topic 28 sources of finance

• Business finance - sources:

  • time required - short/medium/long
  • internal or external finance
  • type of firm - sole trader, partnership, ltd, plc or small/medium/large
• Short term finance:

  • less than a year
  • eg. trade credit, overdrafts, working capital
• Medium term finance:

  • 1-5 years
  • eg. loans or debentures
• Long term finance:

  • 5+ years
  • eg. capital, share capital, mortgage, loans, debentures
• Internal finance vs external finance:

  • all other things being equal - internal sources are preferred because they do not incur the costs of interests or dividends , they also allow firms more freedom/less interference from outsiders, however against this must be weighed the availability of internal finance and the opportunity cost of using internal sources of finance
  • internal sources: capital, profit, retained earnings, working capital and sale of assets
  • external sources: ordinary share capital, loans, debentures, overdrafts and trade credit
• Types of organisation - legal entity and/or size:

  • businesses can raise finance for their activities in a number of different ways
  • this, to an extent, depends on the size and type of business
  • generally, the bigger a company, the easier and cheaper it will be to raise finance and vice versa
• For the company: ordinary shares:

  • advantages: no interest or fixed dividend, dividend varies with profit, low gearing/reduces gearing if new issue and permanent capital - no need to repay
  • disadvantages: voting rights, pressure for higher dividends if higher profits or inflation, risk of takeover if plc, restricted to family and friends if private company and permanent finance which must be serviced
• For the company: debentures:

  • advantages: fixed interest regardless of the level of profit, interest will be less in real terms in the future due to inflation, no voting rights - don't dilute ownership, interest qualifies for tax relief and it's eventually repaid - no longer a liability
  • disadvantages: interest must be paid even when profits are low, increases gearing, secured on company assets - risk of liquidation if loan is not serviced and it must be repaid within a given time period
• For a private investor: ordinary shares:

  • advantages: voting rights, high dividend potential if there are high profits and potential for large capital gains on sale
  • disadvantages: low/zero dividends if profits are low, price fluctuates on stock market - potential for capital losses and sale of shares are restricted if it's a private limited company
• For a private investor: debentures:

  • advantages: interest must be paid, secured on company assets, price less volatile on stock market and it's less risky than shares - a safer investment than ordinary shares
  • disadvantages: interest stays the same even if company makes high profits, less scope for capital gains and loans not shares
• Liquidity:

  • the issue of shares, obtaining a bank loan or the issue of debentures provides an immediate injection of cash/liquidity
  • these are inflows in the financing section of the statement of cash flows
  • if the company pay an equity/ordinary dividend, the annual dividend is an outflow in the financing section of the statement of cash flows
  • with debentures the annual interest is an outflow in operating activities
  • the redemption of debentures at the maturity date is an outflow in the financing section
• Profitability:

  • the finance raised from issuing shares, debentures or obtaining loans or the repayment of loans has no effect on profit
  • the annual interest on loans and debentures is a finance cost in the IS subtracted from profit from operations
  • the annual dividend on ordinary shares has no effect on profit and does not go in the IS, but does reduce retained earnings in the SOCIE