Sources of Finance

— Business Studies · Finance —

Note: Made from the teacher's board pages. Everything written on the board is included; a word marked (?) was hard to read.

1. What are Sources of Finance?

Definition: Sources of finance → the ways a business gets money whenever it is in need of finance → this need is called the financial purpose.

Methods (two main types)

internal = from inside the business · external = from outside it

Internal: within an organisation → by the involvement of internal stakeholders.
External: outside an organisation → by the involvement of external stakeholders.

2. Internal Sources of Finance

① Retained profit

Retained profit = earning of the business → the remaining profit kept in the business → a private source of capital.

PLC profit must be shared between dividends (shareholders) and retained profit (business)

Conflict (PLC): shareholders want dividends ↑ but the business wants retained profit ↑ to reinvest — the two pull in opposite directions.

Example — Business A vs Business B (both: gross profit $50m)

	A (has interest)	B ✓ (no interest)
Gross profit	$50m	$50m
Expenses	($10m)	($10m)
Net profit	$40m	$40m
Interest	($1m)	none
Profit after interest	$39m	$40m
Tax @ 10%	$3.9m	$4.0m
Left after tax (my working)	$35.1m	$36.0m

Board slip: the board labels the $39m as “PAT”, but that is profit after interest, before tax. After 10% tax A keeps $35.1m, B keeps $36.0m → B (ticked on the board) has more to reinvest. The last row is my working; the board stopped at the tax figures.

Points noted for retained profit

✓ No repayment is required.
✓ No interest payable.
✗ Less amount / no amount is available to small businesses.
✓ No loss of secrecy.
✓ It does not require any procedure.

② Disposal of an unwanted non-current asset

Sell out → finance. The asset must be non-operational / excess: a fixed asset (e.g. machinery) that is not being used has cash tied up in it → sell it to release the cash.

② idle fixed asset → cash

④ over-stocking → cash

③ Owner's investment / owner's savings

The owner puts in own money → start-up capital.

For sole trader / partnership the exam wording is:

‘provision of additional capital’
‘further capital injection’

④ Reducing inventories / improving working capital

Inventory = stock. Over-stocking / high stock-holding → cash / finance is tied up. Reduce it → how? → offers / promotion → stock sold → cash released.

Working capital = Current assets − Current liabilities

improving working capital = managing these items better

⑤ Sale and leaseback

Situation:

there is a financial need
the business owns an operational non-current asset (still in use)
there are no other sources of finance

Example — Sonu (an individual):

owns a motor van used for pick & drop. Need for finance ✓, sources ✗.
① Sell out the motor van → finance
② Lease back the van → on a rental basis

sell the asset for cash, then rent it back to keep using it

Drawbacks: rent amount → fixed cost ↑ · loss of an asset.

Advantages & disadvantages of internal sources

(written by the teacher after the internal sources — apply to internal sources in general)

Advantages ✓

No repayment is required.
No interest payable.
Does not increase the gearing (existing debt).
Does not decrease the retained control.
Easily and quickly available.
No loss of secrecy (business plan).

Disadvantages ✗

Amount may be insufficient for high-cost capital expenditure.
Amount may be available only for short-term purposes → payback is quick.
It may affect the internal budgeting.
No tax benefit.

3. External Sources of Finance

External sources → involve external stakeholders → outside the organisation.

① Bank (loan)

Amount borrowed from financial institutions → it is a debt = liability → must be repaid with interest.

Interest → controlled by the govt → central bank.

interest = finance income for the lender, finance cost for the borrower

Time period

bank loans (and other sources) are grouped by time period

Start-ups / small businesses do not qualify for it:

lack of collateral
no previous record
ineffective business plan

② Bank overdraft

Short-term source; bank checks the credit score.
A flexible source.
Used when the account has been overdrawn (more taken out than the balance).
Most expensive source → daily interest.

③ Trade credit

Credit purchases → when goods are bought on credit from the supplier (an external stakeholder).

✗ Start-ups do not get this facility.
✗ A delay in payment can lead to interest payable.
✓ Short-term source of finance.
✓ Flexible source.

④ Issue of shares

Only a PLC → shares = certificate of ownership. PLC issues shares → people buy → they become shareholders → finance for the company.

✗ Retain control ↓ (ownership is shared).
✗ Publishing cost of issuing shares.
✗ Dividends payable ↑.

⑤ Issue of debentures

Debenture = long-term loan certificate = Bond. Limited companies issue debentures → liability ↑ → finance.

① Interest is paid on it.
② Certificate → proof of the loan.

⑥ Micro-finance

A very small amount of money provided to micro-scale owners / unemployed individuals.

In developing countries: → GDP ↑.

⑦ Debt factoring

Selling of business debts / receivables to a third-party organisation against a commission.

business gets cash now; third party collects the debts

⑧ Mortgage

Provision of collateral (security) against the loan.

⑨ Crowd-funding

Raise finance from a group of individuals — like ‘Chanda’ — using internet / technology.

Platform: kickstarter.com
Examples (green on board): Allbirds, Filippo Loreti (?)

4 types: ① Donation · ② Debt-based · ③ Equity-based · ④ Reward-based

many small contributions add up to the finance needed

⑩ Venture capital

For a start-up / newly born business → risk ↑ → failure ↑.
Providers: venture capitalist, angel investor (like Shark Tank).
Mixture: Equity + Debt → equity = ownership, debt = liability.

Extra benefit: in this source the venture gets ideas, skills, time and name of the venture capitalist.

the investor gives money and expertise; takes ownership + a liability claim

⑪ Hire purchase vs ⑫ Leasing

	⑪ Hire purchase	⑫ Leasing
Amount	↓ (smaller)	↑ (larger)
Used for	machinery, motor vehicle	land, building, factory
Paid how	HPA, down payment, then monthly instalments + interest	rental basis / rental amount
Ownership	will be transferred	does not transfer
Type	financial leasing	operational leasing
Parties / extras	—	lessor → provides; lessee → acquires (uses); updation cost; legal contract

Board wording: the board writes “HPA → hire purchase authority”; the usual term is hire purchase agreement.

4. The Concept of Equity vs Debt Financing

	Equity financing	Debt financing
Example	issue of shares ← PLC	bank loan
Nature	Ownership	Liability
Repayment	no repay	must repay
Return	variable return	fixed interest
Effect	ownership ↓ / retain control ↓	existing debt ↑

5. Factors Affecting the Sources of Finance

Which source a business picks depends on these factors:

colour on board: green = control & debt · red = cost & legal · blue = amount, purpose, time

Gearing / existing debt — a source that adds debt raises gearing.
Retain control — some sources (shares) reduce control.
Finance cost — interest rate (loans) · publishing cost (shares).
Amount required · Purpose (revenue vs capital expenditure) · Time period (short-term / long-term).
Legal structure — sole trader, partnership, Pvt Ltd co., PLC.
Collateral available → security for lenders.
Economic and market conditions — recession, growth.

Quick Recap — Cheat-Sheet

✓ Internal sources (within the org)

① Retained profit — remaining earnings; PLC: dividends vs retained = conflict
② Disposal of unwanted non-current asset — idle machinery → cash
③ Owner's investment / savings — ‘provision of additional capital’ / ‘further capital injection’
④ Reducing inventories / improving working capital — offers / promotion
⑤ Sale and leaseback — sell asset, rent it back (fixed cost ↑, loss of asset)

✓ External sources (outside the org)

① Bank loan — debt, repay + interest; short-term ≤ 3 yrs / long-term 3–5 yrs
② Overdraft — short-term, flexible, most expensive (daily interest)
③ Trade credit — buy on credit from supplier; short-term, flexible
④ Issue of shares — PLC; control ↓, publishing cost, dividends ↑
⑤ Debentures — long-term loan certificate / bond; interest; liability ↑
⑥ Micro-finance — tiny sums to micro-scale owners / unemployed; GDP ↑
⑦ Debt factoring — sell receivables to third party for commission
⑧ Mortgage — collateral (security)
⑨ Crowd-funding — group of individuals via internet; donation / debt / equity / reward
⑩ Venture capital — equity + debt; gets ideas, skills, time, name
⑪ Hire purchase — ownership transferred · ⑫ Leasing — rental, no transfer

Working capital = Current assets − Current liabilities

✓ Equity vs Debt & factors

Equity = ownership, no repay, variable return, control ↓ · Debt = liability, repay, fixed interest, debt ↑
Factors: gearing · retain control · finance cost · amount · purpose · time period · legal structure · collateral · economic conditions