contributing a small amount of money.

Advantages of Crowdfunding

• Crowdfunding provides access to thousands of investors who can see, interact and share a project’s fundraising campaign.

• It is a valuable of marketing because pitching a project or business through the online platform can result in media attention that publicizes the business.

• It provides an opportunity for feedback and expert guidance.

• The business still maintains full control and won’t have to forfeit control when raising funds.

• It is a good alternative finance option as it provide another pathway for business that have struggled to get bank loans or traditional funding.

Disadvantages of Crowdfunding

• Businesses seeking crowdfunding have strong competition. As crowdfunding is quite popular.

• The business is subject to thorough scrutiny and rejection.

• Fees need to be paid. Websites take a percentage of the contributions raised.

• There is a potential risk of failure. If the crowdfunding campaign fails. It can be hard to recover. A failed crowdfunding campaign is a sign that the business plan is not good enough to the majority of investors.

Leasing

Source of finance that allows a firm to use an asset without having to purchase it cash.

Finance Lease Agreement

After the ending of a leasing payment, in some cases, they come to an agreement where they are given the option of purchasing the asset.

Advantages of Leasing

• A firm does not need to have high initial capital outlay to purchase the asset

• The lessor takes on the responsibility of repair and maintenance of the asset.

• Leasing is useful when particular assets are required only occasionally or for short periods of time.

Microfinance providers

Institutions that provide banking services to low-income or unemployed individuals or groups of people who would otherwise have no other access to financial services.

Advantages of microfinance providers

• Most microfinance institutions do not seek any collateral for providing financial credit.

• They provide or disburse loans quick;y and with less formalities to individuals,, groups or small businesses, so they can meet any financial emergency.

• They have an extensive portfolio of loans, including working capital, loans, housing loans, etc…

Disadvantages of microfinance providers

• Microfinance institutions can adopt harsh recovery methods in the event of a default if the customer does not have legal representation.

• They offer smaller loan amounts or financial capital than other financial institutions that provide much larger amounts.

• The interest rates on their loans are high and they find it difficult to lower offer rates. They also borrow money from these banks in order to execute their functions, Therefore their operating cost per transaction quite high despite the large volume of transaction every day.

Business Angels (Angel Investors)

These are affluent individuals who provide financial capital to small start-ups or entrepreneurs in return for ownership equity in their businesses. They invest in high-risk businesses that show good potential for high returns or future growth. It may be a capital injection or continuous support of the business.

Advantages of Business Angels

• More opent o negotiation than other institutions or lenders to small or start-up businesses. This is because they are usually successful entrepreneurs who understand the amount of risk involved with business making. They have a flexible and risk-taking attitude.

• NO repayment or interest is required. Angel investors fund the business and in exchange get an ownership stake in the business. If the business succeeds, both investors and owners win, if it doesn’t only the angel isn’t paid back.

• They offer valuable knowledge and they focus on helping a business succeed by using their extensive business experience coupled with good financial capital.

Disadvantages of Business Angels

• They may assume a large decree of control or ownership in the businesses they invest in, therefore, diluting the ownership of the entrepreneur.

• They may expect a substantial return on their investment within a short period of time. Sometimes equal to or greater than 10 times their original investment.

Short-term finance

Money needed for the day-to-day running of a business. External short term finance is expected to be payed within less than a year.

Long-term finance

This is funding obtained for the purpose of purchasing long-term fixed assets or other expansion requirements of a business. It is normally used for the overall improvement of the business. Businesses that take up external long-term financing, usually expected to have more than one financial year to pay back.

(Purpose of Finance) Cost and Opportunity Cost

A business must factor in the interest payments, administration costs, and costs associated with a shared issue. Additionally they must consider th eopportunity cost, or the lost benefit that would have been derived from an alternative.

(Purpose of Finance) Status and Size

The larger and more public a business is, the more and the better, financing options they have. Moreover, large organizations have added collateral that they can use to negotiate lower interest rates from financial institutions.

(Purpose of Finance) Amount Required

Short-term financing is used for small amounts, while long-term financing is used for large amount.

(Purpose of Finance) Flexibility

The ease with which a business may change from one source of finance to another. The flexibility of a business determines their ability to adapt to changes in their financial situation.

(Purpose of Finance) State of external environment

This involves factors (STEEPLE) that the business has no control over.

What is gearing and its two types.

This refers to the relationship between share capital and loan capital.

It may be high geared or low geared.

High Geared

When a Business has a larger proportion of loan capital to share capital.

Low Geared

When a business has a lower proportion of loan capital to share capital.