external source of finance

ACCOUNTS & FINANCE

Unit 3.1 Sources of Finance
Where does the money come from?

Multiple Choice

What does internal source of finance mean?

• A source from within the business

• A source from outside the business

Multiple Choice

What does external source of finance mean?

• A source from within the business

• A source from outside the business

Multiple Choice

Which is an example of an internal source of finance?

• Owner's Capital

• Venture Capitalist

• Overdraft

• Trade credit

Multiple Choice

Which is an example of an external source of finance?

• Owner's capital

• Hire Purchase

• Retained profits

• Sale of assets

Multiple Choice

What does internal source of finance mean?

• A source from within the business

• A source from outside the business

Multiple Choice

What is an advantage of a bank loan?

• There will be little or no interest
• You can pay in smaller installments
• They are quick and easy to arrange
• You don't have to pay it back

Multiple Choice

What is an advantage of owner's capital?

• There will be interest

• You can pay in smaller installments

• They take a long time to arrange

• You don't have to pay it back

Multiple Choice

What is an advantage of an overdraft?

• There is never interest

• You can pay in smaller installments

• Useful for relatively small sums and short term finance

• You don't have to pay it back

Multiple Choice

Which of these facts about venture capitalists is NOT true?

• Venture capitalists tend to operate in fairly risky markets

• Venture capitalists would be paid a share of the profits

• Venture capitalists usually provide money only and have no interest in running the business

• Venture capitalists usually invest large sums of money

Multiple Select

Which of the following are DISADVANTAGES of selling shares as a source of finance? (select as many as appropriate)

• It means limited liability for the owners

• Dividends need to be paid to shareholders

• Large sums of money can be raised

• Does not apply to Partnerships or Sole Traders

Why do we need finance?

1. Setting up a business

2. Need to finance our day-to-day

activities

3. Expansion

4. Research into new products

5. Special situations such as a fall in sales

Finance is required
for many activities

⚫ Setting up a business will require start-

up capital of cash injections from the
owner(s) to purchase essential capital
equipment and, possibly, premises.

Finance is required
for many activities

⚫ Businesses need to finance their working

capital –
•the day-to-day finance needed to pay bills and

expenses and to build up stocks

Finance is required
for many activities

⚫ Business expansion needs finance to

increase the capital assets held by the
firm – and, often, expansion will involve
higher working capital needs.

Finance is required
for many activities

⚫ Expansion can be achieved by taking

over other businesses. Finance is then
needed to buy out the owners of the
other firm.

Multiple Choice

Which of the following would be the most appropriate source of finance for a new business (which is just launching) that makes mobile phone accessories?

• Retained Profit

• Sale of Assets

• Share Capital

• Friends and family

Finance is required
for many activities

⚫ Special situations will often lead to a

need for greater finance. A decline in
sales, possibly as a result of economic
recession, could lead to cash needs to
keep the business stable; or a large
customer could fail to pay for goods, and
finance is quickly needed to pay for
essential expenses.

Finance is required
for many activities

⚫ Apart from purchasing fixed assets,

finance is often used to pay for research
and development into new products or to
invest in new marketing strategies, such
as opening up overseas markets.

Finance is required
for many activities

⚫ Note:

• Some of these situations will need investment in

the business for many years. Others will need only
short-term funding (for around one year or less).

• Some finance requirements of the business are for

between one and five years (medium term
financed).

• All of the situations will need different types of

finance. No one source or type of finance is likely
to be suitable in all cases.

Key Terms

⚫ Start-up capital – capital needed by an

entrepreneur to set up a business

⚫ Working capital – the capital needed to

pay for raw materials, day-to-day running
costs and credit offered to customers. In
accounting terms:
• working capital = current assets – current

liabilities

Working Capital (Balance Sheet)

Capital and Revenue
Expenditures

⚫ Capital Expenditure – is the finance

spent on purchasing fixed assets that
are expected to last for more than one
year, such as land, buildings, equipment
and machinery.

⚫ Revenue Expenditure – is spending on

all costs and assets other than fixed
assets and includes wages, raw
materials, rent and electricity.

Use examples to distinguish

between revenue expenditure and

capital expenditure.

• Revenue expenditure is spending on the daily running

of a business, such as wages and materials used in
the preparation for the 2012 Olympic Games.

• Capital expenditure, on the other hand, refers to

the finance spent on purchasing fixed assets, such
as the land, buildings and machinery used in
preparation of the Olympic Games in London.

Examine the benefits to various

stakeholders of the Olympic
Games being held in London.

• Pre-Olympic Games, firms in the construction and

transport industries will be involved in the
infrastructure needed to host the Olympic
Games, e.g. building an Olympic stadium.

• Huge opportunities exist for job creation and

human resource planning. The development and
preparation of the Olympic Games will create jobs
and wealth in the local community, London and the
UK, thereby providing further potential benefits
to UK businesses.

Examine the benefits to various

stakeholders of the Olympic
Games being held in London.

• The Olympic Games will attract a huge volume of

foreign visitors and tourists to London and the
UK, thereby providing many opportunities, e.g.
airlines and hotels will tend to benefit from the
influx of tourists in London.

• Homeowners near the Olympic Village are likely to

benefit from higher property prices due to the
necessary improvements in transportation links
(Transport for London) and infrastructure in the
area.

Examine the benefits to various

stakeholders of the Olympic
Games being held in London.

• The government benefits from increased tax

revenue, e.g. higher expenditure taxes from
spending in the economy and higher corporate tax
revenues from the boost in profits of London and
UK-based businesses.

• There are huge marketing opportunities for

British multinationals, including advertising
agencies and sponsorship deals. Broadcasters and
corporate sponsors also enjoy the global
attractiveness of the Olympic Games.

Sources of Finance

Internal Sources

of Finance

Funds that come from within the

business, such as profits that have been

retained for business use or from the
sale of goods and services that earn

money for the business.

Personal Funds

⚫ Main source of finance for sole traders

and partnerships
• Sole traders – a business in which one person

provides the permanent finance and in return
has full control of the business and is able to
keep all the profits

• Partnerships – a business formed by 2 or

more people to carry on a business together,
with shared capital investment and usually
shared responsibilities

Profits retained in the business

⚫ If a company is trading profitably, some

of these profits will be taken in tax by the
gov’t (corporate tax) and some is nearly
always paid out to the owners or
shareholders (dividends). If any of the
profit remains, it is kept in the business
and this retained profit becomes a
source of finance for future activities.

Sale of Assets

⚫ Businesses could sell assets that are no

longer fully employed to raise cash.

⚫ Some businesses will sell assets that

they still intend to use, but which they do
not need to own. Assets might be sold to
a leasing specialist and leased back by
the company. This will raise capital but
there will be an additional fixed cost in
the leasing and rental payment.

Evaluation: Advantages

⚫ No direct cost to the business although

there may be opportunity cost

⚫ Does not increase liabilities or debts

⚫ There’s no risk of loss of control by the

original owners as no shares are sold

Evaluation: Disadvantages

⚫ Is not available for all companies

⚫ Can slow down business growth as the

pace of development will be limited by
the annual profits or the value of the
assets to be sold

EXAM TIP!

Do not assume that a

profitable

business is cash rich

–

and that it

can use all of its

profits

as a source

of

finance

for future projects. In

practice,

profits

are often ‘tied up’ in

money owed to the business by

debtors or have been used to

finance

increased stocks or replace

equipment.

EXAM TIP!

Do not

make the mistake of

suggesting that selling shares is a

form of internal finance for

companies. Although the

shareholders own the business, the

company is a separate legal unit,

and therefore, the shareholders are

‘outside’ it.

External Sources of

Finance

Long-term Financing:

To purchase fixed assets that will be
used for many years, or to fund a take-
over.

Issue New Shares
(Share Capital)

Available to limited companies (PLC’s and

LTD’s).

⚫ Advantages:

• A permanent source of finance that does not

have to be repaid.

• No interest is charged.
• Large sums can be raised.

Issue New Shares

⚫ Disadvantages:

• Shareholders will expect dividends to be paid.
• Original owners may lose control of the company if

new shareholders are created (exception – a Rights
Issue allows existing shareholders in plc’s to maintain
their % shareholding).

• Can be expensive to organize (fees paid to advisors

etc).

• May take some time to arrange.
• Dividends paid after tax, so less money available to

shareholders.

Long-term Bank Loan
(Loan Capital)

A loan for 10 years or more.
Example: Mortgages and Business Dev. Loans

⚫ Advantages:

• Quick to arrange (money immediately

available).

• Flexibility over repayment term (eg 10 years-

25 years).

• Discount rates often available if large sums

borrowed.

• Interest is paid before the profits are taxed.

Long-term Bank Loan
(Loan Capital)

⚫ Disadvantages:

• Loans must be repaid.
• Interest is charged and must be paid, even if

the firm makes a loss.

• Interest rates may be variable which adds

risk.

• Collateral or security is often required.

Debentures (long-term loan
certificates)

⚫ Debentures are a type of long-term loan

with the promise of fixed annual interest
payments to the debenture holders and
are repayable on maturity.

Debentures (long-term loan
certificates)

⚫ Advantages:

• Debenture holders can re-sell the debenture

(increased liquidity is an attraction for
investors).

• Interest rate is fixed. This reduces risk for the

business.

• Enables very long-term financing (eg. 25

years).

Debentures (long-term loan
certificates)

⚫ Disadvantages:

• Must be repaid in full on the maturity date.
• A fixed rate of interest is charged throughout

the loan period.

Exam Tip!

◼

Students often write that a fall in a

company’s share price affects its

level of profits as the firm has less

money. It is more likely to be the

other way around; the poor

performance of a company will lead

to a fall in its value so its share price

declines.

◼

When share holders sell their

shares, the company does not

receive any of this money as these

shares are traded on the secondary

market of the stock exchange; no

new shares have been issued by the

company.

Define the term initial public

offering (IPO).

• An initial public offering (IPO) occurs when a

company floats its shares on a stock exchange for
the very first time. For example, ABC floated its
shares in both Shanghai and Hong Kong. In doing
so, ABC became a public limited company.

Comment on why ABC might have
decided to float its shares on the

stock market.

• The main benefit of issuing shares in a company is the

potential to raise a huge amount of share capital. In
the case of ABC, it was able to raise $22.1 billion,
significantly improving its cash flow and sources of
finance.

• The extra source of finance would allow ABC to

compete against more established global banks such as
Citibank, HSBC, Bank of China and ICBC, especially as
it would be able to expand its operations within and

beyond China.

Comment on why ABC might have
decided to float its shares on the

stock market.

• Expansion (funded by the IPO) allows ABC to have a

greater market presence, thereby enhancing its
corporate image.

• In addition, ‘going public’ allows a business to have the

protection of limited liability.

Explain why investors might have been
so keen to buy shares in ABC, despite
the weak market sentiment in Asian

stock markets at the time.

• Investors in the stock market tend to buy for the

medium to long term. Given that ABC is China’s third
biggest lender, with more than 325 million customers,
this may have provided sufficient reason (i.e. a sense
of security) for investors to pour money into the
company.

External Sources of

Finance

Medium-term Financing:

To purchase fixed assets that will be
used for 2 - 5 years (eg. equipment &
vehicles).

Medium-term Bank Loan

⚫ Advantages:

• Quick to arrange (money immediately

available).

• Flexibility over repayment term (eg 2 - 5

years).

• Discount rates often available if large sums

borrowed.

• Interest is paid before the profits are taxed.

Medium-term Bank Loan

⚫ Disadvantages:

• Loans must be repaid.
• Interest is charged and must be paid, even if

the firm makes a loss.

• Interest rates may be variable which adds

risk.

• Collateral or security may be required

(especially for smaller and higher risk
businesses).

Hire Purchase

The business pays monthly installments to a finance company.

When the final installment is paid the asset becomes the
business’.

⚫ Advantages

• Enables businesses to buy assets when they have

little cash available, or when they do not want to
commit large amounts of cash to acquire assets.

• No collateral required (the asset being purchased is

the collateral).

• Useful for businesses that have limited finance

options.

Hire Purchase

⚫ Disadvantages

• A large cash deposit may be required.
• Interest rates are generally higher than for

bank loans.

• Failure to make a payment may result in the

asset being taken back by the HP company.

Leasing
Businesses sign a contract with a leasing firm. They

effectively rent the assets they need from that firm
for an agreed period of time.

⚫ Advantages:

• Firms can make use of assets without the need for large

sums of money.

• Frees money to be used elsewhere in the business (helps

cash flows).
• Gives the firm flexibility. It can lease assets only when it

needs to use them (reduces costs).
• The care and maintenance of the asset is the responsibility

of the leasing company.
• Assets are kept up to date (ideal for computers and other

equipment that become obsolete quickly).

Leasing

⚫ Disadvantages:

• In the long run, total costs will be higher than

buying the asset outright.

• Businesses are committed to lease the asset

for the length of the lease agreement.

Sell and Lease-back

Businesses raise money by selling assets

that they need, then lease them back.

⚫ Advantages:

• Frees money tied up in assets for use by the

business.

• The business is still able to make use of the

assets in return for monthly payments to the
leasing company.

Sell and Lease-back

⚫ Disadvantages:

• The firm will have fewer assets to provide as

collateral for loans in the future.

• Day to day costs will be higher as there will be

an extra monthly payment for using the asset.

• The firm will be committed to lease the asset

for the length of the lease agreement.

External Sources of

Finance

Short-term Financing:

Provides the working capital needed for
the day-to-day expenses of the
business.
Covers the period from a few days to
12 months.

Bank Overdraft

The bank allows the current account of the

business to become ‘overdrawn’. This means
that it will have a negative balance. A facility to
become overdrawn should be arranged with
the bank before the money is required.

⚫ Advantages:

• The most flexible form of financing as the amount of

money needed can change day-to-day.

• Interest is only payable on the amount overdrawn.
• Can be cheaper than a loan if overdrawn period is

kept short.

Bank Overdraft

⚫ Disadvantages:

• Interest rates are generally higher than for a

loan.

• A fee is often charged for having the facility.
• Not generally available for a long period of time.
• The bank can ask for repayment at any time

which could cause the business to be made
bankrupt.

• There will be an upper limit to the facility. The

firm cannot be overdrawn more than this.

Trade Credit

When a business delays paying its

suppliers for an agreed period of time
(usually 30 or 60 days).

⚫ Advantage:

• Is like the business receiving an interest-free

loan for a month or two.

• Allows the business to sell goods before

paying for them.

Trade Credit

⚫ Disadvantages:

• Suppliers may refuse to send more supplies if

payments are left too long.

• The firm cannot usually obtain a discount for

paying the supplier quickly.

• Is generally limited to a period no longer than

60 days.

Debt Factoring

Debt Factors buy the debts of firms for

cash.

⚫ Advantages:

• The business receives most of the money

owed to it (around 80-85%) immediately.

• Helps businesses that give their customers

long trade credit periods.

• The risk of non-payment is taken on by the

Factor.

Debt Factoring

⚫ Disadvantage:

• The firm only receives a % of the money

owed to it (around 80-85%).

External Sources of

Finance

Grants & Subsidies

Grants

Money usually given by the government to

assist firms with important expenditures.
Advantages:
• Enables businesses to fund important projects

like training, or the purchase of new
equipment / technology.

• Encourages businesses to adopt new

methods / technologies eg. alternative energy
generators.

Grants

⚫ Disadvantages:

• There are often ‘strings’ attached, eg firms

must locate in a certain area, create a certain
number of jobs, or purchase a specific item.

Subsidies

Payments made by governments in order

to keep businesses operational.

⚫ Advantages:

• Money does not have to be returned.
• No interest is charged.

⚫ Disadvantage:

• Only available to businesses in certain

industries.

Venture Capital

vs.

Business Angels

Sources of Finance

Venture Capital (VC)

⚫ Is a high-risk capital invested by venture

capital firms, usually at the start of a
business idea. The finance is usually in
the form of loans and/or shares in the
business venture.

⚫ Venture capitalists seek to invest in

small to medium-sized businesses that
have high growth potential.

Business Angels (BA)

⚫ Are wealthy entrepreneurs who risk their

own money by investing in small to
medium-sized businesses that have high
growth potential.

⚫ They take proactive role in the setting up

or running of the business venture –
owner loses some control to the BA

⚫ By contrast, venture capital is typically a

pool of professionally managed funds.

Criteria for VC and BA

⚫ Return on investment – business has to

have good potential to be highly profitable.

⚫ The business plan – should outline the LT

aim and purpose of the business venture.

⚫ People – must have good team of people.

⚫ Track record – Investors will assess the past

track record of the business and its
management before investing any capital.

Describe why the members of

the Phoenix Four might be
classed as business angels.

• Business angels are private individuals who

invest their own money in business ventures
that offer potentially high returns. The
Phoenix Four ‘rescued’ MG Rover by putting in
60,000 GBP each after having bought the
company from previous owners BMW with the
expectation that MG Rover would reap them a

reward.

Explain the dangers outlined in the

article concerning the use of

business angels.

• Lack of experience in the field, i.e. the Phoenix Four

were not familiar with the motor manufacturing
industry. This can lead to gross mismanagement of the
organization.

• Conflict of interest – it is stated that the Phoenix Four

gave themselves ‘extravagant financial rewards’.

• As business angels, the Phoenix Four may not have had

their hearts truly in the business. Business angels tend
not to make follow-on or continual investments in the

same firm.

Analyze how the profitability of a

business, such as MG Rover, affects its

ability to raise external sources of

finance.

• External sources of finance are those that are

obtained from outside the organization, e.g.
overdrafts, bank loans and debentures. The
profitability of a business is likely to have a huge
impact on its ability to raise external finance because:

➢ banks and other creditors tend not to lend to high-risk

customers with a low credit rating, i.e. those that are
unlikely to be able to repay their debts

Analyze how the profitability of a

business, such as MG Rover, affects its

ability to raise external sources of

finance.

➢ debt factoring service providers are unlikely to take on

clients with poor credit ratings

➢ by contrast, firms with high profitability have

collateral (security) to offer to lenders in case they
default on their loans

➢ trade creditors are more likely to grant preferential

credit terms to clients with a good record of
profitability

Analyze how the profitability of a

business, such as MG Rover, affects its

ability to raise external sources of

finance.

➢ shareholders tend not to hold onto shares of companies

that have low profitability, and this indirectly affects
the firm’s ability to raise finance through external
methods

➢ highly profitable firms can also enjoy financial

economies of scale, i.e. borrowing more and at a
relatively lower rate of interest

Managers consider a number of

interlinked factors when

examining the strategic choice
between alternative sources of

finance

Size and status of firm

⚫ A well-known and large MNC will find it

much easier to raise finance from a
wider range of sources than a sole
trader.

⚫ Large organizations are also able to

obtain cheap finance due to financial
economies of scale.

Timeframe

⚫ If finance is needed for a long period of

time, then long-term loans such as
mortgages or debentures are suitable.

⚫ If finance is needed to help fund working

capital, then short-term sources such as
trade credit and overdrafts are more
appropriate.

Amount required

⚫ Large amounts of finance might be

raised through IPO or through secured
long-term loan from banks.

⚫ If only a small amount is needed then

retained profit or an overdraft might be
sufficient.

Gearing

⚫ Lenders assess a firm’s existing gearing

(LT external borrowing of a firm as a %
of its capital employed) before approving
any finance.

⚫ Firms with high gearing are relatively

high risk as they have existing debt
commitments and more vulnerable to
any increase in interest rates.

External factors

⚫ Factors beyond the control of a business

can have a huge impact on the strategic
choice of finance.

⚫ Businesses will be affected by the state

of the economy and consumer
confidence levels.

Purpose of finance

⚫ The choice of finance depends on

whether it is intended for the daily
running of the business (ST purposes) or
for the replacement of fixed assets over
a longer time period.

Cost of finance

⚫ Managers need to consider the purchase

cost of assets and the associated costs,
such as administrative fees and
maintenance charges.

⚫ Higher costs tend to require longer term

sources of finance.

Key Terms

Business & Management

Business angels

• Are wealthy entrepreneurs who risk

their own money by investing in small
to medium-sized businesses that
have high growth potential.

Capital expenditure

• Is investment spending on fixed

assets such as the purchase of land
and buildings.

Debt Factoring

• Is a finance service whereby a factor

(such as a bank) collects debts on
behalf of other businesses, in return
for a fee.

External sources of

finance

• Means getting funds from outside

the organization, e.g. through debt
(overdrafts, loans and debentures),
share capital, or the government.

Grants

• Are government financial gifts to

support business activities. They are
not expected to be repaid by the
recipient.

Initial Public Offering

(IPO)

• Refers to a business converting its

legal status to a public limited
company by floating (selling) its
shares on a stock exchange for the
first time.

Internal sources of

finance

• Means getting funds from within the

organization, e.g. through personal
funds, retained profits and the sale
of assets.

Leasing

• Is a form of hiring whereby a

contract is agreed between the
lessor and the lessee.

Loan capital

• Refers to medium to long-term

sources of interest bearing finance
obtained from commercial lenders.
Examples include mortgages, business
development loans and debentures.

Overdrafts

• Allow a business to spend in excess

of the amount of its bank account, up
to a predetermined limit. They are
the most flexible form of borrowing
in the short term.

Retained profit

• Is the value of surplus that the

business keeps to use within the
business after paying corporate
taxes on its profits to the
government and dividends to its
shareholders.

Revenue Expenditure

• Refers to spending on the day-to-day

running of a business, such as rent,
wages and utility bills.

Sale-and-leaseback

• Is a source of external finance

involving a business selling a fixed
asset (such as its computer systems
or a building) but immediately leasing
the asset back. In essence, the
lessee transfers ownership to the
lessor but the asset does not

physically leave the business.

Share Capital

• Is the money raised from selling

shares in a limited liability company,
from its IPO and any subsequent
share issues.

Share Issue

(share placement)

• Exists when an existing public limited

company raises further finance by
selling more of its shares.

Sources of Finance

• Is the general term used to refer to

where or how businesses obtain their
funds, such as from personal funds,
retained profits, loans and
government grants.

Subsidies

• Are funded by the government to

lower a firm’s production costs as
output provides extended benefits to
society, e.g. farmers are often
provided with subsidies to stabilize
food prices.

Trade Credit

• Allows a business to ‘buy now and pay

later’. The credit provider does not
receive any cash from the buyer until
a later date (usually allow between
30-60 days),

Venture Capital

• Is high-risk capital invested by

venture capital firms, usually at the
start of a business idea. The finance
is usually in the form of loans and/or
shares in the business venture.