BAFS Study Notes: Sources of Financing
Hey everyone! Welcome to your study notes for "Sources of Financing". Don't worry, this topic sounds more complicated than it is. Think of it this way: just like we sometimes need extra money for a new phone or a trip, businesses also need money to start, grow, and operate every day. In this chapter, we'll explore all the different ways a business can get that money, or financing. Understanding this is super important because choosing the right source of money can be the difference between a business succeeding or failing. Let's get started!
1. The Three Big Questions of Financing
When a business needs money, it's not as simple as just asking for it. We need to classify the different types of money available. The easiest way to do this is by asking three key questions:
1. Does the money come from inside or outside the business? (Internal vs. External)
2. Is it borrowed money or are we selling a piece of the company? (Debt vs. Equity)
3. Do we need it for a short time or a long time? (Short-term vs. Long-term)
Let's break each of these down. It's easier than you think!
2. Internal vs. External Financing
This is all about where the money originates from. Is the business using its own piggy bank, or is it asking someone else for help?
Internal Financing: Using Your Own Money
This is when a business generates funds from its own operations or from its owners. It's like using your own savings from your lai see money instead of asking your parents.
Common Sources of Internal Finance:
Retained Profits: This is the number one source for many businesses. It’s the profit that the company decides to keep and reinvest back into the business, instead of paying it all out to the owners. It's like a business saving its own pocket money for a future goal.
Owners' Capital: For smaller businesses like sole proprietorships or partnerships, this is the personal savings the owners put into the business to get it started or to help it grow.
Pros and Cons of Internal Financing:
Pros:
- No Interest or Repayments: It's the company's own money, so there's no need to pay it back.
- Maintain Control: Owners don't have to give up any ownership or control to outsiders.
- Quick and Simple: It's readily available without a long application process.
Cons:
- Limited Amount: There's a limit to how much profit a company makes or how much savings an owner has. It might not be enough for big expansion plans.
- Opportunity Cost: The money could have been used for something else, like paying dividends to owners.
External Financing: Getting Help from Others
This is when a business gets money from individuals or institutions outside of the business. It’s like borrowing money from a bank or asking new partners to invest.
Common Sources of External Finance:
Bank Loans: Borrowing a specific amount of money from a bank, which is paid back over time with interest.
Issuing Shares: Selling ownership stakes in the company to investors.
Debentures: A type of long-term loan from investors instead of a bank.
Trade Credit: Getting goods from a supplier and paying for them later (e.g., in 30 or 60 days). This is a very common form of short-term financing!
Pros and Cons of External Financing:
Pros:
- Can Raise Large Amounts: It allows businesses to fund major projects that they couldn't afford with internal funds alone.
- Access to Expertise: New investors might bring valuable skills and contacts.
Cons:
- Costly: You usually have to pay interest on loans or share profits with new owners.
- Loss of Control: Selling shares means the original owners have less control over the business.
- Complex Process: Applying for loans or issuing shares can be time-consuming and require a lot of paperwork.
Key Takeaway: Internal vs. External
Internal financing is using the business's OWN money (like retained profits). It's cheap and you keep control, but it's limited. External financing is getting money from OUTSIDERS (like banks or new investors). You can raise a lot more money, but it comes with costs and you might lose some control.
3. Debt vs. Equity Financing
Don't worry if this seems tricky at first! This is one of the most important concepts. It’s about the fundamental difference between borrowing money and selling a part of your company.
Debt Financing: The Borrower
With debt financing, you are borrowing money that you promise to pay back later, almost always with interest. The person or bank who lends you the money is a lender, not an owner.
Analogy: Think of a school loan. The bank gives you money for your education, and you have to pay it back with interest after you graduate. The bank doesn't own a part of your future career!
Key Features of Debt:
Repayment is Required: The principal amount and interest must be paid back by a set date.
No Loss of Ownership: The lenders do not get any ownership or voting rights in the company.
Interest is an Expense: The interest paid on a loan is a business expense, which can reduce the amount of tax the company has to pay.
Examples:
Bank loans, bank overdrafts, trade credit, debentures.
Equity Financing: The Partner
With equity financing, you are selling a piece of your company (shares) to investors in exchange for their money. These investors become part-owners, also known as shareholders.
Analogy: You and your friends want to buy a big pizza. You don't have enough money, so you ask another friend to chip in. In return, they get a slice of the pizza and a say in what toppings to get. You don't have to "pay them back", but they now co-own the pizza with you.
Key Features of Equity:
No Repayment Required: The money is not a loan, so it doesn't have to be paid back.
Investors Get Ownership: Shareholders are owners. They have a right to vote on company matters and receive a share of the profits (called dividends).
Sharing Profits: If the company does well, you have to share the profits with all the shareholders.
Examples:
Issuing ordinary shares to new investors.
Quick Review: Debt vs. Equity
Who provides the money?
Debt: Lenders (Creditors)
Equity: Owners (Shareholders)
Do you pay it back?
Debt: Yes, with interest.
Equity: No, it's an investment.
Do you lose ownership?
Debt: No.
Equity: Yes, ownership is diluted.
What do they get in return?
Debt: Interest payments.
Equity: A share of the profits (dividends) and potential increase in share value.
Key Takeaway: Debt vs. Equity
Debt is like a loan. You get money now, but you have a legal obligation to pay it back later. You keep full ownership. Equity is like getting a new partner. You get money you don't have to pay back, but you give up some ownership and control.
4. Short-term vs. Long-term Financing
This classification is all about the time frame. How long will the business need the money for?
Short-term Financing (usually repaid within one year)
This is used to finance the day-to-day operations of a business, also known as its working capital. It helps manage temporary cash flow gaps.
Analogy: It’s like using your Octopus card for daily expenses like MTR fares and buying snacks. You top it up and use it for small, regular needs.
Purpose:
- To buy inventory (stock) that will be sold quickly.
- To pay wages and electricity bills.
- To cover the gap between selling goods and receiving payment from customers.
Examples:
Bank overdrafts, trade credit, short-term loans.
Long-term Financing (usually repaid over several years)
This is used to finance major, long-term investments or projects that will help the business grow over many years.
Analogy: It’s like getting a mortgage to buy a flat. It’s a huge purchase that you will pay back over a very long time, like 20 or 30 years.
Purpose:
- To buy non-current assets like buildings, machinery, or vehicles.
- To fund a major expansion into a new market.
- To finance the research and development of a new product.
Examples:
Long-term bank loans, issuing shares (equity), issuing debentures (debt).
Key Takeaway: Short-term vs. Long-term
The golden rule here is the matching principle: Match the term of the financing to the life of the asset. Use short-term finance for short-term needs (like inventory) and long-term finance for long-term investments (like a factory).
5. How to Choose? Principles for Selecting a Financing Method
So, with all these options, how does a company decide which one to use? There is no single "best" way. Managers must think carefully and consider several factors. We can remember these factors with the word C.A.R.E.
C - Cost
How much will the financing cost the business? This isn't just about interest rates.
- For debt, the cost is the interest you must pay.
- For equity, the cost is the dividends you might have to pay and the share of ownership you give up.
A - Amount and Purpose
How much money is needed and what is it for?
- If you only need a small amount for a short period (e.g., to pay a supplier), a bank overdraft (short-term debt) might be best.
- If you need a huge amount to build a new factory (a long-term project), then a long-term loan or issuing shares (long-term financing) would be more suitable. This is the matching principle in action!
R - Risk
How much risk does this financing option add to the business?
- Debt financing is riskier for the company's cash flow because interest and principal payments are a fixed legal commitment. If the company has a bad year, it STILL has to make these payments or it could go bankrupt.
- Equity financing is less risky. If the company makes no profit, it is usually not obliged to pay dividends. Shareholders share both the rewards and the risks.
E - Effect on Control
Will the current owners lose control of the business?
- With debt financing, the owners keep 100% of their control. The lender has no say in how the business is run (as long as payments are made).
- With equity financing, the original owners' control is diluted. New shareholders get voting rights and can influence major decisions. For many entrepreneurs, keeping control is extremely important.
Common Mistake to Avoid!
A classic mistake is violating the matching principle. For example, using a short-term overdraft to buy a new machine that will last 10 years. The company will have to repay the overdraft quickly, but the machine will only generate income slowly over its 10-year life. This mismatch can cause a serious cash crisis!
Final Summary
Great job! You've learned the main ways businesses get money. Just remember the three key ways to classify financing (Internal/External, Debt/Equity, Short/Long-term) and the C.A.R.E. factors for making the right choice. Every business situation is different, so the best financing choice always depends on the specific circumstances. You've got this!