5.2 SOURCES OF FINANCE

• where does finance come from?

  • internal financing - money raise from inside the business
  • example: (1)retained profit - money raise from business asset or from profits left in the business

  (2) sale of unwanted asset

  (3) sale and leaseback of fixed asset

  (4) reduction in working capital
• retained profits

  • companies profit after deducted the pay out of dividends to the shareholders
  • often 1/3 pay dividends
  • 2/3 are retained asset purchases & investment
• reduction in working capital

  • manage by controlling following components of capital cycle: -

  1. debtors
  2. creditors
  3. stock
  4. cash
• internal & external finance

  • internal - money raise from inside the business
  • external- money raised from outside the business
• share issues

  • public issue - shares sold by company direct to business investors and general public
  • right issue - offer to existing shareholder to buy additional shares
  • issues by tender
  • placing - most or all new share sold direct to institutional investors
  • bonus issue
• debentures

  • more secure than stock, not secure as a bond
  • in case of bankruptcy, you have no collateral thus you can claim from the company
  • to compensate, company pay higher interest rate to debenture holders
• bond

  • debentures and bonds are similar except for one difference
  • bonds more secure, carry lower interest rate
  • company provide collateral for loan, in case of liquidation, bond holder will be paid off before debentures holder
• venture capital

  • specialist group provide capital
  • a risk capital usually in a form of a package of loan & share capital to provide a significant investment in a small or medium size business
  • take ownership of firm, build it up then sell it on at a profit in a few years
  • company MUST have annual capital growth of 35%
  • investors expect to have a high internal rate of return
• what is include in medium term finance

  • sales and leaseback
  • hire purchase
  • medium term loan
• lease purchase

  • similar to hire purchase but does not involve payment of deposit
  • leasing involves acquisition of an asset, but ownership does not pass to the user
  • a lease is a means of financing the use of an asset rather than its purchase
• advantages of leasing

  • minimizes initial outlay
  • maintenance is provided with package
  • equipment can be updated to avoid obsolescence
  • use can claim tax relied against lease payment
  • “pay as u use”
• disadvantage of leasing

  • all payments are outgoing
  • payment is greater in long run
  • lease might place limitations on use or compel the use of specified complementary goods
  • user does not benefit from residual value when equipment is upgraded
• hire purchase

  • method of paying assets by installment
  • financier remains as the legal owner of the asset until the hirer exercises his or her option to purchase at the end of the repayment period
• what is include in short term loans

  • bank overdraft
  • trade credit
  • debt factoring
  • short term bank loan
• Overdraft

  • when someone is able to spend more than what is actually in their bank account, obviously the money doesn’t belong to them but belongs to the bank
• advantage of overdraft

  • flexibility- can change amount borrowed within limits
  • interest is paid on amounts borrowed
• disadvantage of overdraft

  • cannot be used for large borrowing
  • rates of interest higher than loans
  • bank can change limit at any time or ask for money to be paid back sooner than expected
• advantages of loan

  • larger amounts can be borrowed
  • lower interest rates than overdrafts
  • regular repayments helps plan cash flow
• disadvantage of loan

  • less flexible than an overdraft
  • have to pay back in stated time or risk further financial problem
• trade credit

  • credit extended to you by suppliers who let you buy now and pay later
  • anytime you take delivery of materials, equipment or other valuables without paying cash on the spot, you’re using trade credit
• debt factor

  • business experiencing problems as a result of their own customers delaying payment may use debt factor.
  • this is to purchase debts at a discount. even though business seeking repayment does not receive all the money owned to it, there are advantages in early receipt of the money
• mortgages


  charging of real or personal property by a debtor to a creditor as security for a debt, on the condition that it shall be returned on payment of the debt within a certain period
• micro-finance

  • type of banking service that is provided to unemployed or low income individual or groups who have no access to financial services
  • type of financial service for people don’t have enough capital to start up a business
  • goal of micro finance is to give impoverished people an opportunity to become self sufficient
• crowd funding

  • use of small amounts of capital from a large number of individuals to finance a new business venture
  • easy accessibility of vast networks of people through social media and crowdfunding websites to bring investors and entrepreneur together
  • has potential to increase entrepreneurship by expanding pool of investors from whom funds can be raised beyond the traditional circle of owners, relatives and venture capitalists
• government grants

  • financial award given by federal ,state, local government authority for a beneficial project
  • grantee is not expected to repay the money but is expected to use the funds from the grant for their stated purpose, which typically serves some larger good
• factors affecting choice of finance

  • Availability of different sources of finance
  • Relative costs of different methods
  • Consequences for control of the business
  • The implications for shareholders’ dividends
  • The risk element involved: risky ventures should be financed by equity capital
  • Terms & repayment period for loans