3.2_Sources_of_finance_new_syllabus_2024

Sources of Finance

Overview

• Understanding sources of finance is crucial for any business.

• Sources can be categorized as internal or external, and further classified into long-term and short-term funding.

Internal Sources

• Personal Funds

  • Mainly used by sole traders and partnerships.

  • Sourced from the owner's personal savings.

• Retained Profits

  • Profits that remain after dividends are paid out to shareholders.

  • Considered a low-cost source since it does not involve external financing costs.

• Sale of Assets

  • Businesses can sell unused or unwanted assets to generate funds.

  • This provides immediate cash flow but may impact operational capacity.

External Sources

• Loan Capital

  • Interest-bearing finance sourced from commercial lenders.

  • Typically involves collateral and repayment terms.

• Share Capital

  • Funds raised by selling shares during an IPO or subsequent share offerings.

  • Provides equity finance without repayment commitments.

• Debentures/Bonds

  • Debt instruments issued by firms or government.

  • Issuers promise to pay back the principal along with fixed periodic interest. Bonds can be transferable.

• Business Angels

  • Wealthy individuals investing their own money into small to medium businesses with growth potential.

• Leasing

  • Allows businesses to obtain equipment or vehicles without owning them upfront.

  • Payments are made over time, and the leasing company retains ownership.

• Overdraft

  • A flexible borrowing option through a bank allowing businesses to withdraw more than their account balance up to a limit.

• Trade Credit

  • Enables businesses to purchase goods with a delayed payment.

  • Effective for managing cash flow.

• Crowdfunding

  • Financing projects by raising small amounts from a large number of people, often through online platforms.

• Microfinance Providers

  • Offer small loans to individuals lacking access to traditional banking.

  • Associated with social entrepreneurs like Muhammad Yunus, Nobel Peace Prize laureate 2006.

Classification of Financing

• Long-term Sources

  • Typically used for financing fixed assets or long-term projects (e.g., share capital, long-term loans).

• Short-term Sources

  • Includes financing methods relevant for a single fiscal year, such as trade credit or overdrafts.

Factors to Consider in Financing

• Determining the right source involves evaluating:

  1. Amount required

  2. Cost of finance

  3. Necessary repayment period

  4. Level of borrowing (gearing)

Advantages of Debt Finance

• Does not alter ownership structure (existing ownership remains intact).

• Liabilities do not increase permanently since they are repayable.

• Lenders have no voting rights in the company decisions.

• Interest payments can be tax-deductible.

Advantages of Equity Finance

• Unlike debt, dividends do not need to be paid annually.

• Potential to acquire a substantial amount of finance without the pressure of repayment.