Financial Management: Sources of Funds

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LEARNING GOALS Key learning goals: This topic will introduce the major sources of funds for

businesses, including internal and external sources, as well as the key factors affecting the choice of funds.

1. Explain the importance for a business to raise funds2. State the internal sources of funds fro a business 3. State the external sources of funds for a business 4. State the difference between ordinary shares,

preference and deferred shares5. Explain the difference between the operating lease and

the finance lease6. Describe the major factors affecting the choice of funds

The need for funds: No business can live without funds.

Throughout the life of a business, money is needed continuously. Firms raise money mainly to meet the following three types of need:

1. To start a business as initial expenditure;2. To fund continuous business activities and

money flowing;3. To expand the business.

Financial Management -Sources of Funds

The need for funds: Question for your critical thinking: Please give some typical examples for the

three types of needs for funds.

Financial Management -Sources of Funds

Financial Management -Sources of Funds

Sources of funds In general, a business may have two

major sources of funds which are needed for its business operations. They are internal sources of funds and external sources of funds.

See Figure 13-1 for details.

Financial Management -Sources of FundsTable 13-1 Sources of Funds

Financial Management -Internal Sources of Funds

The after-tax profit earned and retained by a business which is an important and inexpensive source of finance, for example, the retained earnings of the business. A large part of finance is funded from profit.

Profit

© PhotoDisc

Financial Management -Internal Sources of Funds

The financial provision for the replacement of worn-out machinery and equipment. Nearly all businesses use depreciation as a source of funds.

Profit

Depreciation

© PhotoDisc

Financial Management -Internal Sources of Funds

Definition: The activity that a business sells off assets to raise funds for the business.

Reasons: When a business can not raise finance from banks or other sources, it may be forced to sell some assets, such as company cars, land property; or even subsidiary or associated company to solve its urgent financial problems (this activity is called divestment).

Profit

Depreciation

© PhotoDisc

Sales of Assets

Financial Management -External Long-term Sources of Funds

Share capital: The most important source of funds for a limited company. It is often considered as permanent capital as it is not repaid by the business, but the shareholder can have a share in the profit, called dividend. Three types of shares are: 1. Ordinary shares: The most common types of shares, and the most riskiest shares since no guaranteed dividend. Dividend depends on how much profit is made by the firm. But all ordinary shareholders have voting rights. 2. Preference shares: The share owners receive a fixed rate of return. They carry less risk because shareholders are entitled to the dividend before the ordinary shares. But they are not strictly owners of the company. 3. Deferred shares: These shares are often held by the founders of the company. Deferred shareholders only receive the dividend after the ordinary shareholders have been paid.

Financial Management -External Long-term Sources of Funds

Loan capital Definition: Any money which is borrowed for a long period of

time by a business is called loan capital. Types: There are four major types of loan capital:

Debentures, Mortgage, Loan specialists’ funds, Government assistance. See next page:

Financial Management -External Long-term Sources of Funds

Types of loan capital:1.Debentures: The holder of a debenture is a creditor of the

company, not an owner. Holders are paid with an agreed fixed rate of return, but having no voting rights. The amount of money borrowed must be repaid by the expiry date. 2.Mortgage: These are long-term bank loans (usually over one

year period) from banks or other financial institutions. The borrower’s land or property must be used as a security on such as a loan. 3.Loan specialists’ funds: These are venture capitalists or

specialists who provide funds for small businesses, especially for high tech investment projects in their start-up stage. There are also individuals who invest in such businesses, which are often called ‘business angels’.4.Government assistance: To encourage small businesses

and high employment, governments may be involved in providing finance for businesses. In the USA, there is an organization which is called the Small Business Administration (SBA). SBA provides guarantees for small businesses’ loans and they even offer some loans themselves.

Financial Management -External Short-term Sources of

Funds Definition: Short term sources of funds are usually the funds

which are less than one year for maturity. They are less stable sources of funds for businesses.

Types: The main types of external short term sources of

funds include: 1. Bank overdraft 2. Bank loan 3. Leasing 4. Credit card5. Trade credit See the next page for details:

Table 13-2 External short-term sources of loansMajor types Main characteristics Bank overdraft

This is a short term financing from banks.The amount to be overdrawn depends on the needs of the business at the time and its credit standing.Interest is calculated from the time the account is overdrawn..

Bank loan This is a loan which requires a rigid agreement between the borrower and the bank. The amount borrowed must be repaid over a certain period or in regular installments.Sometimes, banks change persistent overdrafts into loans, so borrowers must repay at regular intervals.

Leasing Leasing allows businesses to buy plant, machinery or equipment without paying large sums of money immediately. The leasing company or bank hires or buys the equipment and for the use of the hire company for a certain period of time. If the user can never owns the equipment, it is an operating lease, while if it is given the choice to own the equipment at the expiry time, it is a finance lease. Lease payments are made by the hire company yearly or monthly, etc.

Table 13-2 External short-term sources of loans (continued)

Major types Main characteristics Credit card Credit cards can be used to pay for hotel bills,

meals, shopping and materials, etc. They are convenient, and secure because it can avoid the use of cash and the payment of interests within credit periods. Cards may not be suitable for certain purchases, especially a large sum of order because they have a credit limit.

Trade credit It is a common method for businesses to buy materials and to pay for them at a later date, usually between 30 and 90 days. Such trade credit given by the seller is usually an interest free way of short term financing.

Financial Management -External Short-term Sources of Funds

Financial Management -Factors affecting the choice of funds

Costs of the fund Costs in terms of interest payments and other expenses: Long term and short term. Use or purpose of funds For example, the building of a new plant is usually financed by mortgage or share capital, while the purchase of raw materials by trade credit or bank overdraft. Status and size of the business For a large firm, there are more sources of finance and often with lower interest rates. Financial situations of a firm For example, a business in poor financial situation is forced to pay high interest rate for loans. And the bank often requires security or collaterals for their financing.

Financial Management -Factors affecting the choice of

fundsGearing condition Definition: Gearing is the relationship between the loan

capital and share capital of a business. High geared companies have a larger share of loan capital to share capital. Low geared ones have a small amount of loan capital.

Impact over a firm: High gearing may mean ‘no loss of ownership’

but high risk of liquidity since interest rates may change and loans must be repaid in time. Low gearing may mean some loss of ownership but no burden of loans and interest payments.

Question for your critical thinking:

If you are the manager, do you

prefer high gearing or lower gearing for your firm? And why so?

Financial Management -Sources of Funds

Sources of Funds

Debt capital—funds obtained through borrowing.

Equity capital—funds provided by the firm’s owners when they reinvest earnings, make additional contributions, or issue stock to investors.

Debt and Equity Capital: Two Basic Sources of Funds

Comparison of Debt and Equity Capital

Sources of FundsLong term Sources of Funds

Leverage—technique of increasing the rate of return on an investment by financing it with borrowed fundsThe key to managing leverage is ensuring that the

company’s earnings remain larger than its interest payments, which increases the leverage on the rate of return on shareholders’ investment