Chapter 2

Sources of Finance

2.0 Introduction

This chapter is going to focus on the major sources of financing the business

operations. The finance manager’s duty is also to see whether the business

has enough funds to finance its short-term, medium-term and long-term

needs. Sources of finance available can be classified into short term, medium-

term and long-term sources. Specifically, it covers short-term sources of

finance such as bank overdrafts, short-term loans, trade credit, and factoring.

Notably, medium-term sources such as hire purchase, leasing, bill of

exchange, and acceptance credits are will be covered. Moreover, it covers long-

term sources of finance such as syndicated loans, high yield junk bonds,

debentures, and equity finance.

2.1 Short term sources of finance

Are all those finances which are repayable within a year.

a) Bank Overdraft

This is a permit to overdraw on an account up to a stated limit

Advantages

 It’s highly flexible

 Is cheaper
Disadvantages

The bank retains the right to withdraw the facility at short notice

b) Short term loans

This is money borrowed and repaid in a period of less than 12 months

Advantages

 Not repayable on demand

 Lender is committed to providing finance if the borrower meets the

requirement

Disadvantages

 Requires more accompanying documentation

 Requires collateral

c) Trade credit

Is the simplest form of short-term finance. It’s when goods and services are

delivered to a firm for use in its production; they are not paid for immediately.

Advantages

 It’s convenient, informal and cheap

 Is available to companies of any size

Disadvantages

 The firm will not enjoy discounts

  There is a loss of reputation or goodwill if late payment is pushed too

far

 There are high administration costs of managing trade creditor records

and making payments

d)Factoring

This is when cash strapped business, unable to get desperately needed funds

sells off its invoices (accounts receivables) to a third part and in exchange gets

the much-needed cash. It is not a loan but a sale of accounts receivables. It

usually between 90-150 days and is ideal for firms without a credit history.

Advantages

 Quick cash is generated

 Does not require fixed asset backing

 No fear of instant withdrawal of the facility as with the overdraft

 Reduces the risk of bad debts

 Helps to ensure smooth cash flow

Disadvantages

 The company gets less than what is on the accounts receivables

 Factoring companies may not be available with small value transactions

 Some customers prefer to deal with the company directly (factoring

may damage the company’s reputation)

2.2 Medium Term Sources

Refers to all sources of finance for a period above one year but less than 10

years.

a)Hire purchase

Here one pays for an asset in regular installments while having the use of the

item, The individual possesses and controls assets during an agreed time,

while paying rent. It’s used to buy expensive assets that cannot be afforded

at one goal. However, ownership is transferred upon the last installment.

Advantages

 Small initial outlay-the firm does not have to find a full purchase price

at once

 Easy and quick to arrange

 Certainty-cannot be withdrawn like the overdraft

 Often available when all others are not

 Have a fixed rate of interest

 Tax relief(interest payments are tax deductable)

Disadvantages

 Expensive due to additional financial charges that have to be paid

 No ownership of goods until last payment there the asset cannot be

used as collateral

 Seller may repossess the goods in the event of default and no

compensation to the buyer

  Is available only to reputable buyers

b)Leasing

According to the International Accounting Standards, leasing is a commercial

arrangement whereby an equipment owner conveys the right to use the

equipment in return for payment by the user over an agreed period of time. It

is similar to hire purchase but here the lessee pays for the use of the asset in

return for regular rental payments. The lessee does not become the owner,

the company retains the legal title. It can be an operating lease, finance lease

or a sale–and–lease back

Operating lease-Is a lease which commits a lessee to only a short-term

contract and therefore can be terminated at short notice. Here the lesser

retains most of the risks and rewards of ownership and is responsible for

servicing and maintenance of the asset.

Finance lease-Is when the finance provider expects to recover the full cost of

the equipment plus interest over the period of lease. Lessee has no right of

cancellation. It transfers all the risks and rewards of ownership of the asset

to the lessee implying that he will be the one responsible for maintenance,

repairs and insurance.

Sale and lease back-Is when the company that owns the asset sells it to a

financial institution and lease it back. It retains the use of the asset but

generates funds from the sale, whilst paying rent.

Advantages

 Small initial outlay

 If it is an operating lease, there is a possibility of transferring risk to the

service provider

 Can be used to overcome the obsolescence of assets

 Rentals paid are tax deductable

 Easy to arrange

Disadvantages

 The asset cannot be used as collateral

 There is no achievement of the objective of maximizing shareholder’s

value (it reduces the net income without any appreciation in value)

 Requires maintenance of the asset if its finance lease

c) Bill of exchange

d) Acceptance credits

2.3 Long term sources

These cover a period beyond 10 years. Can be debt or equity. Debt financing

occurs when a company borrows money to be paid back at a future date with

interest.
a)Syndicated loans

Is a loan where several financial institutions form a group(syndicate) and lend

money to one borrower. The borrower might be a large company or project or

government

Advantages

 Allows banks to spread risks

 Borrower enjoys flexibility in structure and pricing

 Saves costs(getting a huge sum under one roof)

 Increased chances of networking

Disadvantages

 Negotiations can be time-consuming

 Difficult for the borrower to manage multiple bank relationships

b)High yield junk bonds

Is a hybrid of debt and equity financing that gives the lender the right to

convert an equity interest in the company in the event of default but only after

other senior lenders are paid. Often offers a high return with a high risk

because they are not as liquid as other sources.

Advantages

 Higher rate of return for the investor

 Take precedence overstock during liquidation

 Provides consistent income for as long as the company does not default
Disadvantages

 Have a higher chance of defaulting

 Are less liquid

 Prices are affected by changes in credit rating and interest rates

c) Debentures

Is a written acknowledgement of a debt by a company. It is a long-term debt

instrument in which the bondholders lend money to a company in return for

interest payments when it matures. Can be convertible bonds which can be

converted to shares at the bondholder’s discretion.

Advantages

 Offer low-cost rates

 Is a deductible expense for the issuing company

Disadvantages

 There is risk of dilution if convertible

 Increases gearing of the company

d) Equity finance

Is capital raised in exchange for share ownership of the company. It can be

common stock which is obtained from owners and other parties and these

have the right to vote. Can also be preferred stock which own part of the

business but have no voting rights but receives fixed dividends. They get first

preference before common stock owners but not before debentures

Can also be in the form of retained earnings which is all the profits the

business has kept since it started operation. It’s an internally generated

equity capital.

Advantages

 No obligation to repay dividends

 Capital does not have to be repaid

 More equity increases creditworthiness

Disadvantages

 High costs involved-issue costs such as brokerage costs and

underwriting commissions are high as well as the required rate of

return

 There is dilution of control

 Dividends are not tax deductible

2.4 Summary

This section has covered the major sources of finance that can be utilized by

the finance manager in any organization whether small or large. These

sources can be categorised into three groups, namely, short-term, medium-

term and long-term sources as presented and discussed in this section.

2.5 Self-Assessment Questions

2.5.1 Short Answer Questions

1. What is business finance? Why do businesses need funds? Explain.

2. List sources of raising long-term and short-term finance.

3.What is the difference between internal and external sources of raising

funds? Explain.

4. What preferential rights are enjoyed by preference shareholders.

Explain.

5. Name any three special financial institutions and state their objectives.

2.5.2 Long Answer Questions

1. Explain trade credit and bank credit as sources of short-term finance

for business enterprises.

2.Discuss the sources from which a large industrial enterprise can raise

capital for financing modernisation and expansion.

3.What advantages does issue of debentures provide over the issue of

equity shares?

4.State the merits and demerits of public deposits and retained earnings

as methods of business finance.

5. Discuss the financial instruments used in international financing.

6.What is a commercial paper? What are its advantages and limitations.

2.5.3 Projects/Assignment

1.Collect information about the companies that have issued debentures

in recent years. Give suggestions to make debentures more popular.

2. Institutional financing has gained importance in recent years. In a

scrapbook paste detailed information about various financial institutions

that provide financial assistance to Zimbabwean companies.

3.On the basis of the sources discussed in the chapter, suggest suitable

options to solve the financial problem of the restaurant owner.

4.Prepare a comparative chart of all the sources of finance.