1. finance

SOURCES OF FINANCE
IB BUSINESS & MANAGEMENT
A Course Companion (2009)
P146-157 (Clark Edition)
SOURCES OF FINANCE
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• All businesses require funding for their
activities.
• For example – a loan to purchase a new
computer system or a bank overdraft to pay
suppliers before the receipt of customers
cash.
• Just like people, organizations require a
variety of funding for a range of purposes.
Factors to consider when
choosing finance:
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• A business should match the source of finance to
its specific use – in practice this means that a
business should secure long-term sources of
finance for long term uses or needs and for more
short term finance immediate needs.
• The cost of the source.
• The organization’s objectives.
• The flexibility and availability of the finance, for
example, how easy it is to switch from one form
of funding to another, or whether a particular
form of finance is available for a new business
with no trading record.
Factors to consider when
choosing finance:
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• The impact the new funding would have on
the organizations current financial structure,
for example, its balance sheet.
• The state of the external environment, for
example the economy and consumer trends.
• The type of business structure it is, for
example a sole trader or partnership can raise
funds from the stock market.
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INTERNAL SOURCES OF FINANCE
There are several sources of internal finance
for the business including:
• Retained Profit
• The Sales of Assets
• Utilizing working capital more
effectively
• Depreciation
INTERNAL SOURCES OF FINANCE 6
Retained Profit
• This is one of the most important sources of
business finance.
• It represents the profits generated from sales
after interest payments to lenders, taxes to
the government and payments to
shareholders in the form of dividends.
• The remaining profit is then retained or put
back into the business and available for future
spending by the organization.
INTERNAL SOURCES OF FINANCE 7
Retained Profit
Advantages of using Retained Profit
• The advantages of retained profit are that
there are no associated borrowing costs and
that businesses do not see a rise in debt levels
(gearing).
• The owners control is not diluted and
decisions are not vetted by lenders (banks)
INTERNAL SOURCES OF FINANCE 8
Retained Profit
The Disadvantage of using Retained Profit
• The disadvantages are that the owners may take
out all the organization’s spare cash and there
will be no buffer if the business suddenly needs
cash or another market opportunity arises.
• Equally some businesses are more focused on
investment decisions when borrowing money,
but are more lax when using retained profits.
• There may no outsiders to be accountable to –
especially small and family run businesses with
no outside shareholders.
INTERNAL SOURCES OF FINANCE 9
The Sale of Assets
• Many large retail businesses that own lots of
property have decided to sell off their property
portfolio and raise fresh expansion capital or
cash.
• Supermarkets and banks are examples. They see
themselves as retailers not property developers.
• Companies may sell their assets to property
development or pension companies and then
lease then back for a fixed period of time and
rent.
INTERNAL SOURCES OF FINANCE 10
The Sale of Assets
The Advantage of Selling Assets
• The main advantage is having no associated
borrowing costs or debts.
Disadvantages of Selling Assets
• The business can only sell off the `family
silver` once, so it needs to care what is sells
and how wisely it uses its cash.
INTERNAL SOURCES OF FINANCE 11
The Sale of Assets
Sale and Leaseback Deals
• When setting up a sale and leaseback
situation, it is imperative that the lease allows
the business flexibility, for example, the new
landlord wants to sell the site in 10 years time
or up the rent above inflation.
• Will there be an adequate notice period in the
contract?
INTERNAL SOURCES OF FINANCE 12
Utilizing Working Capital more effectively
• Working capital is money tied up in the
business and used to finance its day to day
needs, such as buying raw materials.
• All businesses have a working capital cycle
that identifies how this money moves around
the business
Working CapitalManufacturing Case Study
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• The first part of the cycle starts with cash being spent on
raw materials.
• These materials become our stock, so the cash is now tied
up as unsold stock items.
• When the finished items of stock are finally sold to
customers, (on credit) these customers owe us money.
• They in effect become the debtors of the business.
• When paid, the debtors cash is returned to the business
and the cycle carries on in funding new stock or paying the
expenses the business (eg: paying suppliers or reducing our
bank deficit.
• If the business is making a profit some of this cash may be
kept in the business as retained profit and not spent in the
short term.
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Reducing our Working Capital Needs
• A possible source of finance is squeezing or
reducing our own working capital needs.
• Therefore the cash we need is more efficiently
used.
• Eg: IF we minimize our stock levels we reduce
the amount of money tied up in stock.
Just in Time Production (JIT)
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Reducing Working Capital Needs
• In modern customer manufacturing the concept of
producing just in time (JIT) and only to a specific order has
grown dramatically.
• Eg: When a customers orders a bed or dining table they
may in some cases have to be wait 2 to 4 weeks for
delivery.
• This is because some items are not held in stock by the
retailer or manufacturer – they are both minimizing their
working capital needs and the amount of money tied up in
the unsold stock.
• The consumer therefore pays upfront to the retailer and is
effect funding the retailing and manufacturing of the
product.
Early Payments Incentives
Reducing Working Capital Needs
• A business can ask its customers who
purchase goods on credit to pay more
promptly, by offering a financial incentive.
• Eg: A 5% discount for payment in 14 days and
this helps to reduce the funding needs from
the bank or shareholders.
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Delaying Payments to Creditors
Reducing Working Capital Needs
• A business can slow down payment to it
suppliers or creditors.
• Therefore a business can use resources for
longer without having paid for them.
• Suppliers or creditors are being asked to fund
more of our operation.
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MRP & MRP2
Reducing Working Capital Needs
• Better management of stock can be done
internally and without always affecting delivery
dates.
• Better MRP (Material Resource Planning) and
MRP2 (Manufacturing Resource Planning)
systems are making the ordering of stock
materials more efficient.
• These systems reduce the time that stock is left
unused and therefore reduce the amount of
money tied up in stock.
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The Advantages of
Reducing Working Capital Needs
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• The advantage of squeezing working capital as
a source of finance is that you do not have to
ask a bank or shareholders to give you more
money and on terms that may be expensive.
The Disadvantages of
Reducing Working Capital Needs
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• The disadvantage is that suppliers and
customers may not be happy waiting for
money or paying upfront for goods, especially
when competitors may be able to offer a
better delivery schedule for customers or
better payment terms to their suppliers.
• Caution has to be exercised and
communication with these two stakeholders is
paramount.
INTERNAL SOURCES OF BUSINESS FINANCE
Depreciation
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• Depreciation is a reduction in value of our assets,
which occurs naturally through wear and tear in
the production process of a business.
• Measuring this fall in value over time is not
always easy.
• There are two normal methods of calculating the
level of asset depreciation:
 The Straight Line Method
 Reducing Balance Method.
Straight Line Method of Depreciation
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Example
• A machine costs $500,000 to
purchase.
• Its useful life in our manufacturing
business is 10 years.
• After that we may be able to sell it to
a second hand dealer for $50,000.
This is called the Residual Value.
Straight Line Method of Depreciation
Example
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Annual Depreciation Value =
(Original Cost of Item – Residual Value)
Useful Life of Asset in Years
$500,000 – 50,000
10
= $45,000 depreciation
each year.
$50,000 – 4000
5
= 46000
5
= $9200
Straight Line Method of Depreciation
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• The straight line method is easy to calculate and
it gives us the same depreciation amount for each
year.
• However, the problem here is that with some
assets, the drop in value is not constant, but is
greater in the earlier years and less in the last
years of ownership.
• Assets where this is more common are cars and
vans, which lose a high amount of value once
they are driven offer the car outlet where they
are purchased (except in Venezuela!)
Reducing Balance Method of
Depreciation
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• The second method of depreciation – the
reducing balance method, attempts to take
account of this problem and weights the
depreciation more heavily in the earlier years.
How is depreciation a source of
finance?
(1)
By recognizing that assets lose value and by
attempting to identify how much each
assets falls in value, it is possible to set
aside cash year to replace each asset when
it is no longer of use to us.
(2)
In many countries depreciation is a major
tax deduction. Depreciation is recognized
as an expense which we can claim to reduce
our taxable income.
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Other Issues with Depreciation:
Inflation
• A major disadvantage is that depreciation
does not take into account the fall in
purchasing power over time due to inflation.
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EXTERNAL SOURCES OF FINANCE
(Long Term)
There are four main sources of external finance
in the long term:
• Share Capital
• Loan Capital
• Venture Capitalists
• Grants from Governments & other
philanthropic organizations.
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EXTERNAL SOURCES OF FINANCE
Share Capital
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• Share capital represents the monies that are
put into a company by investors, who are then
classified as shareholders.
• Note: Sole Traders and Partnerships don’t
have shareholders and this is not a relevant
source of finance for these organizations.
EXTERNAL SOURCES OF FINANCE
Share Capital
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• The original investment by the owners is often
used to fund the purchase of the organizations
initial assets and sometimes to fund the
working capital needs of the business while
other funding is organized.
• However, it is a long term source of finance
and therefore should be used for long-term
needs, such as purchasing machines or
computer systems or acquiring businesses.
EXTERNAL SOURCES OF FINANCE
Share Capital
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• When a business expands it can ask existing
shareholders to put more money into the
business and therefore new shares are issued in
proportion to the size of the increase in the share
capital.
• Note: When people buy and selling existing
shares, usually via a stock exchange, this does not
help the business with raising new capital, as it is
simply swapping ownership between people.
Advantages of Share Capital
as a Source of Finance.
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• The advantages with this sort of finance are there
are no interest payments and so no drain on
company profits.
• If existing shareholders increase their investment
by buying more share in proportion to the
current levels, there is no change in control.
• However, if new shares are bought by new
investors that may dilute the control of the
original shareholders.
Disadvantages of Share Capital
as a Source of Finance.
• The disadvantages are that shareholders may
still expect rewards in the form of dividends,
and this is paid for from profits.
• However, unlike the arrangement with loan
capital, if the business does not make a profit
and does not have a reserve of past profits, it
cannot be compelled to pay a dividend.
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A Share Capital or
Debt Capital Tradition
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• In countries such as the UK, the amount of share
capital used to fund business activities is rather
low relative to debt capital.
• This makes UK companies vulnerable to interest
rate rises, which can hit profits directly.
• In other countries, (eg: Japan & Germany) there
is a tradition of investing in share capital and this
makes for a more long term and perhaps more
stable financial structure.
EXTERNAL SOURCES OF FINANCE
Debt or Loan Capital
• Funding provided by outside banks and lenders is
generally referred to as debt or loan capital.
• It is usually provided for a fixed period of time, with
repayments evenly spread out over the length of the
loan.
• Interest is paid on the loan at regular intervals,
although interest rate holidays (where the lender
agrees not to take interest for a short period of time)
can be negotiated if the business is struggling to fund
the debt.
• Loan capital is provided for more than 1 year and so is
a long term form of finance.
• Any loan shorter than 1 year is classified as current
liabilities or debt.
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The Advantages of Loan Capital
• The advantage of this form of finance is that it
is often easier to access and use for specific
purposes like buying fixed assets, such as
machines or property.
• Payment is spread out over the useful
revenue-earning life of the asset.
• If the loan has a fixed interest rate, and
interest rates rise in the future, the loan could
be a very smart investment.
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The Disadvantages of Loan Capital
• The disadvantages is that lenders have to be paid even
if the business does not make a profit.
• Any default (not paying the loan on time) can lead to
the lender controlling future decision making, in effect
they call the shots.
• Equally if the loan is secured against an asset then the
asset can be seized if payments are missed.
• If the loan has fixed interest rate, and interest rates fall,
the business may find itself with a very undesirable
loan, that is a burden on the business.
• However, large and very profitable organizations may
be able to renegotiate terms with lenders.
EXTERNAL SOURCES OF FINANCE
Venture Capitalists
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• These are specialist bankers who are more
prepared to share the risks of starting a new
business enterprise than traditional banks.
• Venture capitalists invest in the share capital
of the business and provide loan capital for
the business.
• Venture capitalists only target companies with
great expansion or growth potential.
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Advantages of Venture Capitalists
• The advantages are that they often provide
business help and contacts - perhaps for export
drives or for identifying new technologies or
partners.
• They sit as non-executive directors to protect
their investments.
• They will ensure that there is a planned exit route
for the investment in maybe five to seven years,
often through a stock market floatation or via a
trade sale.
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Disadvantages of Venture Capitalists
• The disadvantages are many for the existing
shareholders as venture capitalists impose profit
or sales targets.
• If the businesses they invest in fail to expand as
planned the venture capitalists can automatically
increase their equity stakes, often from that of a
minority investor to being the controlling one.
• However, many organizations have used venture
capital successfully and benefited from the
business advice of their managers.
EXTERNAL SOURCES OF FINANCE 41
Grants from governments & other
philanthropic organizations
• This is a growth area.
• Governments, successful entrepreneurs such as Bill
Gates & large corporations keen on promoting their
social responsibilities, are all increasingly seeking to
help the smaller business sector with grants and soft
loans.
• Soft loans are loans with more relaxed payment terms
and lower than usual interest rates.
• While the sums may be small they can make a big
difference to a projects viability.
• Often the problem is identifying what grants are
actually available, although the internet has made the
research easier.
EXTERNAL SOURCES OF FINANCE
(Short Term)
There are several types of short term finance:
• Bank Overdraft
• Trade Credit
• Factoring
• Leasing.
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EXTERNAL SOURCES OF FINANCE (ST)
Bank Overdraft
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• Banks finance the short-term needs of businesses
by providing short term monies called overdrafts.
• An overdraft is repayable on demand and should
be used for short term funding needs, such as
when a business is waiting for customers to pay,
when it needs to pay suppliers upfront or when
staff have to be paid.
• When business find they are expanding very
quickly due to a successful sales drive they may
well find their overdraft rising as they await
receipts from customers.
EXTERNAL SOURCES OF FINANCE (ST)
Disadvantages of a Bank Overdraft 44
• The disadvantage is that the cost of an overdraft will
vary as interest rates change in the economy.
• This makes budgeting costs a little difficult.
• In some countries (eg UK) bank overdrafts can
represent a very high proportion of total funding for a
business. If the bank decides the business is struggling
or that a recession is coming it may cut back the
overdraft limit without much notice.
• This can lead to a business failing.
• Overdrafts are often secured on a personal guarantee
from the owners and or the assets of the business.
EXTERNAL SOURCES OF FINANCE (ST)
Advantages of a Bank Overdraft 45
• The advantages are that changes in overdraft
limits can be increased quite easily and it is a
flexible source of finance.
EXTERNAL SOURCES OF FINANCE (ST)
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Trade Credit
• Trade Credit is when a business gains
extended time to pay its suppliers – perhaps
30 or 60 days after the delivery of the
suppliers goods.
• This means the business can in effect use its
suppliers as a source of finance.
EXTERNAL SOURCES OF FINANCE
Factoring – Third Party Agency 47
• When working capital is tight or when a business is
struggling to get paid by customers, it may consider
using a third part agency to help.
• A factor agent is a company that buys the current
unpaid invoices of a business at a discount of, say 25%.
• The factor agent pays that cash immediately to the
business and hopes that it can recover more than 75%
of the value of the debts in order to make it a profit.
• The better the quality of the customers a business has,
the greater the percentage that the factor agent may
be prepared to offer upfront.
EXTERNAL SOURCES OF FINANCE
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Advantages of Factoring
• The advantage is that the business receives
cash upfront and can use this money to fund
expansion and working capital needs more
generally.
• In addition, the administration cost to the
business of chasing up its customers, is
immediately removed.
EXTERNAL SOURCES OF FINANCE
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Disadvantages of Factoring
• The disadvantage is that the business is really giving up
some of its profit margin by doing this.
• For example, if the firm is making a 50% profit margin
already, giving away 25% of the sales value may be
acceptable, but not if the business is only making a
small margin.
• Equally factoring will not help very small businesses
and those with very marginal and local clients.
• Also remember that a factor agent ringing up your
biggest customer and demanding immediate payment
(otherwise the customer may be taken to court) could
mean that you could lose vital sales in the future.
EXTERNAL SOURCES OF FINANCE
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Leasing
• When purchasing assets such as new
machines or vehicles it can be sometimes be
useful to consider leasing as a source of
finance.
• Many airlines lease purchase their aircraft.
• GE, a large US finance company, is one of the
largest leasing businesses in the world.
• Equally leasing can be arranged with firm’s
own bank.
EXTERNAL SOURCES OF FINANCE
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Advantages of Leasing
• The advantages are that the business does not
need to find a large initial lump sum to buy
the equipment and can thus pay for the asset
from its own revenue.
EXTERNAL SOURCES OF FINANCE
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Disadvantages of Leasing
• The disadvantages are that the ownership of
the asset does not pass to the business until
the last payment has been made and the
business will probably be paying a reasonably
high level of interest.
FINAL COMMENTS –
EXTERNAL SOURCES OF FINANCE 53
• Using external financing brings in much needed
funding for expansion, but it has its problems or costs.
• Gearing ratios, rises as loans become a larger share of
the total capital of the business, also interest cover
ratios may worsen, unless profit rises proportionally as
well.
• Equally more long term debt will dilute the owners
stake in the business and that of the lenders will rise,
affecting to some extent business decision making.
• It is important to consider a variety of funding sources
and not to become overly dependent on one.