Introduction to Finance/Source of Finance

■ Recognise the difference between capital and revenue

expenditure and the different needs for finance these create
understand why business activity requires finance.

■ Understand the importance of working capital to a business and

how this can be managed.

■ Analyse the different sources of long-, medium- and short-term

finance, both internal and external understand why business
activity requires finance.

■ Analyse the different sources of long-, medium- and short-term

finance, both internal and external
When does a business need finance?
What is finance?
Money used to purchase things the business needs or
want.
What is a source of finance?
It is a method of getting hold of the money you need.
Most of the time you have to pay it back and it can be
expensive.
When might a business need finance?

1. When it is
starting – up.

2. When it needs 3. When it wants to

to buy equipment expand the
or premises. business.
 Cash and Profit

Sanjit is concerned about competition for his jewellery

shop. He buys most of his stock over the internet for cash
but has decided to increase the credit terms he gives to his
customers to two months.
This month he bought some rings for $3 000 and paid in
cash. He sold them all during the month for $7000 but will
not receive payment for another two months.
 Working Capital

Working capital is the finance needed by all businesses to pay for

everyday expenses, such as wages and buying inventory.
In 2018, Alphabet reported that Google’s
capital expenditures, which include the
costs of data centers and other facilities,
more than doubled in 2018, which was
the fastest expansion in at least four
years. CapEx was just over $25 billion.
According to CSI Market, the company's
average capital expenditure ratio is
49.5%.

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Amazon.com's 12-month capital expenditures for
2019 were almost $32 billion.8 But Amazon
reached a CapEx of over $54 billion by 2020,
with people stuck at home and shopping online
en masse amidst the U.S. lockdowns and
restrictions.3 According to the media outlet The
Information, "Amazon has ratcheted up spending
on CapEx this year so fast that it now outspends
all other big tech firms, including the previous
CapEx leader, Alphabet.
Capital Transaction

Capital expenditure is made when a firm

spends money either to:

 Buy fixed assets

 For making improvement and extension to
the fixed assets e.g addition to Building,
Tools, Computers, Vehicles, Machinery.
 Legal costs of buying building
Examples of Capital Expenditure
 Purchase of furniture, motor vehicles,
electric motors, office equipment, loose
tools, building, computers and other
tangible assets.
 Cost of acquiring intangible assets like
goodwill, patents, copy rights, trade
marks, patterns and designs etc.
 Addition or extension of assets. Money
spent on installation and erection of plant
and machinery and other fixed assets.
Examples of Capital Expenditure

 Wages paid for the construction of

building.
 Structural improvements or alterations in
fixed assets resulting in an increase in
their useful life or profit earning capacity.
 Cost of issue of shares and debentures
(certain expenditures are incurred by the
companies when share and debentures
are issued).
Tesla’s capital expenditure 2008 – 2017 (USD
billion):
Revenue Expenditure

Expenditure which is not for increasing

the value of fixed assets, but for
running the business on a day to day
basis, is known as revenue
expenditure. It is for shorter period of
time and the benefit of this expenditure
is for one or less than one year.
Revenue Expenditure
Revenue expenditure refers to business spending on its everyday
and regular operations. These expenses have to be paid in order to
keep the business operational, including routine expenditure on
maintaining the firm's fixed assets. Examples include expenditure
on:

• Stocks of raw materials, components (semi-finished goods) and

finished goods which as ready for sale, paid to suppliers
• Delivery costs
• Utility bills (e.g. gas, electricity, water and telephone bills)
• Wages and salaries to employees
• Rental payments for the premises
• Monthly repayments on bank loans and mortgages
• Insurance premiums (for example, insurance cover for
buildings, employee safety and vehicles).
Example of Revenue Expenditures

1) Wages paid to factory workers.

2) Repair and maintenance expenses
incurred on fixed assets.
3) Freight, cartage, octroi duty,
transportation, insurance paid on
saleable goods.
14 of 20
Self Correction Problem

Classify which of the following is CAPEX or REVEX

 Carriage paid on purchase of machinery.

 Carriage paid on merchandises purchased.
 Old machinery was repaired at cost of Rs.500.
 Cost of extension a Banquet hall.
 Wages paid for installation of machinery.
SOLUTION

No Name of Items Reasons

1 Capital Expenditure This expenditure is considered as part of cost of

machinery, so it is called capital expenditure.

2 Revenue Expenditure This expenditure is done for proper working

condition of machinery.

3 Revenue Expenditure This expenditure is done for proper working

condition of motor car.
SOLUTION

4 Capital Expenditure Because from this expenditure increase the

capacity of hall, so this expenditure called
capital expenditure.

5 Capital Expenditure. This expenditure is considered as part of

cost of machinery, so it is called capital
expenditure.
Table 1 - Summary of the differences
between revenue and capital expenditure
REVENUE
CAPEX EXPENDITURE
• Long term tenure • Short term tenure
• Adds to value the firm's • Adds to value the firm's
capital assets capital assets
• Recurring (regular) • Recurring (regular)
expenditure expenditure
• Provides short term benefits • Provides short term benefits
• Expenditure reflected in profit • Expenditure reflected in profit
and loss account and loss account
• Does not improve operational • Does not improve operational
efficiency efficiency

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 How many source of
finance do you know?

Source
of Definition
finance
Sources of finance

Sources of finance are classed as being either internal or

external.

Internal sources:
finance from within
the business.

External sources:
finance from outside
the business.
Sources of Finance
Internal Sources of Finance

Internal finance saves a business from borrowing from a

lender and having to pay back interest.
1.Owners Funds/Capital
The owner of the business uses
their own personal savings
and invests in the business

Easy to access, no money to pay

back, no interest to pay
The person may lose all their
savings if the business fails.
Could you use this source of finance to
start your business?
Internal Sources of Finance

Internal finance saves a business from borrowing from a

lender and having to pay back interest.
2.Selling Assets
The owner decides to sell items
that they own and use the
money to invest in the business.

Money gained can be used to buy

a new asset. No money to pay
back, no interest to pay
The “sold” asset is lost
Could you use this source of finance to
start your business?
Sale and Leaseback of Assets
Internal Sources of Finance

Internal finance saves a business from borrowing from a

lender and having to pay back interest.
3.Using Profit (Retained Profit)
The owner decides to use the
profit they have made and
invest this profit back into the
firm.
No money to pay back, no interest
to pay
Owner cannot then have this
money for themselves

Could you use this source of finance to

start your business?
Retained Profit and Retention Ratio

The retention ratio is a fundamental

analysis ratio that measures how much
earnings are retained after dividends are
paid out.
Stakeholders – Retention Ratio

• Which Stakeholder prefers high retention

ratio and which one prefers low ratio?
 Dividend The dividend irrelevant theory - postulation
that the dividend policy of a firm does not
Irrelevant affect the net return of an investor
assuming that unpaid dividends are

Theory reinvested by the company to generate

more profits and higher stock returns
External Sources of Finance

External sources of finance come from outside a business

and are more difficult to arrange than internal sources.
1.Bank Loan/ Mortgage
Borrowing an amount of money from a bank and paying it
back in instalments. Interest is added to the loan.

Business can spread the cost of the repayments

Interest is added to the amount borrowed

External sources:
finance from outside
the business.
 • As no shares are sold, the
ownership of the company does
not change or is not ‘diluted’ by
the issue of additional shares.
■ Loans will be repaid eventually
so there is no permanent
increase in the
Advantages liabilities of the business.
of Debt ■ Lenders have no voting rights
Financing at the annual general meetings.
■ Interest charges are an
expense of the business and are
paid
out before corporation tax is
deducted, while dividends on
shares have to be paid from
profits after tax.
External Sources of Finance

External sources of finance come from outside a business

and are more difficult to arrange than internal sources.
4.IPO (Initial Public Offering)
Many businesses decide to *go public by floating their
shares on a stock exchange for the first time. This is
known as an initial public offering (IPO).

What are the Disadvantages of IPO?

External sources:
finance from outside
the business.
External Sources of Finance

External sources of finance come from outside a business

and are more difficult to arrange than internal sources.
4.Selling Shares
Persuading members of the public to invest in the
company by buying shares.
(You need to be a PLC or LTD to do this)
No money to pay back, no interest to pay
Ownership of the company is “shared” between more
people – danger of a possible takeover

External sources:
finance from outside
the business.
 Debt or Equity Financing?

The trade-off theory suggests the amount of debt

and equity financing that a company should
choose to balance their benefits and costs
(Alkhatib, 2012).

Under the framework of this theory, management

team in the firm should evaluate various optional
leverage strategies and consider debt tax
shields, agency cost and costs of bankruptcy
when they assess firm’s level of debt to value
 Pecking Order Theory

Pecking order theory presents the preference of

managers in corporate finance.

It plays an important role in debt ratio analysis

(Mazur, 2007).

Sheikh and Wang (2011) argue that there is no

optimal capital structure because managers give
priority to raising funds internally. If it is
necessary to gain cash by external ways, debt
funding is normally preferred by managers
compared to equity funding.
Example of the Pecking Order Theory

Suppose ABC Company is looking to raise $10 million for an investment project. The company’s
stock price is currently trading at $53.77. Three options are available for ABC Company:

1. Finance the project directly through retained earnings;

2. One-year debt financing with an interest rate of 9%, although management believes that 7% is the
fair rate

3. Issuance of equity that will underprice the current stock price by 7%.
What would be the cost to shareholders for each of the three options?

Option 1: If management finances the project directly through retained earnings, the cost is $10
million.

Option 2: If management finances the project through debt issuance, the one-year debt would cost
$10.8 million ($10 x 1.08 = $10.8). Discounting it back one year with the management’s fair rate
would yield a cost of $10.09 million ($10.8 / 1.07 = $10.09 million).

Option 3: If management finances the project through equity issuance, to raise $10 million, the
company would need to sell 200,000 shares ($53.77 x 0.93 = $50, $10,000,000 / $50 = 200,000
shares). The true value of the shares would be $10.75 million ($53.77 x 200,000 shares = $10.75
million). Therefore, the cost would be $10.75 million.

As illustrated, management should first finance the project through retained earnings, second
through debt, and lastly through equity
External Sources of Finance

External sources of finance come from outside a business

and are more difficult to arrange than internal sources.
Debentures
• These are essentially long-term loans issued by a
business.
• Debenture holders (individuals, governments or other
businesses) receive interest payments even if the
business makes a loss and before shareholders are paid
any dividend.
• The interest payment can be fixed or variable depending
on the type of debenture.
External sources:
finance from outside
the business.
Debt Factoring
The advantages of debt factoring as a source of external finance include:
• The debt factor provides much needed cash to a business, especially if it is
facing a liquidity problem; getting 80 or 90 per cent of the amount owed by
its debtors is better than getting zero amount.

• It frees up the organization to focus on its core business operations, rather

than having to personally spend time and resources to chase outstanding
payments from its customers.

The disadvantages of debt factoring as a source of external finance include:

• The debt factor will charge up to 20% of the value of amount owed by the
firm’s debtors as its fee; this is a significant amount of money for the
business to pay for such a service.

• Being able to chase up its own debtors means the business would have all
of the money owed to it, even if this means waiting a bit longer for the
money to be paid.

• It is usually used as a last resort, especially as the demands from the debt
factoring service provider can be perceived as ‘threatening’. This can
damage the firm’s relationship with its customers, even though they have
yet to settle their invoices.
External Sources of Finance

External sources of finance come from outside a business

and are more difficult to arrange than internal sources.
2. Overdraft
Taking more money out of your bank account than you
have in it.
The overdraft is flexible – you can go overdrawn up to a
maximum (eg £10,000)
Interest is charged for every day you are overdrawn

External sources:
finance from outside
the business.
External Sources of Finance

External sources of finance come from outside a business

and are more difficult to arrange than internal sources.
3.Hiring and Leasing
Rather than buying an asset, a firm decides to lease or
“rent” the item.
The leasing charge is cheaper than buying the asset.
Faults will be mended by the firm leasing the asset
The asset does not belong to the firm and therefore
cannot be sold

External sources:
finance from outside
the business.
External Sources of Finance

External sources of finance come from outside a business

and are more difficult to arrange than internal sources.
4.Sale and Lease back
Involves business selling a property to obtain finance and
immediately leasing back.
Thus physical location of the asset remains same.

External sources:
finance from outside
the business.
External Sources of Finance

External sources of finance come from outside a business

and are more difficult to arrange than internal sources.
5.Government or EU (European Union) Grant
Applying to the government for an amount of money to be
used for a specific purpose. It is usually a non
repayable loan.

Often only available in certain parts of the country where

unemployment is high

External sources:
finance from outside
the business.
External Sources of Finance

External sources of finance come from outside a business

and are more difficult to arrange than internal sources.
6 .Debt Factoring
Debt factoring is a financial service that allows a business to
raise funds based on the value owed by its debtors, i.e.
customers who have bought on credit. Most debt factoring
service providers offer between 80-85% of the outstanding
payments from debtors within 24 hours once the application
has been approved.

External sources:
finance from outside
External Sources of Finance

External sources of finance come from outside a business

and are more difficult to arrange than internal sources.
7 .Trade Credit

This source of finance allows a business to 'buy now and pay

later'.

Organizations that offer trade credit (known as creditors) usually

allow between 30-60 days for their customers (known as
debtors) to pay.

External sources:
finance from outside
External Sources of Finance

External sources of finance come from outside a business

and are more difficult to arrange than internal sources.
8 .Hire Purchase

Hire purchase (HP) allows a business to pay its creditors in

instalments, perhaps over 12 or 24months. The asset is legally
the property of the creditor until all payments have been made.

e.g. Motorcycle Financing/Car Financing

External sources:
finance from outside
External Sources of Finance

External sources of finance come from outside a business

and are more difficult to arrange than internal sources.
9 .Venture Capitals

A form of high-risk capital, usually in the form of loans

or shares, invested by venture capital firms, usually at the start
of a business idea.

Venture capitalists seek to invest in small to medium-sized

businesses that have high growth potential.

e.g. Facebook, Flipkart, Groupon…

External sources:
finance from outside
 Extension Activity
Find five fast growing companies that are funded
by Venture Capital Firms

46 of 20
External Sources of Finance

External sources of finance come from outside a business

and are more difficult to arrange than internal sources.
10 .Business Angels

These are extremely wealthy individuals who choose to

invest their own money in businesses that offer high growth
potential, i.e. high-risk, high-return business ventures

External sources:
finance from outside
Which source of finance?

1. To replace obsolete computer equipment (cost

£50,000)
2. WDP Ltd want to pay wages at the end of the
week but they have no money in their bank
account.
3. To open new offices in an area of
unemployment such as the NE of England.
4. To purchase a fleet of company cars for the
sales reps.
5. Five sources of finance that does not require
the paying back of any interest.
Finance Decision Tree
Which sources of finance do
you think you will/will not use
in your business?

In pencil fill in the first section of

the sheet
 Match the advantages and
disadvantages to the sources
of finance you have picked

In pencil fill in the rest of the sheet

Source of Finance
1. What is finance?
2. Explain three reasons why a business might need finance?
3. What is the difference between internal and external finance?
4. Explain at least two sources of finance that would not be relevant to your
business?
• Give the advantages and disadvantages of each source of finance
• Explain why you could not use them for your business (Not a PLC)

5. Explain the sources of finance that you will use in your business?
• Explain the advantages and disadvantages of each source of finance
• What will you use each source of finance for (Mortgage = Premise)

***Remember to fully explain each source of finance you use***

Who wants to be an A* student?
Extension Activity

Financing Technology Startup – An

Entrepreneurs Dilemma

Read all the information about the case and

present the findings.
References

• Business Management – Paul Hoang,

pg. 219-229