Sources of Finance

Learning Objectives
 Students will be able to identify
different sources of finance.
 Students will be able to listen.

 Some students will be able to apply

the information and produce an
independent information pack.
 Financial Management
-Sources of Funds

 The need for funds:

No business can live without funds.
Throughout the life of a business, money is
needed continuously. Firms raise money mainly
to meet the following three types of need:
1. To start a business as initial expenditure;
2. To fund continuous business activities and
money flowing;
3. To expand the business.
Financing

Internal Financing – funds raised from

cash flows of existing assets
External Financing – funds raised from
outside the company (VC, debt,
equity, etc.)

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 Internal vs. External
Financing

 Firms may prefer internal financing because

 External financing is difficult to raise
 External financing may result in loss of control
 Raising external capital tends to be expensive
 Projects funded by internal financing must meet
same hurdle rates
 Internal financing is limited

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Internal vs. External
Financing
 Firms may prefer internal financing because
 External financing is difficult to raise
 External financing may result in loss of control
 Raising external capital tends to be expensive

 Projects funded by internal financing must meet

same hurdle rates

 Internal financing is limited

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 Financial Management
-Sources of Funds
 The need for funds:
Question for your critical thinking:

Please give some typical examples

for the three types of needs for funds.
 Financial Management
-Sources of Funds
 Sources of funds
In general, a business may have two
major sources of funds which are
needed for its business operations.
They are internal sources of funds and
external sources of funds.
See Figure 13-1 for details.
 Financial Management
-Sources of Funds

Table 13-1 Sources of Funds

Sources of Funds
Internal Sources External Sources

Short term:
Long-term: Overdraft
Profit Depreciation Sales of assets Share Capital Leasing
Loan Capital Credit card…
 Financial Management
-Internal Sources of Funds

Profit  The after-tax profit

earned and retained by a
business which is an
important and
inexpensive source of
finance, for example, the
retained earnings of the
business. A large part of
finance is funded from
© PhotoDisc
profit.
 Financial Management
-Internal Sources of Funds

Profit
 The financial provision
for the replacement of
worn-out machinery and
Depreciation equipment. Nearly all
businesses use
depreciation as a source
of funds.

© PhotoDisc
 Financial Management
-Internal Sources of Funds
 Definition: The activity that
Profit a business sells off assets to
raise funds for the business.
 Reasons: When a business
Depreciation can not raise finance from
banks or other sources, it
may be forced to sell some
Sales of Assets assets, such as company cars,
land property; or even
subsidiary or associated
company to solve its urgent
© PhotoDisc financial problems (this
activity is called divestment).
 Financial Management
-External Long-term Sources of
Funds

 Share capital:
The most important source of funds for a limited company. It
is often considered as permanent capital as it is not repaid by
the business, but the shareholder can have a share in the
profit, called dividend.
Three types of shares are:
1. Ordinary shares: The most common types of shares, and
the most riskiest shares since no guaranteed dividend.
Dividend depends on how much profit is made by the firm.
But all ordinary shareholders have voting rights.
2. Preference shares: The share owners receive a fixed rate of
return. They carry less risk because shareholders are entitled
to the dividend before the ordinary shares. But they are not
strictly owners of the company.
3. Deferred shares: These shares are often held by the
founders of the company. Deferred shareholders only receive
the dividend after the ordinary shareholders have been paid.
 Financial Management
-External Long-term Sources of
Funds
 Loan capital
 Definition:
Any money which is borrowed for a long
period of time by a business is called loan
capital.
 Types:
There are four major types of loan capital:
Debentures, Mortgage, Loan specialists’
funds, Government assistance. See next
page:
 Financial Management
-External Long-term Sources of
Funds
 Types of loan capital:
1. Debentures: The holder of a debenture is a creditor of the
company, not an owner. Holders are paid with an agreed fixed
rate of return, but having no voting rights. The amount of money
borrowed must be repaid by the expiry date.
2. Mortgage: These are long-term bank loans (usually over one
year period) from banks or other financial institutions. The
borrower’s land or property must be used as a security on such as
a loan.
3. Loan specialists’ funds: These are venture capitalists or
specialists who provide funds for small businesses, especially for
high tech investment projects in their start-up stage. There are
also individuals who invest in such businesses, which are often
called ‘business angels’.
4. Government assistance: To encourage small businesses and high
employment, governments may be involved in providing finance for
businesses. In the USA, there is an organization which is called the Small
Business Administration (SBA). SBA provides guarantees for small
businesses’ loans and they even offer some loans themselves.
 Financial Management
-External Short-term Sources of
Funds
 Definition:
Short term sources of funds are usually the funds which
are less than one year for maturity. They are less stable
sources of funds for businesses.
 Types:
The main types of external short term sources of funds
include:
1. Bank overdraft
2. Bank loan
3. Leasing
4. Credit card
5. Trade credit
See the next page for details:
 Table 13-2 External short-term sources of loans
Major types Main characteristics

Bank This is a short term financing from banks.

overdraft The amount to be overdrawn depends on the needs of
the business at the time and its credit standing.
Interest is calculated from the time the account is
overdrawn..
Bank loan This is a loan which requires a rigid agreement between
the borrower and the bank. The amount borrowed must
be repaid over a certain period or in regular installments.
Sometimes, banks change persistent overdrafts into
loans, so borrowers must repay at regular intervals.
Leasing Leasing allows businesses to buy plant, machinery or
equipment without paying large sums of money
immediately.
The leasing company or bank hires or buys the
equipment and for the use of the hire company for a
certain period of time. If the user can never owns the
equipment, it is an operating lease, while if it is given the
choice to own the equipment at the expiry time, it is a
finance lease.
 Financial Management
-External Short-term Sources of Funds
Table 13-2 External short-term sources of loans (continued)
Major Main characteristics
types
Credit card Credit cards can be used to pay for hotel
bills, meals, shopping and materials, etc. They
are convenient, and secure because it can
avoid the use of cash and the payment of
interests within credit periods.
Cards may not be suitable for certain
purchases, especially a large sum of order
because they have a credit limit.
Trade It is a common method for businesses to buy
credit materials and to pay for them at a later
date, usually between 30 and 90 days. Such
trade credit given by the seller is usually an
interest free way of short term financing.
 Financial Management
-Factors affecting the choice of
funds
 Costs of the fund
Costs in terms of interest payments and other expenses:
Long term and short term.
 Use or purpose of funds
For example, the building of a new plant is usually
financed by mortgage or share capital, while the purchase
of raw materials by trade credit or bank overdraft.
 Status and size of the business
For a large firm, there are more sources of finance and
often with lower interest rates.
 Financial situations of a firm
For example, a business in poor financial situation is
forced to pay high interest rate for loans. And the bank
often requires security or collaterals for their financing.
 Financial Management
-Factors affecting the choice of
funds
 Gearing condition (ratio) of the firm 传动比
率 : 公司资本中债务的比率，即资产 (assets) 与负
债 (liability) 的比率 :
 Definition:
Gearing is the relationship between the loan capital and
share capital of a business. High geared companies have a
larger share of loan capital to share capital. Low geared
ones have a small amount of loan capital.
 Impact over a firm:
High gearing may mean ‘no loss of ownership’ but high
risk of liquidity since interest rates may change and
loans must be repaid in time. Low gearing may mean
some loss of ownership but no burden of loans and
interest payments.
 Financial Management
-Sources of Funds

 Question for your critical

thinking:

If you are the manager, do you

prefer high gearing or lower
gearing for your firm? And why
so?
Sources of Funds

Debt capital—funds obtained

through borrowing.

Equity capital—funds provided by

the firm’s owners when they reinvest
earnings, make additional
contributions, or issue stock to
investors.
Debt and Equity Capital: Two Basic
Sources of Funds
Comparison of Debt and Equity Capital