SOURCES OF FINANCE

SOURCES OF FINANCE
• All businesses require funding for their
activities.
• For example – a loan to purchase a new
computer system or a bank overdraft to pay
suppliers before the receipt of customers
cash.
• Just like people, organizations require a variety
of funding for a range of purposes.
 Factors to consider when
choosing finance:
• A business should match the source of finance to its
specific use – in practice this means that a business
should secure long-term sources of finance for long
term uses or needs and for more short term finance
immediate needs.
• The cost of the source.
• The organization’s objectives.
• The flexibility and availability of the finance, for
example, how easy it is to switch from one form of
funding to another, or whether a particular form of
finance is available for a new business with no trading
record.
 Factors to consider when
choosing finance:
• The impact the new funding would have on
the organizations current financial structure,
for example, its balance sheet.
• The state of the external environment, for
example the economy and consumer trends.
• The type of business structure it is, for
example a sole trader or partnership can raise
funds from the stock market.
 INTERNAL SOURCES OF FINANCE
There are several sources of internal finance
for the business including:
• Retained Profit
• The Sales of Assets
• Utilizing working capital more
effectively
•
 INTERNAL SOURCES OF FINANCE
Retained Profit
• This is one of the most important sources of
business finance.
• It represents the profits generated from sales
after interest payments to lenders, taxes to
the government and payments to
shareholders in the form of dividends.
• The remaining profit is then retained or put
back into the business and available for future
spending by the organization.
 INTERNAL SOURCES OF FINANCE
Retained Profit
Advantages of using Retained Profit
• The advantages of retained profit are that
there are no associated borrowing costs and
that businesses do not see a rise in debt levels
(gearing).
• The owners control is not diluted and
decisions are not vetted by lenders (banks)
 INTERNAL SOURCES OF FINANCE
Retained Profit
The Disadvantage of using Retained Profit
• The disadvantages are that the owners may take out all
the organization’s spare cash and there will be no buffer
if the business suddenly needs cash or another market
opportunity arises.
• Equally some businesses are more focused on
investment decisions when borrowing money, but are
more lax when using retained profits.
• There may no outsiders to be accountable to – especially
small and family run businesses with no outside
shareholders.
 INTERNAL SOURCES OF FINANCE
The Sale of Assets
• Many large retail businesses that own lots of
property have decided to sell off their property
portfolio and raise fresh expansion capital or cash.
• Supermarkets and banks are examples. They see
themselves as retailers not property developers.
• Companies may sell their assets to property
development or pension companies and then lease
then back for a fixed period of time and rent.
 INTERNAL SOURCES OF FINANCE
The Sale of Assets
The Advantage of Selling Assets
• The main advantage is having no associated
borrowing costs or debts.
Disadvantages of Selling Assets
• The business can only sell off the `family
silver` once, so it needs to care what is sells
and how wisely it uses its cash.
 INTERNAL SOURCES OF FINANCE
The Sale of Assets
Sale and Leaseback Deals
• When setting up a sale and leaseback
situation, it is imperative that the lease allows
the business flexibility, for example, the new
landlord wants to sell the site in 10 years time
or up the rent above inflation.
• Will there be an adequate notice period in the
contract?
 INTERNAL SOURCES OF FINANCE
Utilizing Working Capital more effectively
• Working capital is money tied up in the
business and used to finance its day to day
needs, such as buying raw materials.
• All businesses have a working capital cycle
that identifies how this money moves around
the business
 Reducing our Working Capital Needs
• A possible source of finance is squeezing or
reducing our own working capital needs.
• Therefore the cash we need is more efficiently
used.
• Eg: IF we minimize our stock levels we reduce
the amount of money tied up in stock.
 Just in Time Production (JIT)
Reducing Working Capital Needs
• In modern customer manufacturing the concept of producing
just in time (JIT) and only to a specific order has grown
dramatically.
• Eg: When a customers orders a bed or dining table they may
in some cases have to be wait 2 to 4 weeks for delivery.
• This is because some items are not held in stock by the
retailer or manufacturer – they are both minimizing their
working capital needs and the amount of money tied up in the
unsold stock.
• The consumer therefore pays upfront to the retailer and is
effect funding the retailing and manufacturing of the product.
 Early Payments Incentives
Reducing Working Capital Needs
• A business can ask its customers who
purchase goods on credit to pay more
promptly, by offering a financial incentive.
• Eg: A 5% discount for payment in 14 days and
this helps to reduce the funding needs from
the bank or shareholders.
 Delaying Payments to Creditors
Reducing Working Capital Needs
• A business can slow down payment to it
suppliers or creditors.
• Therefore a business can use resources for
longer without having paid for them.
• Suppliers or creditors are being asked to fund
more of our operation.
 MRP & MRP2
Reducing Working Capital Needs
• Better management of stock can be done internally
and without always affecting delivery dates.
• Better MRP (Material Resource Planning) and
MRP2 (Manufacturing Resource Planning) systems
are making the ordering of stock materials more
efficient.
• These systems reduce the time that stock is left
unused and therefore reduce the amount of
money tied up in stock.
 The Advantages of
Reducing Working Capital Needs
• The advantage of squeezing working capital as
a source of finance is that you do not have to
ask a bank or shareholders to give you more
money and on terms that may be expensive.
 The Disadvantages of
Reducing Working Capital Needs
• The disadvantage is that suppliers and
customers may not be happy waiting for
money or paying upfront for goods, especially
when competitors may be able to offer a
better delivery schedule for customers or
better payment terms to their suppliers.
• Caution has to be exercised and
communication with these two stakeholders is
paramount.
 EXTERNAL SOURCES OF FINANCE
(Long Term)
There are four main sources of external finance
in the long term:
• Share Capital
• Loan Capital
• Venture Capitalists
• Grants from Governments & other
philanthropic organizations.
 EXTERNAL SOURCES OF FINANCE
Share Capital
• Share capital represents the monies that are
put into a company by investors, who are then
classified as shareholders.
• Note: Sole Traders and Partnerships don’t
have shareholders and this is not a relevant
source of finance for these organizations.
 EXTERNAL SOURCES OF FINANCE
Share Capital
• The original investment by the owners is often
used to fund the purchase of the organizations
initial assets and sometimes to fund the
working capital needs of the business while
other funding is organized.
• However, it is a long term source of finance
and therefore should be used for long-term
needs, such as purchasing machines or
computer systems or acquiring businesses.
 EXTERNAL SOURCES OF FINANCE
Share Capital
• When a business expands it can ask existing
shareholders to put more money into the
business and therefore new shares are issued in
proportion to the size of the increase in the share
capital.
• Note: When people buy and selling existing
shares, usually via a stock exchange, this does
not help the business with raising new capital, as
it is simply swapping ownership between people.
 Advantages of Share Capital
as a Source of Finance.
• The advantages with this sort of finance are
there are no interest payments and so no drain
on company profits.
• If existing shareholders increase their investment
by buying more share in proportion to the
current levels, there is no change in control.
• However, if new shares are bought by new
investors that may dilute the control of the
original shareholders.
 Disadvantages of Share Capital
as a Source of Finance.
• The disadvantages are that shareholders may
still expect rewards in the form of dividends,
and this is paid for from profits.
• However, unlike the arrangement with loan
capital, if the business does not make a profit
and does not have a reserve of past profits, it
cannot be compelled to pay a dividend.
 A Share Capital or
Debt Capital Tradition
• In countries such as the UK, the amount of
share capital used to fund business activities is
rather low relative to debt capital.
• This makes UK companies vulnerable to
interest rate rises, which can hit profits directly.
• In other countries, (eg: Japan & Germany)
there is a tradition of investing in share capital
and this makes for a more long term and
perhaps more stable financial structure.
 EXTERNAL SOURCES OF FINANCE
Debt or Loan Capital
• Funding provided by outside banks and lenders is
generally referred to as debt or loan capital.
• It is usually provided for a fixed period of time, with
repayments evenly spread out over the length of the loan.
• Interest is paid on the loan at regular intervals, although
interest rate holidays (where the lender agrees not to take
interest for a short period of time) can be negotiated if
the business is struggling to fund the debt.
• Loan capital is provided for more than 1 year and so is a
long term form of finance.
• Any loan shorter than 1 year is classified as current
liabilities or debt.
 The Advantages of Loan Capital
• The advantage of this form of finance is that it
is often easier to access and use for specific
purposes like buying fixed assets, such as
machines or property.
• Payment is spread out over the useful
revenue-earning life of the asset.
• If the loan has a fixed interest rate, and
interest rates rise in the future, the loan could
be a very smart investment.
The Disadvantages of Loan Capital
• The disadvantages is that lenders have to be paid even if the
business does not make a profit.
• Any default (not paying the loan on time) can lead to the
lender controlling future decision making, in effect they call the
shots.
• Equally if the loan is secured against an asset then the asset
can be seized if payments are missed.
• If the loan has fixed interest rate, and interest rates fall, the
business may find itself with a very undesirable loan, that is a
burden on the business.
• However, large and very profitable organizations may be able
to renegotiate terms with lenders.
 EXTERNAL SOURCES OF FINANCE
Venture Capitalists
• These are specialist bankers who are more
prepared to share the risks of starting a new
business enterprise than traditional banks.
• Venture capitalists invest in the share capital
of the business and provide loan capital for
the business.
• Venture capitalists only target companies with
great expansion or growth potential.
Advantages of Venture Capitalists
• The advantages are that they often provide
business help and contacts - perhaps for export
drives or for identifying new technologies or
partners.
• They sit as non-executive directors to protect their
investments.
• They will ensure that there is a planned exit route
for the investment in maybe five to seven years,
often through a stock market floatation or via a
trade sale.
 Disadvantages of Venture Capitalists
• The disadvantages are many for the existing
shareholders as venture capitalists impose profit or
sales targets.
• If the businesses they invest in fail to expand as
planned the venture capitalists can automatically
increase their equity stakes, often from that of a
minority investor to being the controlling one.
• However, many organizations have used venture
capital successfully and benefited from the business
advice of their managers.
 EXTERNAL SOURCES OF FINANCE
Grants from governments & other
philanthropic organizations

• This is a growth area.

• Governments, successful entrepreneurs such as Bill Gates
& large corporations keen on promoting their social
responsibilities, are all increasingly seeking to help the
smaller business sector with grants and soft loans.
• Soft loans are loans with more relaxed payment terms and
lower than usual interest rates.
• While the sums may be small they can make a big
difference to a projects viability.
• Often the problem is identifying what grants are actually
available, although the internet has made the research
easier.
 EXTERNAL SOURCES OF FINANCE
(Short Term)
There are several types of short term finance:
• Bank Overdraft
• Trade Credit
• Factoring
• Leasing.
 EXTERNAL SOURCES OF FINANCE (ST)
Bank Overdraft
• Banks finance the short-term needs of businesses by
providing short term monies called overdrafts.
• An overdraft is repayable on demand and should be
used for short term funding needs, such as when a
business is waiting for customers to pay, when it needs
to pay suppliers upfront or when staff have to be paid.
• When business find they are expanding very quickly
due to a successful sales drive they may well find their
overdraft rising as they await receipts from customers.
 EXTERNAL SOURCES OF FINANCE (ST)
Disadvantages of a Bank Overdraft
• The disadvantage is that the cost of an overdraft will vary
as interest rates change in the economy.
• This makes budgeting costs a little difficult.
• In some countries (eg UK) bank overdrafts can represent a
very high proportion of total funding for a business. If the
bank decides the business is struggling or that a recession
is coming it may cut back the overdraft limit without much
notice.
• This can lead to a business failing.
• Overdrafts are often secured on a personal guarantee from
the owners and or the assets of the business.
 EXTERNAL SOURCES OF FINANCE (ST)
Advantages of a Bank Overdraft
• The advantages are that changes in overdraft
limits can be increased quite easily and it is a
flexible source of finance.
 EXTERNAL SOURCES OF FINANCE (ST)
Trade Credit
• Trade Credit is when a business gains
extended time to pay its suppliers – perhaps
30 or 60 days after the delivery of the
suppliers goods.
• This means the business can in effect use its
suppliers as a source of finance.
 EXTERNAL SOURCES OF FINANCE
Factoring – Third Party Agency

• When working capital is tight or when a business is

struggling to get paid by customers, it may consider
using a third part agency to help.
• A factor agent is a company that buys the current
unpaid invoices of a business at a discount of, say 25%.
• The factor agent pays that cash immediately to the
business and hopes that it can recover more than 75%
of the value of the debts in order to make it a profit.
• The better the quality of the customers a business has,
the greater the percentage that the factor agent may
be prepared to offer upfront.
 EXTERNAL SOURCES OF FINANCE
Advantages of Factoring

• The advantage is that the business receives

cash upfront and can use this money to fund
expansion and working capital needs more
generally.
• In addition, the administration cost to the
business of chasing up its customers, is
immediately removed.
 EXTERNAL SOURCES OF FINANCE
Disadvantages of Factoring

• The disadvantage is that the business is really giving up some

of its profit margin by doing this.
• For example, if the firm is making a 50% profit margin already,
giving away 25% of the sales value may be acceptable, but not
if the business is only making a small margin.
• Equally factoring will not help very small businesses and those
with very marginal and local clients.
• Also remember that a factor agent ringing up your biggest
customer and demanding immediate payment (otherwise the
customer may be taken to court) could mean that you could
lose vital sales in the future.
 EXTERNAL SOURCES OF FINANCE
Leasing
• When purchasing assets such as new machines
or vehicles it can be sometimes be useful to
consider leasing as a source of finance.
• Many airlines lease purchase their aircraft.
• GE, a large US finance company, is one of the
largest leasing businesses in the world.
• Equally leasing can be arranged with firm’s own
bank.
 EXTERNAL SOURCES OF FINANCE
Advantages of Leasing
• The advantages are that the business does not
need to find a large initial lump sum to buy
the equipment and can thus pay for the asset
from its own revenue.
 EXTERNAL SOURCES OF FINANCE
Disadvantages of Leasing
• The disadvantages are that the ownership of
the asset does not pass to the business until
the last payment has been made and the
business will probably be paying a reasonably
high level of interest.
 FINAL COMMENTS –
EXTERNAL SOURCES OF FINANCE
• Using external financing brings in much needed
funding for expansion, but it has its problems or costs.
• Gearing ratios, rises as loans become a larger share of
the total capital of the business, also interest cover
ratios may worsen, unless profit rises proportionally
as well.
• Equally more long term debt will dilute the owners
stake in the business and that of the lenders will rise,
affecting to some extent business decision making.
• It is important to consider a variety of funding sources
and not to become overly dependent on one.