Sources of Finance

Quick revise

Sources of finance

These are how businesses get money to finance growth, to overcome working capital / cash flow problems etc.

Choosing the right source of finance
  • Businesses need to consider a number of factors when deciding what sources of finance to use
  • External sources of finance are more expensive as you need to pay interest
  • To use retained profits you need to get agreement from shareholders
  • The source of finance chosen also depends on the time period and what you need the finance for

The key questions that managers have to answer are:

  • how much finance is needed
  • whether it can be obtained internally
  • whether it should be borrowed temporarily, with a view to paying back, or obtained as permanent (e.g. share) capital
  • (if borrowed) whether the loan is for the short (up to one year), medium (1–5 years) or long term.

The amount and nature of this finance varies from firm to firm, and is influenced by a firm’s size, its form of ownership, the type of technology currently being used within the firm, the relationship between capital and labour, the length of credit periods (taken and allowed), and the age of the firm’s assets.

Internal sources

  • From inside the business e.g. directors
  • No external body to pay Generally
  • No time limit

Internal Sources - Retained Profit

  • Cheap and flexible
  • Technically profit is shareholders so they need convincing its used effectively
  • Usually okay infrequently
  • Idea retained profit used to generate future profits and therefore used for purchase of fixed assets
  • Opportunity cost needs to be assessed

Internal Sources - Control of working capital and cashflow

  • Working capital measures the amount of money the business has to pay day-to-day expenses
  • Working capital = current assets – current liabilities
  • Businesses need to be aware of their working capital and ensure that they have enough cash to survive
  • Stock and debtor control – arranging appropriate credit terms
  • Liquidity – need to manage assets to ensure that the business has sufficient liquidity (ease of converting assets to cash)
  • Stock needs to be valued correctly
  • Need to ensure are not holding excess stocks or excess cash
Internal Sources - Sales of Assets
  • This can allow business to develop more profitable ventures
  • If in crisis can sell fixed assets but will lead to a decrease in profitability in long term
  • In principle the sale of these assets should allow a firm to increase its level of profit
Internal Sources - Sale and Leaseback
  • This allows the organisation to receive a cash payment – improving short term cash flow
  • But have to rent the asset which may reduce profit long term
  • If cash used to buy more profitable assets the cost of rental is covered
External sources
  • From outside the business
External Sources of Finance – Long Term

Share Capital

  • Limited companies can issue shares
  • Share holders receive dividends
  • Shares can be
    • - Preference shares – fixed % dividend
    • - Ordinary shares – risk capital / equity

Loan Capital

  • Providers of loans = creditors
  • Four main types of loan capital:
    • - Debentures – long term loan to the business at an agreed fixed % of interest repayable on a stated date. Up to 25 years.
    • - Mortgages – used to purchase property. Up to 25 years Long term loans – provided by specialist organisations
    • - Government assistance – selective and takes form of grants generally
External Sources of Finance – Medium Term
  • Bank loans
  • Leasing
  • Hire purchase
External Sources of Finance – Short Term
  • Bank overdrafts – agreed limit, stated time period
  • Trade credit – suppliers allow time period before money is due
  • Debt factoring – business receives immediate payment for credit sales