Sources of Finance Definition:A company would choose from among various sources of finance depending on the amount of capital required and the term for which it is needed. Without cash, the business would not be able to survive. With many possible uses of finance - wages, advertising, expansion, paying the interest on loans, etc - we should consider the various sources of finance available to businesses.
There are two main sources of finance, these are internal sources and external sources. Internal sources include:
•
Retained profit - profit made is reinvested into the business.
•
Sale of assets - Assets the company owns can be sold and then leased back which frees up a large amount of capital in the short term
•
Depreciation
•
Working Capital
External Sources include:-
•
Long Term
•
Short Term
Internal Sources of Finance:These are sources of finance that come from the business' assets or activities. Retained Profit
If the business had a successful trading year and made a profit after paying all its costs, it could use some of that profit to finance future activities . This can be a very useful source of long term finance, provided the business is generating profit (see section on profit & loss accounts). Sale of Assets
The business can finance new activities or pay-off debts by selling its assets such as property, fixtures & fittings, machinery, vehicles etc. It is often used as a short term source of finance (e.g. selling a vehicle to pay debts) but could provide more longer term finance if the assets being sold are very valuable (e.g. land or buildings)
If a business wants to use its assets, it may consider sale and lease-back where it may sell its assets and then rent or hire it from the business that now owns the assets. It may mean paying more money in the long run but it can provide cash in the short term to avoid a crisis. Depreciation:Depreciation is a reduction in value of our assets, which occurs naturally through wear and tear in the production process of a business. 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. In many countries depreciation is a major tax deduction. Depreciation is recognized as an expense which we c an claim to reduce our taxable income
Working capital 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. 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. Working capital is the amount of money available for the day to day running of the business. It is the difference between current assets and current liabilities. See below for more details of how working capital can be used.
External Sources include:-
Long Term Share capital An important source of finance for limited companies. A share issue involves a business selling new shares that entitle the shareholders to share in the control of the business. Each share gives the shareholder a vote on the direction of the company. This usually means that the shareholder can elect the board of directors of the company each year. If the shareholder doesn't like the way the directors are running the business, they can elect new directors. This is a good incentive to the directors to run the business well and make a profit which will be paid to the shareholders in the form of dividends. The more shares a person holds, the more control they have over a company. If one company wanted to take another company over, it could arr ange to buy over 50% of that company's shares. This would give it a majority of control and, therefore, ownership. Issuing new shares can raise a lot of capital that can be used for expansion (buying more fixed assets, etc). It is a long term source of finance. If the total number of shares rises,
the votes of existing shareholders will have slightly less significance and they will have less control. The business will also have to pay dividends on a larger number of shares. Three types of shares are:
1. Ordinary shares. Ordinary shares are issued to the owners of a company. They have a nominal or 'face' value, typically of $1 or 50 cents. The market value of a quoted company's shares bears no relationship to their nominal value, except that when ordinary shares are issued for cash, the issue price must be equal to or be more than the nominal value of the shares.
2. Preference shares Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid if sufficient distributable profits are available, although with 'cumulative' preference shares the right to an unpaid dividend is carried forward to later years. The arrears of dividend on cumulative preference shares must be paid before any dividend is paid to the ordinary shareholders.
3. Deferred shares Deferred shares are a form of ordinary shares, which are entitled to a dividend only after a certain date or if profits rise above a certain amount. Voting rights might also differ from those attached to other ordinary shares. Ordinary shareholders put funds into their company: a) by paying for a new issue of shares b) through retained profits. Simply retaining profits, instead of paying them out in the form of dividends, offers an important, simple low-cost source of finance, although this method may not provide enough funds, for example, if the firm is seeking to grow. Loan capital Loan that can be taken out by a public limited company for a large sum and it will be paid back over several years. It is usually borrowed from specialist financial institutions. Loan
stock is long-term debt capital raised by a company for which interest is paid, usually half yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the company.
Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at a stated "coupon yield" on this amount. For example, if a company issues 10% loan stocky the coupon yield will be 10% of the nominal value of the stock, so that $100 of stock will receive $10 interest each year. The rate quoted is the gross rate, before tax. Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt incurred by a company, normally containing provisions about the payment of interest and the eventual repayment of capital.
Types:
•
Debentures
These are debentures for which the coupon rate of interest can be changed by the issuer, in accordance with changes in market rates of interest. They may be attractive to both lenders and borrowers when interest rates are volatile. •
Mortgage
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan. However, the word mortgage alone, in everyday usage, is most often used to mean mortgage loan. •
Loan specialists’ funds
•
Government assistance
The government provides finance to companies in cash grants and other forms of direct assistance, as part of its policy of helping to develop the national economy, especially in high technology industries and in areas of high unemployment. For example, the Indigenous Business Development Corporation of Zimbabwe (IBDC) was set up by the government to assist small indigenous businesses in that country.
Short term finance The need for finance may be for long-term, medium-term or for short-term. Financial requirements with regard to fixed and working capital vary from one organisation to other. To meet out these requirements, funds need to be raised from various sources. Some sources like issue of shares and debentures provide money for a longer period. These are therefore, known as sources of long-term finance. On the other hand sources like trade credit, cash credit, overdraft, bank loan etc.which make money available for a shorter period of time are called sources of short-term finance.
Purpose of Short-term Finance After establishment of a business, funds are required to meet its day to day expenses. For example raw materials must be purchased at regular intervals, workers must be paid wages regularly, water and power charges have to be paid regularly. Thus there is a continuous necessity of liquid cash to be available for meeting these expenses. For financing such requirements short-term funds are needed. The availability of short-term funds is essential. Inadequacy of short-term funds may even lead to closure of business. Sources of Short-term Finance Trade Credit Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods, components, etc. Usually business enterprises buy supplies on a 30 to 90 days credit. This means that the goods are delivered but payments are not made until the expiry of period of credit. This type of credit does not make the funds available in cash but it facilitates purchases without making immediate payment. This is quite a popular source of finance.
Bank Credit Commercial banks grant short-term finance to business firms which is known as bank credit. When bank credit is granted, the borrower gets a right to draw the amount of credit at one time or in instalments as and when needed. Bank credit may be granted by way of loans, cash credit, overdraft and discounted bills. a) Loans When a certain amount is advanced by a bank repayable after a specified period, it is known as bank loan. Such advance is credited to a separate loan account and the borrower has to pay interest on the whole amount of loan irrespective of the amount of loan actually drawn. Usually loans are granted against security of assets. b) Cash Credit It is an arrangement whereby banks allow the borrower to withdraw money upto a specified limit. This limit is known as cash credit limit. Initially this limit is granted for one year. This limit can be extended after review for another year. However, if the borrower still desires to continue the limit, it must be renewed after three years. Rate of interest varies depending upon the amount of limit. Banks ask for collateral security for the grant of cash credit. In this arrangement, the borrower can draw, repay and again draw the amount within the sanctioned limit. Interest is charged only on the amount actually withdrawn and not on the amount of entire limit. c) Overdraft When a bank allows its depositors or account holders to withdraw money in excess of the balance in his account upto a specified limit, it is known as overdraft facility. This limit is granted purely on the basis of credit-worthiness of the borrower. Banks generally give the limit upto Rs.20,000. In this system, the borrower has to show a positive balance in his account on the last friday of every month. Interest is charged only on the overdrawn money. Rate of interest in case of overdraft is less than the rate charged under cash credit.
3. Leasing
A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the lease to the lessor, for a specified period of time. Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery, cars and commercial vehicles, but might also be computers and office equipment. There are two basic forms of lease: "operating leases" and "finance leases".
Credit Cards This is a surprisingly popular way of financing a start-up. In fact, the use of credit cards is the most common source of finance amongst small businesses. It works like this. Each month, the entrepreneur pays for various business-related expenses on a credit card. 15 days later the credit card statement is sent in the post and the balance is paid by the business within the credit-free period. The effect is that the business gets access to a free credit period of aroudn30-45 days!
