Business (9609) | Sources of finance

AS & A Level Business (9609) Study Notes: 5.2 Sources of Finance

Hello future Business leaders! Welcome to one of the most practical and crucial topics in finance: Sources of Finance. Every business, from a tiny startup to a massive multinational corporation, needs money to operate, survive, and grow. This chapter is all about understanding where that money comes from and how a business decides which source is best. Mastering this will not only help you ace the exam but also give you vital insight into real-world business decision-making!

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5.2.2 The Great Divide: Internal vs. External Sources

When a business needs cash, it has two main places to look. Think of it like a student needing money: you can either find it in your desk (internal) or ask your parents or the bank (external).

A. Internal Sources of Finance

These sources are generated within the business itself. They do not increase the business's debt or involve new owners.

Key Internal Sources:

1. Owners’ Investment (or Personal Savings):
• What is it? Money injected by the owner(s) (especially common in sole traders and partnerships).
• Pro: No interest to pay; full control remains with the owner.
• Con: Limited amount available; carries high personal risk (unlimited liability often applies).

2. Retained Earnings (or Retained Profit):
• What is it? Profit kept back in the business after all costs, taxes, and dividends to shareholders have been paid. This is the most important internal source for established businesses.
• Pro: Free (no interest or repayment date); flexible use.
• Con: Only available if the business is profitable; may cause shareholder dissatisfaction if dividends are reduced.

3. Sale of Unwanted Non-Current Assets:
• What is it? Selling assets that are no longer needed (e.g., old machinery, vehicles, or unused land).
• Pro: Generates a lump sum of cash immediately.
• Con: Once sold, the asset cannot be used again; the book value might be lower than expected, leading to a loss on disposal.

4. Sale and Leaseback:
• What is it? Selling an asset (like a building or expensive machine) to a financial institution, then immediately leasing it back. The business gets a lump sum of cash but retains the use of the asset.
• Pro: Rapid cash injection while maintaining use of the asset.
• Con: Monthly lease payments must be made (a long-term cost); the business loses ownership of the asset.

5. Working Capital Management:
• What is it? Improving the flow of cash internally, for example, by reducing the time given to customers to pay (trade receivables) or running down inventory levels.
• Pro: Improves liquidity and immediate cash flow.
• Con: Chasing customers too aggressively can harm relationships; reducing inventory risks running out of stock (stock-outs).

B. External Sources of Finance

These sources come from outside the business. They usually involve either incurring debt (loans) or giving up a portion of ownership (equity).

1. External Finance - Equity (Giving Ownership)

Share Capital (or Equity Finance):
• What is it? Money raised from selling shares to investors. Crucial for private limited companies (Pvt Ltd) and public limited companies (PLC).
• Pro: Does not have to be repaid; dividends are flexible (not fixed costs like interest).
• Con: Owners lose control (dilution of ownership); PLC shares are highly scrutinised by the public market.

New Partners:
• What is it? In partnerships, new partners invest capital in exchange for a share of the profits and management responsibilities.
• Pro: Brings in new skills and capital.
• Con: Existing partners must share profits and control.

Venture Capital:
• What is it? Funds provided by investors (venture capitalists) to small businesses or start-ups with exceptional growth potential, usually in exchange for equity (shares).
• Pro: Significant funds and professional business advice provided.
• Con: Venture capitalists demand a high return and usually require a significant stake in the business.

Crowdfunding:
• What is it? Raising small amounts of money from a large number of people, typically online. This can be equity-based (giving shares) or rewards-based (giving a product in advance).
• Pro: Good way to test market demand and gain publicity.
• Con: If the campaign fails, no money is received; sharing the idea publicly means competitors can copy it.

2. External Finance - Debt (Taking Loans)

Bank Loans and Mortgages:
• What is it? Fixed sums borrowed from a bank, repaid over a set period with interest. A mortgage is a long-term loan secured against property.
• Pro: Fixed repayment schedule allows for easy planning; control remains with current owners.
• Con: Interest must be paid regardless of profit; collateral (security) is often required.

Bank Overdrafts:
• What is it? A bank allows the business to temporarily spend more money than is in its account, up to an agreed limit.
• Pro: Highly flexible; only used when needed (ideal for short-term working capital needs).
• Con: High interest rates; bank can demand repayment at very short notice.

Debentures:
• What is it? Long-term loan certificates issued by limited companies to raise large sums of money. Debenture holders are creditors (lenders), not owners.
• Pro: Interest is tax deductible; control is not diluted.
• Con: Must be repaid on maturity; interest payments are fixed and mandatory.

Leasing and Hire Purchase (HP):
• What is it? Leasing means renting assets long-term (e.g., equipment). HP means buying assets by paying installments, where ownership transfers only after the last payment.
• Pro: Avoids a large upfront cost; good for assets that depreciate quickly.
• Con: Total cost is often higher than outright purchase (leasing payments/HP interest).

Trade Credit:
• What is it? When suppliers allow a business to buy goods now and pay for them later (usually 30 to 90 days).
• Pro: Very short-term, interest-free source of finance.
• Con: If payment is late, relationships with suppliers are damaged, and future discounts might be lost.

Debt Factoring:
• What is it? Selling trade receivables (invoices owed by customers) to a specialist agency (a factor) for immediate cash (usually 80-90% of the invoice value).
• Pro: Immediate cash injection, improving liquidity.
• Con: The business loses a percentage of the money owed (the fee charged by the factor).

Micro-finance:
• What is it? Providing very small loans to entrepreneurs or small businesses in developing economies that cannot access traditional bank loans.
• Pro: Accessible to the very poor; encourages enterprise.
• Con: Interest rates can sometimes be high due to administrative costs and risk.

Government Grants:
• What is it? Funds provided by the government, often for specific purposes like training, innovation, or locating in certain areas.
• Pro: Does not need to be repaid.
• Con: Often restrictive (must be used for a specific purpose); application process is usually long and complex.

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5.2.1 Business Ownership and Sources of Finance

The legal structure of a business severely limits or expands its financing options.

1. Sole Traders and Partnerships:
• Rely heavily on internal sources (owners' investment, retained earnings).
• Can get bank loans, but often need to secure them using personal assets because they have unlimited liability.
• Cannot sell shares (equity) to the public.

2. Private Limited Companies (Ltd):
• Have limited liability, making banks more willing to lend.
• Can sell shares, but only privately to invited friends or family, not to the general public.
• Can issue debentures.

3. Public Limited Companies (PLC):
• Have the widest range of options.
• Can raise huge amounts of capital through an Initial Public Offering (IPO) by selling shares on the stock market.
• Have access to large bank loans and can easily issue debentures and bonds.

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5.2.3 & 5.2.4 Choosing the Right Source: Key Factors

When selecting a source of finance, managers must assess the appropriateness of each possible source in a given situation. This is the crucial part for analytical and evaluative questions!

Use the mnemonic CF ULC to remember the factors influencing choice:

Cost | Flexibility | Use | Level of existing debt | Control

1. The Use to Which It Is Put (Matching the Source and Need)

• This is often called the Golden Rule of Finance: Match the length of the source to the length of the need.
• Example: Buying a long-lasting machine (capital expenditure, long-term need) should be financed by long-term sources (e.g., share capital, bank mortgage, debentures).
• Example: Paying a sudden utility bill (revenue expenditure, short-term need) should be financed by short-term sources (e.g., bank overdraft, trade credit).

2. Cost

• This includes not just the interest rate, but also administrative fees or the opportunity cost.
• Debt has a fixed cost (interest), which is mandatory. Equity (shares) has a variable cost (dividends), which is discretionary but can be expensive if the business is highly profitable.
• Common Mistake: Don't forget the opportunity cost of retained earnings—the owner or shareholder might have used that money elsewhere.

3. Level of Existing Debt (Gearing)

• If a business already has a high level of debt (it is highly geared), taking on more loans makes it riskier. Banks may refuse or charge very high interest rates.
• Highly geared businesses often need to look for equity finance to reduce their reliance on mandatory debt repayments.

4. Need to Retain Control

• Debt finance (loans, debentures) allows current owners to retain 100% control.
• Equity finance (selling shares) means new owners (shareholders) gain voting rights, which dilutes the original owners’ control and decision-making power. Sole traders and partners value control highly.

5. Flexibility

• How quickly can the finance be accessed? (An overdraft is fast; selling shares takes months.)
• Can the finance be paid back early without penalty? (Bank loans are often less flexible than overdrafts or trade credit.)

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Summary Checklist

You should now be able to distinguish between:

• Short-term needs (working capital) and long-term needs (capital expenditure).
• Internal sources (retained earnings, asset sales) and external sources (loans, shares).
• Equity finance (shares, venture capital) and Debt finance (loans, debentures).

Remember that the form of business ownership fundamentally limits the available options, and the final decision must always be appropriate given the cost, control, and intended use of the funds!