Sources of Finance

What is finance?

Why do businesses need finance?

Start a business
Expansions to production capacity
To develop and market new products
To enter new markets
Take-over or acquisition
Moving to new premises
To pay for the day to day running of business

Sources of
finance

Internal
Retained profits
Sales of existing
assets
Cut down stock
levels

External
Short term

Medium
term

Shares
Debentures
Loans
Grants

Leasing
Hire
purchase
Loans

Long term

Bank O/D
Bank Loans
Creditors
Factoring

Sources of Finance
Short term: Less than one year
Medium term: One to Five years
Long term: Over Five years

Internal Sources
This is money raised from inside the business.
It includes:
Sales of assets: Business might sell off old,
obsolete assets which are no longer used by the
business to raise additional cash for the business.

Better use of capital

A new business might not have
any old or obsolete assets

 Reduction in working capital: Cutting the

stock levels can also help the business to raise
additional cash.

Costs related to storage of stock

is reduced
May lead to shortage of stock
and loss of sales

 Retained profits: Businesses (especially limited

companies) usually keep some part of the profit
every year for future use. This is also known as
ploughed back profit. Over a period of time it can
total up to a huge amount which can be used for
financing the business.
No need to pay interest
Any time it can be used
Less legal formalities
No repayment
Doesnt increase liabilities
It affects shareholders dividends
All the companies may not have retained
profit

EXTERNAL
This is the money raised from outside the
business. It can be:
Short term
Medium term
Long term

Short Term
Bank overdraft: Bank overdraft is a facility given
by banks to its business customers, people having
current accounts. Through this facility the
customers can overdraw their accounts to a
greater value than the balance in the account. To
overdrawn amount is agreed in advance with the
bank manager. The bank assigns a limit to
overdraw from the account and the business can
meet its short term liabilities by writing cheques
to the extent of limit allowed.

No need for collaterals or

security.
More flexible and the overdraft
amount can be adjusted every
month according to needs.
Interest rates are usually variable
and higher than bank loans.
Cash flow problems can arise if
the bank asks for the overdraft to
be repaid at a short notice.

 Trade Credit: Usually in business dealing

supplier give a grace period to their customers
to pay for the purchases. This can range from
1 week to 90 days depending upon the type of
business and industry. By delaying the
payment of bills for goods or services
received, a business is, in effect, obtaining
finance which can be used for more important
expenditures.
No interest has to be paid.
Helps to solve temporary financial problems
Less legal formalities
Used only for short-term purposes
Small amount
Prices of goods are high
Not available from all creditors

Factoring
Business might find difficult collecting debts:
If sales are rising rapidly, increase in credit sales
could pressure businesss cash flow
Giving long term credits to debtors

To overcome such problems, business could

get help from a factor

 Factoring of debts: It involves the business

selling its bills receivable to a debt factoring
company at a discounted price. In this way the
business get access to instant cash.
1

Selling Company X

Buying Company Y

Factoring Company

 Factoring could be good alternative when

bank refuse to give larger bank overdrafts
Factoring company may provide a debtor
management service
Factoring companies are generally reluctant to
give such advances for new companies and as
there will be more risks involved in it

 Advantages:
It will boost the cash flow
there are many factoring companies, so prices are usually
competitive
it can be a cost-effective way of outsourcing your sales
ledger while freeing up your time to manage the business
it assists smoother cash flow and financial planning
some customers may respect factors and pay more quickly
you may be given useful information about the credit
standing of your customers and they can help you to
negotiate better terms with your suppliers
factors can prove an excellent strategic - as well as
financial - resource when planning business growth
you will be protected from bad debts (non-recourse)
factors will credit check your customers and can help your
business trade with better quality customers and improved
debtor spread

 Disadvantages
The cost will mean a reduction in your profit
margin on each order or service fulfillment.
It may be difficult to end an arrangement with a
factor as you will have to pay off any money they
have advanced you on invoices if the customer
has not paid them yet.
Some customers may prefer to deal directly with
you.
How the factor deals with your customers will
affect what your customers think of you. Make
sure you use a reputable company that will not
damage your reputation.

Invoice discounting
This is some what similar to factoring
Lots of factoring companies do provide this service
Invoice discounting is purchase of a selection of
invoices, at a discount
Certain invoices are easy to sell than others
This is an arrangement purely for advancement of
cash, normally a one-off-deals
Riskier than factoring
Only offered to reliable and well established firms

Customer prepayments
Normally customers do not pay until the
goods or services received
But sometimes customers are persuaded to
pay in advance or just a percentage of
payment in advance

Medium and Long term

Hire purchase: It involves purchasing an asset
paying for it over a period of time. Usually a
percentage of the price (15% to 33%) is paid
as down payment and the rest is paid in
installments for the period of time agreed
upon. The business has to pay an interest on
these installments.
Goods such as company vehicles, plant and
machineries, office equipments are normally
bought through hire purchase

 This is similar to the leasing except that the

ownership transfers to the hirer upon the
payment of last installment .
This is a relief to the cash flow as assets are
not purchased outright
This is fairly simple to arrange and useful
alternative to bank loans

 Shares: Investors invest their

money to buy the shares to earn
profit in the form of dividend
Ordinary Shares
Preference Shares
New share issues
Rights Issue
Bonus or Scrip Issue

 Advantages:
Large amount of cash
Avoiding need to raise from existing shareholders
(fresh issue)
No need to pay interest to shareholders
No repayment of share capital except redeemable
shares

Disadvantages:

More legal formalities

Dilution of the control of existing shareholders
Dividend is to be paid when company makes profit
Its expensive to issue shares
Unsuitable for small amounts
Repayable after an agreed period

 Investors: Apart from the individuals, there

are other parties who invest in the companies
by operating in stock exchange
Pension funds
Insurance companies
Investment trusts
Venture capitalists

 Debentures: A debenture is defined as a

certificate of acceptance of loans which is
given under the company's stamp and carries
an undertaking that the debenture holder will
get a fixed return (fixed on the basis of
interest rates) and the principal amount
whenever the debenture matures. It is issued
for a long periods of time. Debentures are
generally freely transferrable by the
debenture holder. Debenture holders have no
voting rights and the interest given to them is
a charge against profit.

 Advantages:
Large amount of cash
Money can be used for longer period
No voting rights to debenture holders

Disadvantages:
Fixed rate of interest has to be paid whether
company makes profit or loss

 Leasing: Leasing involves using an asset, but the

ownership does not pass to the user. Business
can lease a building or machinery and a periodic
payment is made as rent, till the time the
business uses the assets. The business does not
need to purchase the asset.
Saves capital expenditure
Losses due to technical improvements will be reduced
Lessor makes a good profit
Leasing is cheaper than bank loans
Has the advantage of using most recent assets
Rent is to be paid regularly
More legal formalities
Equipments cannot be used as securities for loans

 Operating lease: agreements between lessor

and lessee where the period of the lease is
fairly short, less than useful life of the asset
At the end of the agreement:
Lease the same asset to someone else, or
Sell the asset at a second hand value

This is more like renting an asset

 Finance lease: agreements between the

lessee and the lessor for the main part of the
assets expected useful life, if not its entire life
The lessee is responsible for servicing and
maintenance of the asset
The lessee effectively owns the asset,
although in law lessor owns it (substance over
form)

 Practice of using another firm's successful

business model.
The franchisor owns the overall rights and
trademarks of the company and allows its
franchisees to use these rights and trademarks to
do business.
The franchisor usually charges the franchisee an
upfront franchise fee for the rights to do business
under the franchise name.
Royalty: Ongoing fee that the franchisee pays to
the franchisor

 Franchising is a business model in which many

different owners share a single brand name.
A parent company allows entrepreneurs to
use the company's strategies and trademarks;
in exchange, the franchisee pays an initial fee
and royalties based on revenues.
The parent company also provides the
franchisee with support, including advertising
and training, as part of the franchising
agreement.

Advantages
Be your own boss (at least to a point) as
appose to working for an employer
Get a head start: "You're in business for
yourself, but not by yourself."
Gain additional training and assistance :
business set-up, personnel training, site
selection, lease negotiation, collective buying
power, and advertising
Profit from name recognition.

Disadvantages
You must play by the rules: the products you
are allowed or must carry, reporting
procedures, dress codes, hours
Nothing is ever free: royalties, may have to
buy the products from parent company.

Why Buy a Franchise?

Self management
Financial
independence
Career advancement
New skills/training
Long-term investment

Advantages for Franchisees

Site-selection assistance
Credit
Construction expertise
Fixtures and equipment assistance

Training
Opening support
Promotional assistance
Economies of scale
Ongoing support

Disadvantages for Franchisees

Restrictions
Unwanted products or procedures

Unwanted advertising
Unprotected territories
Cancellation
Inadequate training

Advantages for Franchisors

Little or no capital required for expansion
Quick expansion possible

Franchisees shoulder investment risk

Unit owners connected to local community

Disadvantages for Franchisors

They give up the profits generated
by the franchise units

They give up some control

Commercial mortgages
Some companies own freehold of real estate
premises such as factories, offices and
warehouses.
These assets have value in companys
accounts
It could take out a commercial mortgage with
a property company

 Sales and lease back: this involves a firm

selling its assets or property to an investment
company and then leasing it back over a long
period of time. The business thus can use the
asset without purchasing it and can use the
revenue earned from its sale for other
purposes.
Advantages:
No need to pay interest
Large amount of money

Disadvantages:
Difficult to sell immediately
Lease back will increase the firms expenses

Long term Bank loan

Borrowing from bank for a limited period of
time. The business has to pay an interest on
the borrowing. This interest may be fixed or
variable. Businesses taking loan will often
have to provide security or collateral for the
loan.
Money can be used for long term investments
Reasonable rate of interest
Fixed rate of interest has to be paid whether
company makes profit or loss
Repayable after an agreed period

 Venture capital: Venture capital is money put

into an enterprise which may all be lost if the
enterprise fails. A businessman starting up a
new business will invest venture capital of his
own, but he will probably need extra funding
from a source other than his own pocket.
However, the term 'venture capital' is more
specifically associated with putting money,
usually in return for an equity stake, into a new
business, a management buy-out or a major
expansion scheme.

Venture capital companies

There are high risk investments which the normal
banks and other financial institutes do not want
to invest.
Venture capital companies invest in such projects
by lending or by buying shares.
They lend money in exchange for part ownership
of the business in the hope that the business will
flourish and grow and eventually float on the
stock market. So they can sell their shares.
E.g. Advantage Capital Limited, Braveheart
Ventures, Permira and Hermes Private Equity.

Government Aids
Grants: Governments will provide financial support
in certain circumstances.
Successful businesses provide employment and
create wealth for the country
The major grants are related to regional policy
There are usually conditions attached with the
grants such as guarantees of continued operations
and creation of jobs.
There are no interest charge or repayment of capital
sum as long as business keeps up the conditions.

 Grants are given for innovation, R&D, training,

economic regeneration for Assisted areas,
government guarantees for lending to
businesses, regional development, and local
authorities for helping existing businesses to
expand and attracting new business for the
benefits of local community such as
generating more wealth and creating job
opportunities etc..