Financial Management:

Sources of Funds

Traditional and New & Innovative

sources of funds
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 LEARNING GOALS
• Key learning goals:
This topic will introduce the major sources of funds for
businesses, including internal and external sources, as well as
the key factors affecting the choice of funds.
1. Explain the importance for a business to raise funds
2. State the internal sources of funds fro a business
3. State the external sources of funds for a business
4. State the difference between ordinary shares, preference and
deferred shares
5. Explain the difference between the operating lease and the
finance lease
6. Describe the major factors affecting the choice of funds

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 Financial Management
-Sources of Funds

 The need for funds:

No business can live without funds. Throughout the life of
a business, money is needed continuously. Firms raise
money mainly to meet the following three types of need:
1. To start a business as initial expenditure;
2. To fund continuous business activities and money flowing;
3. To expand the business.

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 Financial Management
-Sources of Funds
 The need for funds:
Question for your critical thinking:

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 Financial Management
-Sources of Funds
 Sources of funds

In general, a business may have two major

sources of funds which are needed for its
business operations. They are internal sources of
funds and external sources of funds.

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 Financial Management

-Sources of Funds

Sources of Funds
Internal Sources External Sources

Short term:
Long-term: Overdraft
Profit Depreciation Sales of assets Share Capital Leasing
Loan Capital Credit card…

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 Financial Management
-Internal Sources of Funds
Profit  The after-tax profit earned
and retained by a business
which is an important and
inexpensive source of
finance, for example, the
retained earnings of the
business. A large part of
finance is funded from
profit.

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 Financial Management
-Internal Sources of Funds

 The financial provision for the

Profit
replacement of worn-out
machinery and equipment. Nearly
Depreciation all businesses use depreciation as
a source of funds.

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 Financial Management
-Internal Sources of Funds

 Definition: The activity that a

Profit business sells off assets to raise
funds for the business.

Depreciation
 Reasons: When a business can
not raise finance from banks or
other sources, it may be forced to
sell some assets, such as company
Sales of Assets cars, land property; or even
subsidiary or associated company
to solve its urgent financial
problems (this activity is called
divestment).
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 Financial Management

-External Long-term Sources of Funds

 Share capital:
The most important source of funds for a limited company. It is often
considered as permanent capital as it is not repaid by the business, but
the shareholder can have a share in the profit, called dividend.
Three types of shares are:
1. Ordinary shares: The most common types of shares, and the most
riskiest shares since no guaranteed dividend. Dividend depends on how
much profit is made by the firm. But all ordinary shareholders have
voting rights.
2. Preference shares: The share owners receive a fixed rate of return. They
carry less risk because shareholders are entitled to the dividend before
the ordinary shares. But they are not strictly owners of the company.
3. Deferred shares: These shares are often held by the founders of the
company. Deferred shareholders only receive the dividend after the 10/28/20
ordinary shareholders have been paid.
 Financial Management
-External Long-term Sources of Funds
 Loan capital
• Definition:

Any money which is borrowed for a long period of time by

a business is called loan capital.
• Types:

There are four major types of loan capital: Debentures,

Mortgage, Loan specialists’ funds, Government
assistance
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 Financial Management
-External Long-term Sources of Funds
 Types of loan capital:
1. Debentures: The holder of a debenture is a creditor of the company, not an
owner. Holders are paid with an agreed fixed rate of return, but having no
voting rights. The amount of money borrowed must be repaid by the expiry
date.

2. Mortgage: These are long-term bank loans (usually over one year period)
from banks or other financial institutions. The borrower’s land or property
must be used as a security on such as a loan.

3. Loan specialists’ funds: These are venture capitalists or specialists who

provide funds for small businesses, especially for high tech investment
projects in their start-up stage. There are also individuals who invest in such
businesses, which are often called ‘business angels’.

4. Government assistance: To encourage small businesses and high employment,

governments may be involved in providing finance for businesses. In the USA, there is
an organization which is called the Small Business Administration (SBA). SBA provides
guarantees for small businesses’ loans and they even offer some loans themselves.

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 Financial Management
-External Short-term Sources of Funds
 Definition:

Short term sources of funds are usually the funds which are less than one year for maturity. They are less
stable sources of funds for businesses.

 Types:

The main types of external short term sources of funds include:

1. Bank overdraft

2. Bank loan

3. Leasing

4. Credit card

5. Trade credit

See the next page for details:

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 Table 13-2 External short-term sources of loans
Major types Main characteristics
Bank This is a short term financing from banks.
overdraft The amount to be overdrawn depends on the needs of the business at
the time and its credit standing.
Interest is calculated from the time the account is overdrawn..
Bank loan This is a loan which requires a rigid agreement between the borrower
and the bank. The amount borrowed must be repaid over a certain
period or in regular installments.
Sometimes, banks change persistent overdrafts into loans, so
borrowers must repay at regular intervals.
Leasing Leasing allows businesses to buy plant, machinery or equipment
without paying large sums of money immediately.
The leasing company or bank hires or buys the equipment and for the
use of the hire company for a certain period of time. If the user can
never owns the equipment, it is an operating lease, while if it is given the
choice to own the equipment at the expiry time, it is a finance lease.
Lease payments are made by the hire company yearly or monthly, etc.

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 Financial Management
-External Short-term Sources of Funds
Table 13-2 External short-term sources of loans (continued)
Major types Main characteristics
Credit card Credit cards can be used to pay for hotel bills, meals,
shopping and materials, etc. They are convenient,
and secure because it can avoid the use of cash and
the payment of interests within credit periods.
Cards may not be suitable for certain purchases,
especially a large sum of order because they have a
credit limit.

Trade credit It is a common method for businesses to buy

materials and to pay for them at a later date, usually
between 30 and 90 days. Such trade credit given by
the seller is usually an interest free way of short
term financing. 10/28/20
 Financial Management

-Factors affecting the choice of funds

• Costs of the fund
Costs in terms of interest payments and other expenses: Long term
and short term.
• Use or purpose of funds
For example, the building of a new plant is usually financed by
mortgage or share capital, while the purchase of raw materials by
trade credit or bank overdraft.
• Status and size of the business
For a large firm, there are more sources of finance and often with lower
interest rates.
• Financial situations of a firm
For example, a business in poor financial situation is forced to pay high
interest rate for loans. And the bank often requires security or
collaterals for their financing.
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 Financial Management
-Factors affecting the choice of funds
• Gearing condition (ratio) of the firm
 Definition:

Gearing is the relationship between the loan capital and share

capital of a business. High geared companies have a larger
share of loan capital to share capital. Low geared ones have a
small amount of loan capital.
 Impact over a firm:

High gearing may mean ‘no loss of ownership’ but high risk of
liquidity since interest rates may change and loans must be
repaid in time. Low gearing may mean some loss of ownership
but no burden of loans and interest payments.
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 Financial Management
-Sources of Funds

 Question for your critical thinking:

If you are the manager, do you prefer

high gearing or lower gearing for your
firm? And why so?

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 Sources of Funds

• Debt capital—funds obtained through borrowing.

• Equity capital—funds provided by the firm’s

owners when they reinvest earnings, make
additional contributions, or issue stock to
investors.

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• Debt and Equity Capital: Two Basic Sources of
Funds

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• Comparison of Debt and Equity Capital

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 Sources of Funds

• Long term Sources of Funds

• Leverage: Technique of increasing the rate of
return on an investment by financing it with
borrowed funds
• The key to managing leverage is ensuring that the company’s
earnings remain larger than its interest payments, which
increases the leverage on the rate of return on
shareholders’ investment

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• How Leverage Works

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Sources of Finance

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Business Growth

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 Internal Sources of Finance and Growth
• ‘Organic growth’ – growth
generated through the
development and expansion of the
business itself. Can be achieved
through:

• Generating increasing sales –

increasing revenue to impact on
overall profit levels

• Use of retained profit – used to

reinvest in the business
Selling more? Mind the queues.
Copyright: iStock.com • Sale of assets – can be a double
edged sword – reduces capacity?

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 External Sources of
Finance • Long Term – may be paid back after
many years or not at all!

• Short Term – used to cover

fluctuations in cash flow

• ‘Inorganic Growth’ – growth

generated by acquisition

The existence of capital markets enable firms to raise

long term loans and share capital.
Copyright: Photolibrary Group

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 Long Term
• Shares (Shareholders are part owners of a company)
• Ordinary Shares (Equities):
• Ordinary shareholders have voting rights
• Dividend can vary
• Last to be paid back in event of collapse
• Share price varies with trade on stock exchange
• Preference Shares:
• Paid before ordinary shareholders
• Fixed rate of return
• Cumulative preference shareholders – have right to dividend carried over to next year
in event of non-payment
• New Share Issues – arranged by merchant or investment banks
• Rights Issue – existing shareholders given right to buy new shares at discounted
rate
• Bonus or Scrip Issue – change to the share structure – increases number of
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shares and reduces value but market capitalisation stays the same
 Long term
• Loans (Represent creditors to the company – not
owners)
• Debentures – fixed rate of return, first to be paid
• Bank loans and mortgages – suitable for small to medium sized
firms where property or some other asset acts as security for the
loan
• Merchant or Investment Banks – act on behalf of clients to
organise and underwrite raising finance
• Government/EU – may offer loans in certain circumstances
• Grants

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 Short Term
• Bank loans – necessity of paying interest on the payment, repayment periods
from 1 year upwards but generally no longer than 5 or 10 years at most

• Overdraft facilities – the right to be able to withdraw funds you do not

currently have
• Provides flexibility for a firm
• Interest only paid on the amount overdrawn
• Overdraft limit – the maximum amount allowed to be drawn - the firm
does not have to use all of this limit

• Trade credit – Careful management of trade credit can help ease cash flow –
usually between 28 and 90 days to pay

• Factoring – the sale of debt to a specialist firm who secures payment and
charges a commission for the service.

• Leasing – provides the opportunity to secure the use of capital without

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ownership – effectively a hire agreement
 'Inorganic Growth'
• Acquisitions

• The necessity of financing

external inorganic growth
• Merger:
• firms agree to join together –
both may retain some form of
identity
• Takeover:
• One firm secures control of the
other, the firm taken over may
lose its identity
Safeway – subject to a £3 billion takeover by
Morrisons. Securing the £3 billion necessary is a
specialist job.

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Business Angels

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 Business Angels
• Individuals looking for investment opportunities

• Generally small sums up to £100,000

• Could be an individual or a small group

• Generally have some say in the running of the

company

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Venture Capital

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 Venture Capital
• Pooling of capital in the form of limited companies – Venture
Capital Companies
• Looking for investment opportunities in fast growing businesses
or businesses with highly rated prospects
• May also buy out firms in administration
who are going concerns
• May also provide advice, contacts
and experience
• In the UK, venture capitalists have invested £50 billion since
1983

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 Some example of VCs in
India
• https://www.business.com/articles/angel-invest
ors-vs-venture-capitalists/
• https://inc42.com/resources/top-47-active-vent
ure-capital-firms-india-startups/

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 Depository Receipts
• Depository Receipts are – Basically negotiable instruments
denominated in U.S. dollars. Whereby an Issuer or a non-
U.S Indian company tap the global equity market to raise
foreign fund thru it’s public listing and trading it in local
currency equity shares in form of “Depository Receipts”
• These Depository Receipts may be traded freely on an
exchange or an over- the- counter market.
• Depository Receipts can be either “GDRs” which are usually
listed on a European stock exchange, or American
Depository Receipts (“ADRs”), listed on the US stock
exchange
• https://www.goodreturns.in/adr-gdr-listings.html

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 Euro equity
• Euro equity represents shares that are denominated in dollars
and are issued by either non-American or non-European
companies. These shares are then listed on American and
European stock exchanges by complying to their regulations
• 4 Different Forms of Euro Equity Issue

 Global Depository Receipts (GDR)

 American Depository Receipts (ADR)- #Popular

 European Depository Receipts- #Popular

 Singapore Depository Receipts

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 Top 3 Goals of floating DR

• Diversify investor base

• Enhance visibility and global presence

• Increase liquidity

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 Global Depository
Receipts (GDR)
• GDR equity shares are denominated in dollar and
tradable on a stock exchange in Europe or any other
non USA exchange. For example, a GDR of EUR 100
may comprise 2 equity shares of EUR 50 each
amounting to whatever the prevailing exchange rate
is.

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 Main features of GDR
• GDR represents certain number of equity shares
denominated in dollar terms
• The issuer collects the proceeds in foreign currency
• GDRs are traded on stock exchanges of Europe
• All shares to be issued are deposited with an
intermediary called ‘depository’ located in the
listing country
• The Depository issues a receipt against these
shares
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 CONTD
• Each receipt has a fixed number of shares usually 2
or 4
• The shares issued to the depository may be in
physical possession of another
• Intermediary called ‘custodian’ who acts as
depositor’s agent.
• The equity shares registered in the name of
depository are then issued in form of GDR to the
investors of that foreign country

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 CONTD
• ADR or GDR holders do not have voting rights and
therefore not bound by strict definition of foreign
ownership
• Two-way fungibility is permitted in GDRs whereby they are
freely convertible into Shares and back into GDRs without
restriction to the extent of the original issue size.
• The issue of GDR is governed by international laws

• Since GDR is also denominated in rupees, hence, GDR does

not carry any exchange risk as its face value is protected
against the exchange risk
• NRIs and foreign residents can buy GDR by using their
regular share trading account
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American Depository Receipts (ADR)

• Devised in the late 1920s to help Americans

invest in overseas securities. The main reason
for introducing ADRs were the complexities
involved in buying shares in foreign countries
and the difficulties associated with trading at
different prices and currency values.

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GDR v/s ADR​

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 Similar instruments
• Like ADR and GDR there are”Other depository
receipts” depending on the country where it’s
issued. Euro equity issued in European countries is
called as European Depository Receipts (EDRs) #3
• In Singapore is called as Singapore Depository
Receipts #4
• Debts raised in form of bonds from international
capital complying to regulations of the respective
country is called as Euro Debt.

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 Types of Euro Debt

• External Commercial Borrowings (ECB)

• Foreign Currency Convertible Bonds (FCCB)-

#Popular
• Foreign Currency Exchangeable Bonds (FCEB)

• Euro Bonds

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Foreign Currency Convertible Bonds
(FCCB)

• Foreign currency convertible bond (FCCB) is a

convertible bond issued by an issuer company
in a country whose currency different from its
own currency. A company can raise funds in
the form of foreign currency by this
instrument.
• FCCB are bonds issued in accordance with the
scheme defined by Ministry of Finance,
Government of India.

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 Salient features of FCCB

• The bonds are issued in a currency different from that

of the issuing country for the purpose of fundraising.
• FCCBs can be subscribed by a non- resident in foreign
currency
• They collectively act like debt and equity instruments
whereby regular payment of interest and a principal
payment on maturity is made.
• At the same time, these bonds also give the
bondholder the choice to convert them into ordinary
shares, either in whole or in part.

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 Common Terms in EURO
Issues
• Issuer: A company that plans to tap the foreign market through
DRs complying with the global issue mechanism. The Issuer will,
along with the Lead Manager to the issue decide the following
issues, namely:
• Public private placement

• The number of GDRs/ADRs to be issued

• The issue price

• Lead Manager: The lead manager is the person responsible for

marketing the issue. He also advises the Issuer what type of
security should be issued like equity, bonds, FCCB along with the
rate of interest as per coupon rate, the price of the security
(conversion price), etc.

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 CONTD
• Co- Managers/ Underwriters

• They assist the Lead Manager in fulfilling his obligations

• Depository

• It is the bank authorized by the Issuer to issue GDRs/ADRs against the

issue of ordinary shares of the Issuer (the “Depository”). It is the
overseas agent of the Issuer

• Custodian

• It is the banking company (situated in India), acting as a custodian for

the ordinary shares of an Indian Company, issued by it against
GDRs/ADRs. The Custodian acts in coordination with the Depository. The
physical possession of the shares is with the Custodian.

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 CONTD
• Legal Advisors

• They assist the Issuer, Lead Manager, Co-Managers and the

Underwriters in the preparation of the prospectus,
depository agreement, indemnity agreement and
subscription agreement and help the Issuer to comply with
proper disclosures relating to the issue.
• Auditors

• The Issuer must appoint auditors who will prepare the

auditor’s report for inclusion in the prospectus, provide
requisite consent and comfort letters and reconcile the
Issuer’s accounts with International accounting standards
(the “Auditors”)

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 FCCBs vs FCEBs

• Fundamental differences between FCCBs and FCEBs.

• In the case of FCCBs, the bonds convert into shares of

the company that issued the bonds, while in the case
of FCEBs, the bonds are exchangeable for shares of
another company, i.e., the Offered Company.

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 Eurobond
• A Eurobond is a fixed-income debt instrument
(security) denominated in a different currency
than the local one of the country where the
bond's been issued. Hence, it is a unique type
of bond. Eurobonds allow corporations to
raise funds by issuing bonds in a foreign
currency.

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THANK YOU

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