Chapter 9: Sources of Finance

Need for Business Finance

Businesses require capital at various stages of their operational lifecycle. Financing is required primarily for:

Start-up Capital: Funds required to establish a new business from scratch, including purchasing essential assets and covering initial operating costs.
Expanding an Existing Business: Capital needed to fund growth initiatives, such as purchasing additional machinery, opening new outlets, or acquiring another firm.
A Business in Difficulty: Emergency funding needed to cover cash flow deficits, pay off pressing debts, or restructure operations during downturns.

Classifications of Business Expenditure

Business expenditure is categorized based on the nature and longevity of the assets acquired:

Capital Expenditure: Money spent on fixed assets that will last for more than one year (e.g., land, buildings, machinery, and vehicles). These assets are essential when launching a business and during expansion phases.
Revenue Expenditure: Money spent on day-to-day running costs and operational expenses that do not result in the acquisition of long-term assets (e.g., employee wages, rent, insurance, and electricity).

Internal Sources of Finance

Internal sources of finance refer to funds generated from within the business's existing operations or assets.

Retained Profit: Profit kept back in the business after owners or shareholders have taken their share.
- Advantages: Does not need to be repaid; no interest payments.
- Disadvantages: Not available to new businesses; profit retained may be insufficient for expansion; reduces dividend payments to shareholders.
Selling Fixed Assets: Selling existing assets that are no longer required (e.g., surplus vehicles, equipment, or redundant buildings).
- Advantages: Makes better use of capital tied up in unused assets.
- Disadvantages: Takes time to sell; unavailable to new businesses with no surplus assets.
Selling Stocks (Running Down Stock Levels): Selling off inventory for cash.
- Advantages: Reduces storage costs and opportunity costs associated with holding high stock levels.
- Disadvantages: Risk of disappointing customers if inventory runs too low.
Owners' Savings: Personal savings invested into unincorporated businesses (e.g., sole traders or partnerships).
- Advantages: Quickly available; no interest charged.
- Disadvantages: Savings may be limited; increases personal financial risk for owners.

External Sources of Finance

External sources of finance are funds obtained from individuals or institutions outside of the business.

Issue of Shares: Selling equity to the public (available only to limited companies).
- Advantages: Permanent capital source that does not require repayment or interest.
- Disadvantages: Dividends must be paid; dilutes control and ownership.
Bank Loans: Borrowed funds returned over an agreed period with interest.
- Advantages: Quick to arrange; variable duration; large firms benefit from financial economies of scale (lower interest rates).
- Disadvantages: Requires repayment with interest; collateral or security is usually required.
Debentures: Long-term loan certificates issued by limited companies.
- Advantages: Provides long-term capital (e.g., up to 25 years).
- Disadvantages: Must be repaid with interest.
Factoring of Debts: Selling trade debts to specialist agencies for immediate cash (e.g., receiving 90% of debt value).
- Advantages: Provides immediate cash flow; shifts debt collection risk to the factor.
- Disadvantages: Business loses a percentage of the total debt value.
Grants and Subsidies: Financial support provided by governments or outside agencies.
- Advantages: Do not need to be repaid.
- Disadvantages: Often accompanied by strict conditions regarding location or employment.
Micro-financing: Small-scale loans provided by specialist financial institutions in developing countries.
- Advantages: Helps poor entrepreneurs, lowers unemployment, and improves living standards.
- Disadvantages: Low profits for lenders; higher risk of non-payment.

Classification of Finance by Longevity

Short-Term Finance

Finance needed for 1 to 3 years to provide working capital for day-to-day operations:

Overdrafts: Agreement with a bank to overdraw an account up to an agreed limit.
- Advantages: Flexible; interest is charged only on the overdrawn amount.
- Disadvantages: Bank can demand immediate repayment; variable interest rates.
Trade Credit: Delaying payments to suppliers for goods or services received.
- Advantages: Provides an interest-free short-term loan.
- Disadvantages: Suppliers may withhold discounts or refuse future supplies.
Factoring of Debts: Provides immediate cash by selling receivables.

Long-Term Finance

Finance available for over 3 years, used to purchase fixed assets, expand, or fund takeovers:

Bank Loans: Used for long-term investments.
Hire Purchase: Purchasing an asset through monthly installments including interest.
- Advantages: Spreads the cost of expensive assets without needing a large initial cash outlay.
- Disadvantages: Deposit required; high interest charges overall.
Leasing: Renting an asset for monthly payments without purchasing it outright.
- Advantages: No large initial outlay; maintenance covered by the leasing company.
- Disadvantages: Total leasing cost exceeds the original purchase price.
Issue of Shares: Long-term equity capital.
Debentures: Very long-term loan certificates.

Factors Influencing the Choice of Finance

When selecting a source of finance, businesses must evaluate:

Purpose and Time Period: Matching short-term needs with short-term finance and long-term needs with long-term finance.
Amount Required: Certain sources are better suited for large sums (e.g., share issues or debentures).
Status and Size of Business: Limited companies have access to share issues and debentures, unlike sole traders.
Control: Selling shares dilutes ownership and control.
Risk and Financial Gearing: High debt levels increase financial risk due to mandatory interest repayments.