9

LUBS1235 Introductory Financial Accounting

Lecture 9: Sources of Finance

Objectives

• Understand the main sources of internal finance available to businesses, including their advantages and disadvantages.

• Understand the main sources of external finance available to businesses, including their advantages and disadvantages.

• Prepare relevant calculations and discuss the effects of issuing loan stock or ordinary shares on an organization.

1. Internal Sources of Finance

Internal sources are preferred due to their low cost and flexibility.

1.1 Retained Earnings

• Definition: Profits retained in the business instead of distributed as dividends.

• Advantages:

  • Major source for most businesses.

  • No costs associated with retention.

  • Retaining earnings can enhance shareholder capital appreciation, particularly in growing companies.

• Disadvantages:

  • May upset shareholders preferring dividends.

  • Dividends depend on the directors' decisions, which can be influenced by shareholder votes at annual meetings.

  • Timing and amount of future retained profits can be uncertain.

1.2 Working Capital

• Definition: Current assets minus current liabilities. Key components include inventories, receivables, cash, and payables.

• Considerations:

  • Variation exists between industries in working capital needs; for instance, retail may have negative working capital, while manufacturing requires substantial amounts.

  • Effective management is vital for business operations.

2. External Sources of Finance

External finance typically involves more cost than internal sources.

2.1 Long-term Sources of Finance

2.1.1 Ordinary Shares

• Description: Represents a company's equity and risk capital.

• Key points:

  • Ordinary shareholders control the company via voting rights.

  • Dividends are paid only if profits allow; there is no tax relief on dividends.

  • Shareholders risk losing capital in liquidation.

2.1.2 Loans (Borrowings)

• Description: Companies often utilize loans alongside equity for financing.

• Types of Loans:

  • Term Loans: Negotiated with banks; defined amounts, interest rates, and repayment schedules.

  • Loan Notes or Stocks: Divided into units; tradable on stock exchanges.

  • Eurobonds: Unsecured bonds usually raised in foreign currency.

  • Convertible Loan Stocks: Allow lenders to convert loans into shares at specified terms.

  • Mortgages: Long-term loans secured against property.

2.1.3 Finance Leases

• Description: Acquires non-current assets via lease instead of outright purchase.

• Advantages:

  • Offers ease of borrowing, cost-effective solutions, and flexibility in cash flow management.

2.2 Gearing and Long-term Financing Decisions

• Definition: Refers to the proportion of debt to equity in a company's capital structure.

• Gearing Implications:

  • Higher gearing increases financial risk, particularly in low-profit scenarios.

  • Strategic adjustments can be made by altering ratios of equity and debt.

  • Affects earnings per share positively when profits increase.

3. Relationship Between Debt and Equity

• Investor Concern: The interplay between debt obligations (which must be paid regardless of profit) and equity returns (dependent on profit).

• Profitability Analysis:

  • High debt can be detrimental in low-profit situations, but advantageous in high-profit scenarios due to lower borrowing costs.

4. Short-term Sources of External Finance

• Typically last less than one year, catering to immediate financial needs.

4.1 Bank Overdraft

• Features:

  • Offers flexibility and can be easily adjusted.

  • Generally cheaper than term loans, but interest rates can be competitive.

  • Requires regular evaluation by banks with a limit that can be renegotiated.

4.2 Debt Factoring

• Description: Involves selling receivables to a third party (factor) who collects debts from customers.

• Financial implications: Usually involves a fee of 2-3% of sales; helps manage credit more effectively.

5. Long-term vs Short-term Borrowings

Key Considerations

• Matching Assets to Borrowing:

  • Long-term borrowings should finance permanent assets; short-term should support seasonal increases.

• Flexibility and Interest Rates:

  • Short-term borrowings can adapt quickly to changes in interest rates.

  • Stability of long-term debts provides a secure environment against fluctuating rates.