Sources of Finance

Why businesses need finance

• Three reasons why businesses need finance
are:
• 1.Initial setting up
• 2. Day to day running
• 3. Expansion purpose
Sources of Finance
Business Growth
 Sources of Finance
• Sources of finance can be classified into:

– Internal sources (raised from within the

organisation)

– External (raised from an outside source)

 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.
• Sale of assets – can be a
double edged sword –
reduces capacity?
 Internal Sources
• There are five internal sources of finance:
– Owner’s investment (start up or additional capital)
– Retained profits
– Sale of stock
– Sale of fixed assets
– Debt collection
 Internal Sources
Owner’s investment
• This is money which comes Advantages
from the owner/s own • Doesn’t have to be repaid
savings • No interest is payable
• It may be in the form of
start up capital - used when
the business is setting up Disadvantages
• It may be in the form of • There is a limit to the
additional capital – perhaps amount an owner can
used for expansion invest
• This is a long-term source of
finance
 Internal Sources
Retained Profits
• This source of finance is Advantages
only available for a business • Doesn’t have to be repaid
which has been trading for • No interest is payable
more than one year
• It is when the profits made
are ploughed back into the Disadvantages
business • Not available to a new
• This is a medium or long- business
term source of finance • Business may not make
enough profit to plough
back
 Internal Sources
• This money comes in from
selling off unsold stock
• This is what happens in the
January sales
• It is when the profits made
are ploughed back into the
business
• This is a short-term source
of finance
Sale of Stock
Advantages
• Quick way of raising finance
• By selling off stock it
reduces the costs
associated with holding
them
Disadvantages
• Business will have to take a
reduced price for the stock
 Internal Sources
Sale of Fixed Assets
• This money comes in from Advantages
selling off fixed assets, such • Good way to raise finance
as: from an asset that is no
– a piece of machinery that is longer needed
no longer needed
• Businesses do not always
have surplus fixed assets Disadvantages
which they can sell off • Some businesses are
• There is also a limit to the unlikely to have surplus
number of fixed assets a assets to sell
firm can sell off • Can be a slow method of
• This is a medium-term raising finance
source of finance
 Internal Sources
Debt Collection
• A debtor is someone who Advantages
owes a business money • No additional cost in getting
• A business can raise finance this finance, it is part of the
by collecting the money businesses’ normal
owed to them (debts) from operations
their debtors
• Not all businesses have Disadvantages
debtors ie those who deal • There is a risk that debts
only in cash owed can go bad and not be
• This is a short-term source repaid
of finance
 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
The existence of capital markets enable firms to raise
long term loans and share capital. acquisition
 Sources of Long Term Financing
• 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 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
 Sources of Short Term Financing
• 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 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
Safeway – subject to a £3 billion takeover by
control of the other, Morrisons. Securing the £3 billion necessary is a
specialist job.
the firm taken over
may lose its identity
 External Sources
• There are eight external sources of finance:
– Bank Loan or Overdraft
– Additional Partners
– Share Issue
– Leasing
– Hire Purchase
– Mortgage
– Trade Credit
– Government Grants
 External Sources
Bank Loan
• This is money borrowed Advantages
at an agreed rate of • Set repayments are
interest over a set spread over a period of
period of time time which is good for
• This is a medium or budgeting
long-term source of Disadvantages
finance • Can be expensive due to
interest payments
• Bank may require
security on the loan
 External Sources
Bank Overdraft
• This is where the business is
allowed to be overdrawn on
its account
• This means they can still
write cheques, even if they
do not have enough money
in the account
• This is a short-term source
of finance
Advantages
• This is a good way to cover
the period between money
going out of and coming into
a business
• If used in the short-term it is
usually cheaper than a bank
loan
Disadvantages
• Interest is repayable on the
amount overdrawn
• Can be expensive if used over
a longer period of time
 External Sources
Additional Partners
• This is sources of finance Advantages
suitable for a partnership • Doesn’t have to be repaid
business • No interest is payable
• The new partner/s can Disadvantages
contribute extra capital • Diluting control of the
partnership
• Profits will be split more
ways
 External Sources
Share Issue
• This is sources of finance Advantages
suitable for a limited • Doesn’t have to be repaid
company • No interest is payable
• Involves issuing more
Disadvantages
shares
• Profits will be paid out as
• This is a long-term source
dividends to more
of finance shareholders
• Ownership of the
company could change
hands
 External Sources
• This method allows a
business to obtain assets
without the need to pay a
large lump sum up front
• It is arranged through a
finance company
• Leasing is like renting an
asset
• It involves making set
repayments
• This is a medium-term
source of finance
Leasing
Advantages
• Businesses can have the use
of up to date equipment
immediately
• Payments are spread over a
period of time which is
good for budgeting
Disadvantages
• Can be expensive
• The asset belongs to the
finance company
• This method allows a
business to obtain assets
without the need to pay a
large lump sum up front
• Involves paying an initial
deposit and regular
payments for a set period of
time
• The main difference
between hire purchase and
leasing is that with hire
purchase after all
repayments have been
made the business owns
the asset
• This is a medium-term
source of finance
External Sources
Hire Purchase
Advantages
• Businesses can have the use of
up to date equipment
immediately
• Payments are spread over a
period of time which is good
for budgeting
• Once all repayments are made
the business will own the asset
Disadvantages
• This is an expensive method
compared to buying with cash
 External Sources
Mortgage
• This is a loan secured on Advantages
property • Business has the use of the
• Repaid in instalments property
over a period of time • Payments are spread over a
typically 25 years period of time which is good for
• The business will own budgeting
the property once the • Once all repayments are made the
final payment has been business will own the asset
made
Disadvantages
• This is a long-term • This is an expensive method
source of finance compared to buying with cash
• If business does not keep up with
repayments the property could be
repossessed
 External Sources
Trade Credit
• Trade credit is nothing but Advantages
the credit given to a • Business can sell the goods first
business by their and pay for them later
creditors/ suppliers. It • Good for cash flow
allows a business to delay
• No interest charged if money is
its payments for some
paid within agreed time
period. The period of
credit depends on the Disadvantages
credit terms between the • Discount given for cash payment
business and the would be lost
suppliers. • Businesses need to carefully
• This is a short-term source manage their cash flow to ensure
of finance they will have money available
when the debt is due to be paid
 External Sources
Government Grants
• Government Advantages
organisations such as • Don’t have to be repaid
Invest NI offer grants to Disadvantages
businesses, both
• Certain conditions may
established and new
apply eg location
• Usually certain
• Not all businesses may
conditions apply, such
as where the business be eligible for a grant
has to locate
 Short-Term Vs. Long-Term Financing
• Short-term financing tends to be riskier than long-term
financing:
– Uncertainty concerning future rates.
– May not be able to renew.
• Use of short-term financing, however, may lead to higher
returns:
– Most frequently, short-term rates are lower than long-
term rates (i.e., the term structure is normally upward
sloping)
– Flexibility: When financing is not required, short-term
debt can be paid off.
 Factors Affecting Choice of
Source of Finance
• The source of finance chosen will depend on a
number of factors:
– Purpose – what the finance is to be used for
– Time Period – how long the finance will be needed
for
– Amount – how much money the business needs
– Ownership and Size of the business
Business Angels
 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
Venture Capital
 VENTURE CAPITAL DEFINITION
• VENTURE CAPITAL IS A SUBSET OF PRIVATE EQUITY,
MADE FOR THE LAUNCH, EARLY DEVELOPMENT OR
EXPANSION OF A BUSINESS.

• PRIVATE EQUITY IN THE SENSE OF VENTURE CAPITAL

PROVIDES EQUITY CAPITAL TO ENTERPRISES NOT
QUOTED AT THE STOCK MARKET. THE MONEY CAN BE
USED TO DEVELOP NEW PRODUCTS AND
TECHNOLOGIES, TO EXPAND WORKING CAPITAL, TO
MAKE ACQUISITIONS, OR TO IMPROVE A COMPANIES
GEARING-UP. IT IS ALSO USED TO RESOLVE OWNERSHIP
AND MANAGEMENT ISSUES AS THE SUCCESSION IN
FAMILY-OWNED COMPANIES OR THE BUY-OUT OR BUY-
IN BY EXPERIENCED MANAGERS.
• Venture Capital means Funds made available
for startup firms and small businesses with
exceptional growth potential. Managerial and
technical expertise are often also provided.
also called risk capital.
 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
 KEY ELEMENTS OF VENTURE CAPITAL
THE KEY ELEMENTS ARE:
1. INVESTMENTS IN UNQUOTED COMPANIES
2. IS EQUITY CAPITAL BY NATURE
3. IS MEDIUM TO LONG-TERMS TARGETED AT COMPANIES
WITH GROWTH POTENTIAL
4. IS COMBINED WITH AN ACTIVE SHAREHOLDER INFLUENCE
BY THE INVESTOR

AMONG DIFFERENT COUNTRIES, THERE ARE VARIATIONS IN

WHAT IS MEANT BY VENTURE CAPITAL AND PRIVATE EQUITY.
IN EUROPE, THESE TERMS ARE GENERALLY USED
INTERCHANGEABLY AND VENTURE CAPITAL THUS INCLUDES
THE FINANCING OF MANAGEMENT BUY-OUTS AND BUY-
INS.
 INVOLVED PARTIES
RETURNS RETURNS
MANAGEMENT
SKILLS

MONEY MONEY
VC
INVESTORS INVESTEE
COMPANIES

MARKET ACCESS

EXTERNAL MANAGERS