3.

1 Sources of
finance

IB BUSINESS MANAGEMENT
3.1 Sources of finance
By the end of this chapter, you should be able to:
▪ Explain the role of finance for businesses in terms of capital
expenditure and revenue expenditure
▪ Comment on the internal sources of finance
▪ Comment on the external sources of finance
▪ Define short, medium and long term finance
▪ Discuss the appropriateness, advantages, and disadvantages
of sources of finance for a given situation
External source of finance
▪Share capital
▪Loan capital
▪Overdraft
▪Trade credit
▪Grants
▪Subsidies
▪Debt factoring
▪Leasing
▪Venture capital
▪Business angels
Share capital
▪ Limited companies may raise funds through the sale of
shares.
▪ Should be used for long-term needs, such as purchasing
machines or computer systems, or acquiring businesses.
▪ When a business expands it can ask existing shareholders to
put more money into the business and therefore new shares
are issued in proportion to the size of the increase in share
capital.
▪ Note that when people buy and sell existing shares, usually
via a stock exchange, this does not help the business with
raising new capital as it is simply swapping ownership
between people.
Share capital
Advantages
▪ There are no interest payments and so no drain on company
profits.
▪ If existing shareholders increase their investment by buying
new shares in proportion to their current levels there is no
change in control.
Disadvantages
▪ Shareholders still require rewards in the form of dividends,
and this is paid for from profits.
▪ If the business doesn’t make a profit and doesn’t have a
reserve of past profit it cannot be compelled to pay a
dividend.
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’ of it.
▪ When answering case study examination questions, you
should analyse what type of legal structure the business has
and what sources of finance are available to it.
Unincorporated businesses – sole traders and partnerships –
cannot issue shares, for example.
Loan capital
▪ Loan capital or debt is provided for more than one year.
▪ Funding provided by banks and other lenders.
▪ Usually provided for a fixed period of time, with repayments
evenly spread out over the length of the loan.
▪ Interest is paid on the loan at regular intervals.
▪ Interest rate holidays is where the lender agrees not to take
interest for a short period of time.
Loan capital
Advantages
▪ It is often easier to access and use for specific purpose and
so payment is spread out over the useful revenue-earning
life of the asset.
▪ If interest rates rise in the economy, the loan interest does
not change as it is fixed at the outset.
Disadvantages
▪ The lenders have to be paid even if the business does not
make a profit.
▪ If the loan is secured against an asset, then the asset can be
seized if repayments are missed.
▪ If interest rates fall, the business will pay the agreed rate,
although renegotiating loan interest is quite common.
Bank overdraft
▪ Is a short-term bank loan.
▪ A bank will allow a business to
withdraw from its account more
than it has deposited.
▪ It is a flexible way for businesses to
borrow small sums of money as
and when required.
▪ Interest is paid only when the
account is overdrawn.
▪ Overdrafts are often used to cover
cash shortages, so a business may
be overdrawn only for a matter of
days.
Bank overdraft
Advantages
▪ Changes in overdraft limits can be increased quite easily and
it is a flexible source of finance.
Disadvantages
▪ The cost will vary as interest rates change in the economy,
making budgeting costs a little difficult.
▪ It is often secured on a personal guarantee from the owners
and/or on the assets of the business.
Trade credit
▪ Most business-to-business transactions are completed on a
credit basis.
▪ Goods purchased are not paid for immediately.
▪ Using trade credit, a business can get stock even if it does
not have the cash to pay for it at the time.
▪ It is intended that, by the time payment is due, the stock will
have been sold and the necessary cash generated to pay the
bill.
Trade credit
Advantages
▪ By delaying payments to suppliers, businesses are left in a
better cash-flow position than if they paid cash immediately.
▪ It is an interest-free means of raising funds for the length of
the credit period.
Disadvantages
▪ Debtors (trade credit receivers) lose out the possibility of
getting discounts rather than if they pay in cash.
▪ Delaying payment to creditors after the agreed period may
lead to the development of poor relations and suppliers may
even refuse to engage in future transactions with the
debtors.
Grants
▪ Governments, successful entrepreneurs and large
corporations keen on promoting their social responsibilities
are all increasingly seeking to help the smaller business
sector with grants and soft loans.
▪ In most cases grant makers are very selective on who
receives the grant.
▪ While sums may be small they can make a difference to a
project’s viability.
▪ Often the problem is identifying
what grants are actually
available.
Grants
Advantages
▪ It does not have to be paid back by the recipient.
Disadvantages
▪ It mostly comes with “strings attached” depending on the
objective of the grant maker.
Subsidies
▪ Financial assistance granted by a government, a
non-governmental organization (NGO) or an individual to
support business enterprises that are in the public interest.
▪ Farm subsidies are common subsidies given to domestic
farming industries.
▪ In most cases the cash subsidies are given to help these
industries survive in a very competitive environment by
being able to sell their product at low market prices, while
still being able to reap financial gain.
▪ In situations where the market price goes below the cost of
production, this is known as subvention.
Subsidies
Advantages
▪ It helps businesses to increase their demand for goods by
charging lower prices for their products.
▪ Do not need to be repaid.
Disadvantages
▪ Government subsidies are often
marred by political interference
in the subsidization process.
Debt factoring
▪ When working capital is tight or when a business is
struggling to get paid by customers, it may consider using a
third party agency to help.
▪ A factor agent or debt-factoring company is a company that
buys the current unpaid invoices of a business with a
percentage discount. It pays that cash immediately to the
business and hopes that it can recover more than the value
paid of the debts in order to make a profit.
Debt factoring
Advantages
▪ The business receives cash upfront and can use this money
to fund expansion and working capital needs more generally.
▪ The administration cost to the business of chasing up its
customers’ unpaid bills is immediately removed.
Disadvantages
▪ The business is really giving up some of its profit margin.
▪ A factor agent ringing up your biggest customer and
demanding immediate payment otherwise the customer
may be taken to court could mean that you lose vital sales in
the future.
Leasing
▪ By leasing an asset instead of purchasing it, a business can
reduce the amount of finance it needs to raise.
▪ A business pays a set fee to lease the asset for a set time.
▪ After this, the asset is returned to the leasing company.
▪ The business might then renew the leasing contract and
receive a new asset.
▪ Leasing is useful for equipment such as computers, which
quickly become outdated.
Leasing
Advantages
▪ The business does not need to
find a large initial lump sum to
buy the equipment, and thus
pay for the asset from its own
revenue.
Disadvantages
▪ The ownership of the asset
does not pass to the business.
▪ The business will probably be
paying a reasonable high level
of interest.
Venture capital
▪ Financial capital provided by investors who are most
prepared to share the risks of business enterprise.
▪ They invest in the share capital as well as providing loan
capital for businesses with expansion potential.
▪ Venture capitalists usually fund start-ups that find it difficult
to access money from other financial institutions or capital
markets.
▪ They own a stake in the businesses they invest in with the
expectation of benefiting from future profits.
▪ Due to the high risks involved, they expect the firms needing
the funds to produce a thoroughly researched business plan
to help mitigate the risk of investment.
Venture capital
Advantages
▪ They often provide business help and contacts for export
drives or for identifying new technologies or partners.
▪ They sit as non-executive directors.
Disadvantages
▪ Profit or sales targets are imposed.
▪ If the business fails to expand, they increase their equity
stake.
Business angels
▪ Also known as angel investors.
▪ Very affluent individuals who
provide financial capital to small
start-ups or entrepreneurs in
return for ownership equity in
their businesses.
▪ Invest in high-risk businesses that
show good potential for high
returns or future growth.
▪ May provide a one-time initial
capital injection or continually
support the businesses through
their lifetime.
Business angels
Advantages
▪ They give more favourable financial terms than other
institutions or lenders of small or start-up businesses.
▪ They are known to invest in the person rather than how
viable a business venture is.
▪ They focus on helping a business succeed by using their
extensive business experience coupled with good financial
capital.
Disadvantages
▪ They may assume a good degree of control or ownership in
the businesses they invest in, therefore diluting the
ownership of the entrepreneur.
External sources of finance
Time frame Possible usage
Short-term Under 1 year Working capital
Medium-term 1 – 5 years Capital expenditure (vehicles, refurbishment, etc.)
Long-term Over 5 years Major capital expenditure (buildings, land, etc.)
External sources of finance
Short-term Medium-term Long-term
Bank overdraft Leasing Share capital
Trade credit Bank loans Loan capital
Debt factoring Grants Venture capital
Factors influencing the choice of a
source of finance
▪Purpose or use of funds
▪Cost
▪Status and size
▪Amount required
▪Flexibility
▪State of the external environment
▪Gearing
Key concept link
▪ Selecting appropriate sources of finance is an important
strategic choice for businesses.
▪ Selecting inappropriate sources can impact on ownership
and control and the ability of managers to meet the needs
and wants of stakeholders.
Sources
▪ Stimpson, P., Smith, A. (2015) Business Management for the
IB Diploma. Cambridge
▪ Lominé, L., Muchena, M., and Pierce, R. (2014) Business
Management. Oxford
▪ Clark, P. and Golden, P. (2009) Business and management
Course Companion
▪ Gutteridge, L. (2009) Business and Management for the IB
Diploma
▪ Thompson, R. and Machin, D. (2003) AS Business Studies