BUSINESS MANAGEMENT

3.1 Sources of finance

Section 3 Finance and accounts

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Unit content
Contents Assessment
objective
The role of finance for businesses AO2
Sources of internal finance and the AO2 and AO3
appropriateness, advantages and
disadvantages of sources of finances for a
given situation.
Sources of external finance and the AO2 and AO3
appropriateness, advantages and
disadvantages of sources of finances for a
given situation.
Short, medium and long-term finance AO1
Sources of finance and the CUEGIS concepts
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The role of finance for businesses

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The role of finance

• All businesses need money • Business spend their money
to finance their various on either capital or revenue
activities. expenditure
• Businesses can use
sources of finance from
internal or external
sources.
• However, there are various
factors they need to
consider when selecting
sources of finance. These
include:
• Availability
• Cost of finance (usually
from interest charges)
• Time period of repayment
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Capital expenditure
• Capital expenditure is
finance spent on fixed
assets.
• i.e. items used
repeatedly in the long-
term to generate sales
revenue.
• Examples include
equipment, machinery,
Identify the capital expenditure vehicles and buildings.
items in this picture.

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Revenue expenditure
• Revenue expenditure
is finance spent on the
daily running of the
business.
• Examples wages, rent,
utilities and raw
materials.

Identify the revenue expenditure

items in this picture.

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Sources of internal finance

• Personal funds (for sole traders)
• Retained profit
• Sale of assets

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Personal funds (for sole traders)

• This is the main source Features
of finance for sole Uses • Capital and revenue
traders and for expenditure
partnerships.
Advantages • Zero cost of finance
(unless borrowed
from friends and
family who expect it
to be repaid with
interest)

Disadvantages • Amount available is

limited to the size of
savings owned by
the sole trader
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Retained profit
Features • This is the value of
Uses • Capital and revenue finance that the business
expenditure. keeps (after paying taxes
Advantages • Zero cost of finance (as to the government and
there are no interest dividends to its
charges). shareholders) to use
Disadvantages • If the business makes a within the business.
loss, this source of
finance will not be
available.
• If shareholders are paid
high dividends, there
will not be much
retained profit left over
to be reinvested back
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into the business.
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Sale of assets Features

• Businesses can sell their Uses • Capital expenditure.
unused assets to raise • Revenue expenditure
finance. (but only in extreme
cases when a
• Examples include old business is facing a
machinery, computer liquidity crisis)
equipment that has been
replaced, land and Advantages • Zero cost of finance
buildings. (as there are no
interest charges)
Disadvantages • If assets are
undesirable (e.g.
obsolete technology)
or there is no demand,
funds cannot be raised
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Sources of external finance

• Share capital • Subsidies
• Loan capital • Debt factoring
• Overdrafts • Leasing
• Trade credit • Venture capital
• Grants • Business angels

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Share capital Features

• This is the main source of Uses • Revenue
finance for most limited expenditure
companies. Advantages • Can raise huge
• Private limited companies amount of finance,
cannot sell their shares to especially for public
the general public. limited companies

• Companies wishing to ‘go Disadvantages • Time-consuming

public’ will launch an initial and expensive to
public offering (IPO) on the prepare and launch
stock market. an IPO/share issue
• There is no
• Existing public limited guarantee that
companies can raise investors will be
finance by issuing even interested in buying
more shares, known as a shares
share issue.
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Features
Loan capital Uses • Capital expenditure
Advantages • Repayment by
• These are sources instalments gives the
of finance obtained business time to earn
from lending revenue so they can
institutions such as repay the loan
banks. Disadvantages • Depending on the
• Interest is charged interest rate, cost of
borrowing may be high
for the loan and the • If collateral is provided
amount borrowed is (such as property
repaid in instalments bought using a
over a fixed period mortgage) and the
of time. business fails, the lender
takes possession of the
asset
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Examples of loan capital

• Examples of loan capital include:
• Mortgage – a loan specifically for
property. The property is provided
as collateral to the lender.
• Business loans – a loan to start or
continue business activity.
• Debentures – a long-term loan
issued by a business. Debenture
holders receive interest from the
business, even if the business
makes a loss.

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Overdrafts Features

Uses • Revenue
expenditure
Advantages • Flexible finance for
unexpected large
cash outflows

Disadvantages • Cost of borrowing

is high due to high
• Overdrafts allow a interest rates
business to temporarily compared to other
take out more money that loan-bearing
it has in its bank account. sources of finance

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Trade credit
• This allows a business to ‘buy now
and pay later’.
• Although a business has received
goods it has purchased, it is given a
period of time (usually 30 to 60 days)
to pay for those goods.
1. Food ingredients supplied at no
cost by supplier.
2. Restaurant sells meals to
customers.
3. Customers pay restaurant for
meals.
4. Restaurant pays supplier for the
food ingredients.
Trade credit for a restaurant
business
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Trade credit Features

Uses • Revenue expenditure
Advantages • Allows time for
businesses to
process raw materials
into goods/services
and earn revenue so
they can pay for the
raw materials
Disadvantages • If payment on
invoices are late,
businesses are
charged overdue
payment penalties

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Grants
Features
• A grant is a one-off
Uses • Revenue or capital payment from the
expenditure
government to a
Advantages • Grants do not need to be business.
repaid as they are financial
gifts from the government
Disadvantages • Grants are only available in
regions or industries the
government is interested in
developing/supporting
• Applications are time-
consuming and there is no
guarantee they will be
approved
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Subsidies • Subsidies are very similar

to grants but the purpose is
Features to provide extended
Uses • Revenue or capital benefits to society.
expenditure • Examples include essential
Advantages • Shortfalls in profit are products and services such
made up by the subsidy. as:
• Education
Drawbacks • Subsidies are only
• Health care
available in regions or
industries the • Farming of subsistence
government is interested food crops
in developing/supporting.
• Applications are time-
consuming and there is
no guarantee they will be
approved.
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Debt factoring
• Debt factoring is a
financial service that Debt factoring
allows funds to be company
raised based on the
value owed by the
company’s debtors.
• Debtors are customers
that owe money to the
business (e.g.
customers that have Customer Business
30 days to pay for
goods purchased).

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Debt factoring at Ed’s Watch this video and answer the

following questions:
Trucking 1. What is the value of Ed’s
invoices)?
2. How much can Ed get
immediately from the debt
factoring company?
3. When Ed’s customers pay
their invoices, who do they
send payment to?
4. After customers have paid,
how much does the debt
factoring company pay Ed?
5. How much does the debt
factoring company earn for
providing this service to Ed?
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Leasing
• Leasing is the renting of
assets (such as machinery,
equipment and premises)
over a contracted rental
period.
• Sale and leaseback is a
particular form of leasing
whereby businesses sell
their asset and immediately
hire the use of the asset
from the new asset owner.
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Features
Uses • Capital expenditure
Advantages • Useful for businesses who
do not have the capital to
purchase expensive
assets outright.
• Repairs and maintenance
are the responsibility of the
owner of the asset.
• Leasing is treated as an
expense which helps to
reduce profits tax on the
business.
Drawbacks • In the long-run, the cost of
leasing can add up to be
more than purchasing the
asset outright.
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Venture capital
Features
Uses • Capital expenditure
Advantages • A source of funding for
firms that are unable to
secure loans from banks
due to the high risk of
business failure.
Disadvantages • Some loss of control of
the business as VCs
invest in return for a stake
in the business.
• Eventually, a business
may have to buy out the
stake owned by the VC at
great expense.
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• Funds are provided by
venture capital (VC) firms.
• VCs like to invest in
business ventures that
have high growth potential.
• If the business is
successful, the potential for
returns are very high.
• However, there is also a
high risk of failure. Thus
VCs have very demanding
criteria for investment.
• Technology firms are often
targeted by VCs.
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Features
Business angels
Uses • Capital expenditure
• These are extremely
wealthy individuals who Advantages • A source of funding for
choose to invest their own firms that are unable to
money in businesses that secure loans from banks
offer high growth potential and/or attract
(i.e. high-risk, high-return). investments by venture
capitalists.
• They are different from
venture capitalists who Drawbacks • Some loss of control of
operate as a pool of the business as
professionally managed business angels tend to
funds. take a proactive role in
the business.
• Business may eventually
have to buy out the
stake owned by the
business angel.
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Short, medium and long-term finance

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Sources of finance & their repayment periods

• It is essential for financial
managers to be aware of Timeframe Repayment period for
the repayment periods for source of finance
all sources of finance.
Short-term Within the next twelve
• This is so the firm’s cash- months.
flow position has more
cash coming in that going Medium- More than one year but
out. term less than five years.

• Hence, financial managers Long-term More than five years.

should select sources of
finances with repayment
periods that suit the
purpose and amount of the The time frame of each source of
money needed. finance can be found on page 241 of
the Hoang textbook.
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Sources of finance and the CUEGIS

concepts

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Sources of finance and CUEGIS

• When choosing a source of finance, strategy must be
employed in deciding which source of finance would be
appropriate for the needs of the firm.
• This is in order to make the most cost-effective decision as
most sources of finance incur a cost of borrowing (such as
interest).
• An easy way to remember these strategies is by using the
acronym SPACED:
• Size and status of firm
• Purpose of finance
• Amount required
• Cost of finance
• External factors
• Duration
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