Sources of Finance

SOURCES OF FINANCE
Internal finance is obtained from within the business itself.
Retained Profit: profit kept in the business after owners have been
given their share of the profit. Firms can invest this profit back in the
businesses.
Advantages:
– Does not have to be repaid, unlike, a loan.
– No interest has to be paid
Disadvantages:
– A new business will not have retained profit
– Profits may be too low to finance
– Keeping more profits to be used as capital will reduce owner’s share of
profit and they may resist the decision.
Sale of existing assets: assets that the business doesn’t need anymore,
for example, unused buildings or spare equipment can be sold to raise
finance
Advantages:
– Makes better use of capital tied up in the business
– Does not become debt for the business, unlike a loan.
Disadvantages:
– Surplus assets will not be available with new businesses
– Takes time to sell the asset and the expected amount may not be
gained for the asset
Sale of inventories: sell of finished goods or unwanted components in

inventory.
Advantage:
– Reduces costs of inventory holding
Disadvantage:
– If not enough inventory is kept, unexpected increase demand form
customers cannot be fulfilled
Owner’s savings: For a sole trader and partnership, since they’re
unincorporated (owners and business is not separate), any finance the
owner directly invests from his own saving will be internal finance.
Advantages:
– Will be available to the firm quickly
– No interest has to be paid.
Disadvantages:
– Increases the risk taken by the owners.
External finance is obtained from sources outside of the business.
Issue of share: only for limited companies.
Advantage:
- A permanent source of capital, no need to repay the money to
shareholders
- no interest has to be paid
Disadvantages:
- Dividends have to be paid to the shareholders
- If many shares are bought, the ownership of the business will
change hands.
- The ownership is decided by who has the highest percentage of
shares in the company
Bank loans: money borrowed from banks
Advantages:
Quick to arrange a loan
Can be for varying lengths of time
Large companies can get very low rates of interest on their loans
Disadvantages:
- Need to pay interest on the loan periodically
- It has to be repaid after a specified length of time
- Need to give the bank a collateral security (the bank will ask for
some valued asset, usually some part of the business, as a security
they can use if at all the business cannot repay the loan in the
future. For a sole trader, his house might be collateral. So there is a
risk of losing highly valuable assets)
Debenture issues: debentures are long-term loan certificates issued by
companies. Like shares, debentures will be issued, people will buy them
and the business can raise money. But this finance acts as a loan- it will
have to be repaid after a specified period of time and interest will have to
be paid for it as well.
Advantage:
Can be used to raise very long-term finance, for example, 25 years
Disadvantage:
Interest has to be paid and it has to be repaid
Debt factoring: a debtor is a person who owns the business money for
the goods they have bought from the business. Debt factors are
specialist agents that can collect all the business’ debts from debtors.
Advantages:
Immediate cash is available to the business
Business doesn’t have to handle the debt collecting
Disadvantage:
The debt factor will get a percent of the debts collected as reward. Thus,
the business doesn’t get all of their debts
Grants and subsidies: government agencies and other external sources
can give the business a grant or subsidy
Advantage:
Do not have to be repaid, is free
Disadvantage:
There are usually certain conditions to fulfil to get a grant. Example, to
locate in a particular under-developed area.
Micro-finance: special institutes are set up in poorly-developed countries
where financially-lacking people looking to start or expand small
businesses can get small sums of money. They provide all sorts of
financial services
Crowdfunding: raises capital by asking small funds from a large pool of
people, e.g. via Kickstarter. These funds are voluntary ‘donations’ and
don’t have to be return or paid a dividend.
Short-term finance provides the working capital a business needs for its
day-to-day operations.
Overdrafts: similar to loans, the bank can arrange overdrafts by allowing
businesses to spend more than what is in their bank account. The
overdraft will vary with each month, based on how much extra money the
business needs.
Advantages:
Flexible form of borrowing since overdrawn amounts can be varied each
month
Interest has to be paid only on the amount overdrawn
Overdrafts are generally cheaper than loans in the long-term
Disadvantages:
Interest rates can vary periodically, unlike loans which have a fixed
interest rate.
The bank can ask for the overdraft to be repaid at a short-notice.
Trade Credits: this is when a business delays paying suppliers for some
time, improving their cash position
Advantage:
No interests, repayments involved
Disadvantage:
If the payments are not made quickly, suppliers may refuse to give
discounts in the future or refuse to supply at all
Debt Factoring: (see above)
Long-term finance is the finance that is available for more than a year.
Loans: from banks or private individuals.
Debentures
Issue of Shares
Hire Purchase: allows the business to buy a fixed asset and pay for it in
monthly instalments that include interest charges. This is not a method to
raise capital but gives the business time to raise the capital.
Advantage:
The firm does not need a large sum of cash to acquire the asset
Disadvantage:
- A cash deposit has to be paid in the beginning
- Can carry large interest charges.
Leasing: this allows a business to use an asset without purchasing it.
Monthly leasing payments are instead made to the owner of the asset.
The business can decide to buy the asset at the end of the leasing period.
Some firms sell their assets for cash and then lease them back from a
leasing company. This is called sale and leaseback.
Advantages:
- The firm doesn’t need a large sum of money to use the asset
- The care and maintenance of the asset is done by the leasing
company
Disadvantage:
The total costs of leasing the asset could finally end up being more than
the cost of purchasing the asset!
Factors that affect choice of source of finance
Purpose: if a fixed asset is to be bought, hire purchase or leasing will be

appropriate, but if finance is needed to pay off rents and wages, debt
factoring, overdrafts will be used.
Time-period: for long-term uses of finance, loans, debenture and share
issues are used, but for a short period, overdrafts are more suitable.
Amount needed: for large amounts, loans and share issues can be used.
For smaller amounts, overdrafts, sale of assets, debt factoring will be
used.
Legal form and size: only a limited company can issue shares and
debentures. Small firms have limited sourced of finances available to
choose from
Control: if limited companies issue too many shares, the current owners
may lose control of the business. They need to decide whether they would
risk losing control for business expansion.
Risk- gearing: if business has existing loans, borrowing more capital can
increase gearing- risk of the business- as high interests have to be paid
even when there is no profit, loans and debentures need to be repaid etc.
Banks and shareholders will be reluctant to invest in risky businesses.
Finance from banks and shareholders
Chances of a bank willing to lend a business finance is higher when:

A cash flow forecast is presented detailing why finance is needed and how
it will be used.
An income statement from the last trading year and the forecast income
statement for the next year, to see how much profit the business makes
and will make.
Details of existing loans and sources of finance being used
Evidence that a security/collateral is available with the business to reduce
the bank’s risk of lending
A business plan is presented to explain clearly what the business hopes
to achieve in the future and why finance is important to these plans
Chances of a shareholder willing to invest in a business is higher
when:
the company’s share prices are increasing- this is a good indicator of

improving performance
dividends and profits are high
the company has a good reputations and future growth plans

Sources of Finance

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SOURCES OF FINANCE

Internal finance is obtained from within the business itself.

Sale of inventories: sell of finished goods or unwanted components in

Factors that affect choice of source of finance

Purpose: if a fixed asset is to be bought, hire purchase or leasing will be

Chances of a bank willing to lend a business finance is higher when:

the company’s share prices are increasing- this is a good indicator of

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