UU-MAN-4008-MW - ENTREPRENEURSHIP

Week 5 – Topic Overview

Sources of Finance

Learning Objectives
1. To identify the different sources of finance available for entrepreneurs
2. To understand the pros and cons of these different sources of finance
3. To highlight the role of microfinance to entrepreneurs

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Table of Contents

1. Introduction ............................................................................................................................................... 3
2. Internal sources ...................................................................................................................................... 3
2.1 Owner’s investment ......................................................................................................................... 3
2.2 Retained profits ................................................................................................................................ 3
2.3 Sale of stock/inventory .................................................................................................................... 4
2.4 Sale of fixed assets/non-current assets............................................................................................. 4
2.5 Debt collection ................................................................................................................................. 4
3. External sources..................................................................................................................................... 4
3.1 Bank loan ......................................................................................................................................... 4
3.2 Bank overdraft ................................................................................................................................. 5
3.3 Additional partners .......................................................................................................................... 5
3.4 Share issue ....................................................................................................................................... 5
3.5 Leasing ............................................................................................................................................. 7
3.6 Hire purchase ................................................................................................................................... 7
3.7 Mortgage .......................................................................................................................................... 8
3.8 Trade credit ...................................................................................................................................... 8
3.9 Government grants ........................................................................................................................... 9
4. Factors affecting choices of finance .................................................................................................... 10
5. Introduction to microfinance ................................................................................................................... 10
References ................................................................................................................................................... 12

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1. Introduction
Starting a business requires capital, and as most would-be entrepreneurs are not independently wealthy,
thus, there is a need to know the various sources of finance. These sources of funds are used in different
situations. They are classified based on time period, ownership and control, and their source of generation.
Based on a time period, sources are classified as long-term (3 years or more), medium-term (between 1 – 3
years), and short-term (Up to 12 months). Ownership and control classify sources of finance into owned
capital and borrowed capital. Internal sources and external sources are the two sources of generation of
capital. All the sources of capital have different characteristics to suit different types of requirements.

2. Internal sources
Internal financing is generated from operating and investment activities rather than attracting funds on
capital market (Bazilinska, 2008; Educba, 2022). There is normally no cost to the business associated with
internal finance because the business is using its own money. However, there is an opportunity cost
involved because once the business has used the money, it cannot use it for other purposes. There are five
main sources of internal finance:

2.1 Owner’s investment

This is the money that comes from the owner’s own savings. It may be in the form of start-up capital used
when the business is starting-up or may be in the form of additional capital perhaps used for expansion. It
is a long-term source of finance and is most suitable when the money needed is not a large amount. The
advantages are that it does not have to be repaid and there is no interest payable. The disadvantage is that
there is a limit to the amount that an owner can invest (Study smarter, 2022; Longenecker et al., 2008, BBC,
2023).

2.2 Retained profits

This is when profits made are ploughed back into the business and this source of financing is suitable for a
business that has been trading for at least a year. This is a medium- or long-term source of finance and is
also suitable when the amount required is not very large (Grozdanovska et al., 2017; Shrotriya, 2019;
Educba, 2022; BBC, 2023).
Pros and cons of retained profits
Table 1: Pros and cons of retained profits
Pros Cons
Does not need to be repaid Not available to a new business
No interest is payable The business may not make enough profits to plough back
The affairs of the business remain private Dissatisfaction among shareholders due to low dividends
caused by excessive ploughing back into the business
As the funds are generated internally, there is a greater It is an uncertain source of funds as the profits of a business
degree of operational freedom and flexibility may fluctuate

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 It enhances the capacity of the business to absorb
unexpected losses
It may lead to increase in the market price of the equity
shares of a company
Source: Grozdanovska et al (2017); Shrotriya (2019); Educba (2022); BBC (2023)

2.3 Sale of stock/inventory

This is money that comes from selling off unsold stock. Usually, the business offers unsold goods at a
discounted price to the public to raise finance quickly. This is done if the money is required in the short
term. The advantages are that it is a quick way of raising funds and selling off stock reduces the cost
associated with holding them. The disadvantage is that the business will have to take a reduced price for
the stock (BBC, 2023).

2.4 Sale of fixed assets/non-current assets

Financing of the business can be done through money that comes from fixed assets such as a premise and
equipment that is no longer needed. It is also known as This is considered a short-term, medium-term, or
long-term source of finance depending on what kind of assets are sold. For example, selling a car can cater
to short-term and smaller financial needs while selling land, buildings or machinery can cater to medium-
term to long-term and bigger financial needs. Although it is a good way to raise finance from an asset that
is no longer needed, there is a challenge that businesses are unlikely to have surplus assets to sell and even
a business with surplus assets can find the method slow (Grozdanovska et al., 2017; Educba, 2022).

2.5 Debt collection

A business can raise finance by collecting money owed to them (debts) from their debtors (those who owe
the business money). This is a short-term method of finance. The advantage of this method is that there is
no additional cost in getting finance as it is part of the business’s normal operations. The disadvantage is
that there is a risk that debts owed can go bad and fail to be repaid (Jaber & Al-ali, 2021).

3. External sources
An external source of finance is the capital generated from outside the business (Grozdanovska et al., 2017;
Educba, 2022). The external sources of finance include:

3.1 Bank loan

This is money borrowed at an agreed rate of interest over a set period of time. The interest rate charged by
banks depends on various factors such as the characteristic of the firm and the level of interest in the
economy. Banks extend loans to firms of all sizes and in many ways (Bank for International Settlements,
2010). This is a medium or long-term source of finance. The advantage is that the set payments are spread

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over a period of time, which is good for

budgeting. The disadvantages are that it can be expensive due to interest payments and that the bank may
require security on the loan (Longenecker et al., 2008; Study smarter, 2022; BBC, 2023).

3.2 Bank overdraft

This is an arrangement with the bank where the business is allowed to pay out amounts from its bank
account to an agreed limit beyond the amount which has been lodged in the account. This means that they
can still write cheques, even if they do not have enough money in the account. This is a short-term source
of finance (Bank for International Settlements, 2010). A bank overdraft is usually cheaper than a bank loan
which has a fixed rate of interest as interest is paid on the amount actually overdrawn each day for a bank
overdraft. However, it can be expensive if used over a longer period of time (Carter et al., 1997; Jaber &
Al-ali, 2021; Study smarter, 2022; BBC, 2023).

3.3 Additional partners

This source of finance is suitable for a partnership. The new partner(s) can contribute extra capital. The
advantages are that there is no need for paying back the new partner(s) and that there is no interest payable.
Nevertheless, the business profits will be split more ways as the new partner(s) are entitled to a share of the
profits of the business (Longenecker et al., 2008; BBC, 2023).

3.4 Share issue

This is the capital obtained by issuing shares and is known as share capital. This source of finance is suitable
for private and public limited companies. In a private limited company these shares will be issued to family
and friends while in a public limited company, additional members of the public may become shareholders
by using the shares on the Stock Exchange (Harper, 2005; Study smarter, 2022; BBC, 2023). This is a long-
term source of finance for the company. There are two types of shares normally issued by a company:

3.4.1 Equity shares

These represent the ownership of a company and the capital raised by the issue of equity shares is known
as ownership capital or owner’s funds. The capital raised by the issue of equity shares is called equity share
capital, ownership capital, or owner’s funds. Equity shareholders do not get fixed dividends but are paid on
the basis of earnings by the company and are referred to as residual owners since they receive what is left
after all other claims on the company’s income and assets have been settled (Educba, 2022; Study smarter,
2022).

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Merits and demerits of equity shares
Table 2: Merits and demerits of equity shares
Merits Demerits
Equity shares are suitable for investors who are willing to Investors who want steady income may not prefer equity
assume risk for higher returns shares as equity shares get fluctuating returns
Payment of dividend to the equity shareholders is not The cost of equity shares is generally more as compared to
compulsory. Therefore, there is no burden on the company in the cost of raising funds through other sources
this respect
Equity capital serves as permanent capital as it is to be repaid Issue of additional equity shares dilutes the voting power, and
only at the time of liquidation of a company. As it stands last earnings of existing equity shareholders
in the list of claims, it provides a cushion for creditors, in the
event of winding up of a company
Equity capital provides creditworthiness to the company and More formalities and procedural delays are involved while
confidence to prospective loan providers raising funds through issue of equity share
Funds can be raised through equity issue without creating any
charge on the assets of the company. The assets of a company
are, therefore, free to be mortgaged for the purpose of
borrowings, if the need be
Democratic control over the management of the company is
assured due to the voting rights of equity shareholders
Source: Educba (2022); Study smarter (2022); BBC (2023)

3.4.2 Preference shares

The capital raised by the issue of preference shares is called preference share capital. The preference
shareholders enjoy a preferential position over equity shareholders in two ways: (i) receiving a fixed rate
of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders;
and (ii) receiving their capital after the claims of the company’s creditors have been settled, at the time of
liquidation. In other words, as compared to the equity shareholders, the preference shareholders have a
preferential claim over dividends and repayment of capital. Preference shareholders generally do not enjoy
any voting rights. A company can issue different types of preference shares (Carter, Macdonald & Chang,
1997; Educba, 2022).
Merits and demerits of preference shares
Table 3: Merits and demerits of preference shares
Merits Demerits
Preference shares provide reasonably steady income in the Preference shares are not suitable for those investors who are
form of a fixed rate of return and safety of investment willing to take risks and are interested in higher returns
Preference shares are useful for those investors who want a Preference capital dilutes the claims of equity shareholders
fixed rate of return with comparatively low risk over assets of the company
It does not affect the control of equity shareholders over the The rate of dividend on preference shares is generally higher
management as preference shareholders don’t have voting than the rate of interest on debentures
rights
Payment of a fixed rate of dividend to preference shares may As the dividend on these shares is to be paid only when the
enable a company to declare higher rates of dividend for the company earns profit, there is no assured return for the
equity shareholders in good times investors. Thus, these shares may not be very attractive to the
investors
Preference shareholders have a preferential right of The dividend paid is not deductible from profits as an

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 repayment over equity shareholders in the event of the expense. Thus, there is no tax saving as in the case of interest
liquidation of a company on loans

Preference capital does not create any sort of charge against

the assets of a company
Source: Carter et al (19997); Educba (2022); BBC (2023)

3.5 Leasing
This is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right
to use the asset grants the other party the right to use the asset in return for a periodic payment. In this
arrangement, a business obtains assets without the need to pay a large sum upfront. It is similar to renting
an asset and is arranged through a finance company. It involves making set payments and is a medium
source of finance. The ‘lessor’ is the owner of the assets while the ‘lessee’ is the party that uses the assets.
Such type of financing is more prevalent in the acquisition of assets such as computers and electronic
equipment which become obsolete quicker because of fast-changing technological developments (Carter et
a., 1997; Barringer & Ireland, 2019; Educba, 2022; BBC, 2023).
Pros and cons of leasing
Table 4: Pros and cons of leasing
Pros Cons
It enables firms to use up-to-date equipment (the asset will be These payments can be very high because they include profits
updated regularly) and the business is able to get the asset for the finance company
immediately
Maintenance and repair costs are usually paid by the finance The asset remains the property of the finance company
company. A common example is a fleet of company cars,
which are frequently leased.
Businesses can have use of up-to-date equipment A lease arrangement may impose certain restrictions on the
immediately use of assets. For example, it may not allow the lessee to make
any alteration or modification to the asset
Payments are spread over a period of time which is good for Normal business operations may be affected in case the lease
budgeting is not renewed
It enables the lessee to acquire the asset with a lower It may result in higher payout obligation in case the
investment equipment is not found useful and the lessee opts for
premature termination of the lease agreement
Simple documentation makes it easier to finance assets The lessee never becomes the owner of the asset. It deprives
him of the residual value of the asset
Lease rentals paid by the lessee are deductible for computing
taxable profits
It provides finance without diluting the ownership or control
of business
The lease agreement does not affect the debt-raising capacity
of an enterprise
The risk of obsolescence is borne by the lesser. This allows
greater flexibility for the lessee to replace the asset
Sources: Carter et al (1997); Barringer and Ireland (2019); Educba (2022); BBC (2023)

3.6 Hire purchase

This is another method of medium-term finance that is used for the purchase of assets. This method allows
a business to obtain assets without the need to pay a large lump sum upfront. It involves paying an initial
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deposit and regular payments for a set period of time. It is different from leasing in that with a hire purchase

after all installments have been made the business owns the asset. The pros of this method are that: (a)
business can have the use of up-to-date equipment immediately and can even have the option to hire it out;
(b) payments are spread over a period of time which is good for budgeting, and; (c) once all repayments
are made the business will own the asset. The limitation is that it is an expensive method compared to
buying with cash (Carter et al., 1997).

3.7 Mortgage
A mortgage is a very long-term method of raising finance and is often used to help in the purchase of
premises. The mortgage is arranged with a building society or a bank over a long period of years (usually
20 to 25) and the sum borrowed, plus interest charges and has to be repaid in installments over that period.
This is a long-term source of finance, and the business will own the property once the final payment has
been made. Mortgages can be one of two types: (a) chattel mortgages which are loans for which certain
items of inventory or other movable property serve as collateral. The borrower retains title to the inventory
but cannot sell it without the banker’s consent, and (b) real estate mortgages which are loans for which real
property, such as land or a building, provides the collateral (Longenecker et al., 2008). The advantages are
that: (i) the business can use the premises from the beginning and can carry on its work there while making
repayments; (ii) the premises eventually become the property of the business when all the payments have
been made, and (iii) payments are spread over a period of time which is good for budgeting. The
disadvantages are: (i) the purchase is more expensive than if it were bought by cash; (ii) since the premises
act as collateral, they can be taken and sold by the building society or bank should the business fail to make
repayments (BBC, 2023).

3.8 Trade credit

When a company receives goods, materials, equipment, or services without making a cash payment, it is
called trade credit. This is a short-term means of finance and is where suppliers allow their customers to
have a period of time (usually 30 days) in which to pay for the goods they have received. Those who are
granted trade credit are customers with a reasonable amount of financial standing and goodwill. The volume
and period of credit extended depend on factors such as the reputation of the purchasing firm, the financial
position of the seller, the volume of purchases, past records of payment, and the degree of competition in
the market. The terms of trade credit vary from one industry to another and from one person to another and
a firm may also offer different credit terms to different customers (Jaber & Al-ali, 2021; Shrotriya, 2019;
Study smarter, 2022; BBC, 2023).

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Advantages and disadvantages of trade credit
Table 5: Advantages and disadvantages of trade credit
Advantages Disadvantages
Trade credit gives an advantage to buyers because they have Discount given for cash payment would be lost
the immediate use of the goods. This would help the working
capital of a small shop, for example, because the shop could
buy the goods on credit, and then sell them and raise money
from them before having to pay the supplier
Businesses can sell the goods first and pay for them later. The Businesses need to carefully manage their cash flow to ensure
company does not have to arrange for cash to pay they will have money available when the debt is due to be
immediately but gets time for the payment paid
Good for cash flow The availability of easy and flexible trade credit facilities may
induce a firm to indulge in overtrading, which may add to the
risks to the firm
No interest is charged if money is paid within an agreed time Only a limited amount of funds can be generated through
trade credit
Trade credit is a convenient and continuous source of funds It is generally a costly source of funds as compared to most
other sources of raising money
Trade credit may be readily available in case the
creditworthiness of the customers is known to the seller
Trade credit needs to promote the sales of an organisation
If an organisation wants to increase its inventory level in order
to meet the expected rise in sales volume in the near future, it
may use trade credit to, finance the same
It does not create any charge on the assets of the firm while
providing funds
Sources: Shrotriya (2019); Jaber & Al-ali (2021); BBC (2023)

3.9 Government grants

Governments from both developed and developing countries intervene to address small businesses’ ability
to access finance due to the recognition that small businesses face constrained access to external financing.
Thus, many governments have put forward initiatives, programs, and financial institutions that ensure small
enterprises have easier access to financing (Amarteifio & Frimpong, 2019; Jaber & Al-ali, 2021). The
government-backed financial institutions provide both owned capital and loan capital for long and medium-
term requirements and supplement traditional financial agencies like commercial banks. Besides providing
financial assistance, these institutions also conduct market surveys and provide technical assistance and
managerial services to people who run the enterprises. These government grants are mainly given to create
employment in depressed areas in order to regenerate that area or to attract foreign investment, but they
usually come with certain attached conditions such as where the business has to be located and this becomes
a disadvantage. The other disadvantage is that not all businesses may be eligible for a grant (Carter et al.,
1997; Harper, 2005; Amarteifio & Frimpong, 2019; Jaber & Al-ali, 2021; BBC, 2023). In some developing
countries, especially in Africa, these government grants may be linked to political parties, hence some
businesses not affiliated with the ruling party may not benefit from such grants. The main advantage is that

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the businesses usually do not have to repay the money.

4. Factors affecting choices of finance

As discussed, financial needs of a business are of different types (i.e., short-term, medium-term, short-term)
and therefore businesses resort to different types and sources for raising funds. The factors that affect the
choice of source of finance are discussed below:
A firm’s economic potential: A business with a potential for high growth and large profits has many
possible sources of financing than a business that provides a comfortable lifestyle for its owner but
insufficient profits to attract outside investors (Longenecker et al., 2008; Study smarter, 2022).
Company size and maturity: The size and maturity of a company have a direct bearing on the types of
financing available. Larger and older firms have access to bank credit more than younger and smaller
companies. This is because financial institutions are interested in providing finance to businesses with an
established track record. Thus, bankers demand evidence that the business will be able to repay a loan and
that evidence usually must be based on what has been done in the past and not what will be achieved in the
future (Longenecker et al., 2008; Study smarter, 2022).
Types of assets: A bank considers two types of assets when evaluating a loan (i.e., tangible assets that can
be seen and touched such as inventories, equipment, and buildings as well as intangible assets such as
goodwill or past investments in research and development but have little value as collateral. Therefore,
companies with substantial tangible assets have a much easier borrowing money than companies with
intangible assets (Longenecker et al., 2008).
Owner preferences for debt or equity: Most financial institutions specialize in either debt or equity
financing. Thus, the choice between debt and equity financing must be made early in a firm’s life cycle and
may have long-term financial consequences. To make an informed decision, a small business owner needs
to recognize and understand the tradeoffs between debt and equity with regard to potential profitability,
financial risk, and voting control (Longenecker et al., 2008).

5. Introduction to microfinance
The sources of finance that are widely used by entrepreneurs have been explained. Another source of
income known as microfinance has been made available to very small business start-ups that carry
significant risks, mostly in low-income developing countries. Microfinance refers to “an array of financial
services, including loans, savings, and insurance, available to poor entrepreneurs and small business owners
who have no collateral and wouldn't otherwise qualify for a standard bank loan” (Jafar et al., 2016, p. 53).
Two main reasons have been put forward on why it is difficult for banks to lend to the poor: (i) the size of

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the loans they require (usually a few dollars) do not attract banks as they do not make a profit from such

loans; (ii) they do not have assets to act as collateral (Borrington & Stimpson, 2018).
There are various institutions that focus on lending small sums of money to people and these include postal
savings banks, finance cooperatives, credit unions and development banks. The capital they give to people
is known as micro-finance or micro-credit (Jafar et al., 2016; Borrington & Stimpson, 2018)
These microfinance institutions use a variety of strategies to reduce their own risks such as: (a)
microborrowers where microcredit is given to low-income clients and entrepreneurs who often have
informal or family businesses; (b) lending to those without collateral although a credit risk analysis is done
by the loan officers. However, microborrowers have to pledge something of little value although highly
valued by them (eg TV, furniture).; (c) weekly biases repayment schedule, which entails strict control of
arrears; (d) group lending through solidarity groups which involves 5 person solidarity groups in which
each group member guarantees the other member’s repayment and village banking where a solidarity group
is expanded to a larger group of 15-30 people who are responsible for managing the loan provided by the
microfinance institution as well as making and collecting loans from each other; (e) On initial stage very
small loans provided, which can be increased over time to good borrowers; (f) regular monitoring of clients
by credit officers; (g) High-interest rates (at least 20% a year or more) (Moloi & Ntshakala, 2002; Barr,
2004; Bank of International Settlements, 2010; Jafar et al., 2016).
Nevertheless, according to Ledgerwood (1999), there have been more failures than successes when it comes
to microfinancing due to the following reasons: (1) some MFIs target a segment of the population that has
no access to business opportunities because of a lack of markets, inputs, and demand. Productive credit is
of no use to such people without other inputs; (2) many MFIs never reach either the minimal scale or the
efficiency necessary to cover costs; (3) many MFIs face non-supportive policy frameworks and daunting
physical, social, and economic challenges; (4) some MFIs fail to manage their funds adequately enough to
meet future cash needs and, as a result, they confront a liquidity problem; (5) others develop neither the
financial management systems nor the skills required to run a successful operation; and (6) replication of
successful models have at times proved difficult, due to differences in social contexts and lack of local
adaptation.

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