Sources of finance
(Or where can we get money from?)
Why do we need finance?
1. Setting up a business
2. Need to finance our day-to-day activities
3. Expansion
4. Research into new products
5. Special situations such as a fall in sales.
Where does finance come from?
There are two areas of finance. Internal (from within
the company), and external (from outside the organisation.). It can also be classified
depending upon how long you need it for.
INTERNAL
 Profit. If a business is trading profitably, then some of the profit can be used to fund
expansion. (Profit can go to three places… 1. Taxation, 2. Dividends, 3. Retained in the
business.). This is a good source of finance for existing companies (as no interest has
to be paid), but of no use to new ones. Care must be taken with it however, because
profit is not the same as cash. Also the owners of a business may resent not getting a
large dividend, because the firm thinks it needs the money to grow.
 Sale of assets. An organisation may find itself with assets (things of value) that it no
longer wants. These can be sold to raise finance for new ventures. The drawback is,
obviously, that you loose the use of that asset because you no longer own it.
 Sale and lease back.
One way around not having the use of the asset anymore is
sale and lease back. The asset is sold, and then the firm rents it back from the new
owner. This can get expensive in the longer term.
 Reductions in WORKING CAPITAL. Working capital is the money used to run the
business on a day-to-day basis (to pay the bills, wages etc). Finance can be squeezed
from working capital, by holding less stock, chasing up debtors (People who you
money), or paying your creditors (People you owe money to) later. There are several
dangers with this though. Firstly, the problem of overtrading, that is still making a
profit, but not having enough money to pay your day-to-day bills. This is what
bankruptcy is! It is the reason most businesses fail. Secondly, the firm may get a bad
reputation as a late payer, and find it hard to get credit in the future. Finally, customers
may go elsewhere if they are not getting the length of credit that they think they
deserve.
In general then, these have no direct cost to the business, but there are still risks
and draw backs, and is only available for established firms.
External
Long term
Sale of shares (Equity finance) All limited companies issue shares when they first form.
The capital raised will be used to by essential items to get the business up and running. If
they then want to expand both private (ltd) and public (PLC) limited companies can sell
extra shares to raise extra finance.
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Private limited companies.
They can sell more shares to existing
shareholders. This will not change the ownership of the company, provided
they all buy in the same proportion as already owned. WHY WOULD THEY
WANT TO DO THIS?
They could also decide to “go public”, that is, seek a listing on the stock
exchange. This, obviously, has the potential to raise far more money than just selling to
existing shareholders (As there are loads more potential buyers of shares). There are two
options by prospectus, which advertises the shares and invites people to apply for them.
This is an expensive method, but does mean a wider share ownership. It is normal for a
merchant bank to underwrite such an offer. This means they will guarantee to buy any
unsold shares. They do, of course, charge for this service. The second option is to place
the shares with institutional investors. This is a cheaper option, but means a smaller
number of more powerful shareholders. Once a PLC is formed, it can raise further money
by selling shares in two ways. Firstly by a Rights issue. This means selling shares to
existing shareholders, depending upon how many shares they already own. These shares
are sold at a discount to the market price of the shares to encourage people to purchase
them. This means the ownership of the company does not change. They could, instead,
just sell more sells to whoever wants them. But this dilutes the current ownership.
There are loads of issues connected with this option. Firstly, it may well mean that the
original owners loose control of ‘their’ business. However, as a private limited company, it
may well be difficult for the shareholders to spend their wealth. They own a
successful company, but can only spend their salary. Which, whilst being
large, almost certainly will not be anywhere near as much as their wealth.
(They own this valuable thing, the company, but can not spend that money as
it is in the form of shares.) Converting to a PLC will allow them to sell their
shares ( or usually just some of them), and buy the sports cars, mansions,
yachts, Lear jets etc that they have always dreamed of.
Because the owners of PLCs are not involved in the day to day running of the
company, they will expect large dividends as a reward for holding shares.
This means that there will be less retained profit for investment in the
business than there would be if it were a private limited company. Owners of a private
limited company tend to see their future and the company’s as being much more tightly
linked. PLC’s have more status than Ltd’s. For some being a director of a PLC may
provide them with the status they require.
BANK LOANS
This is the same as an individual borrowing money. It
can be at either a fixed or variable interest rate. A business may have to
provide collateral or security for the loan. This means if they do not pay
it back, the lender has the right to sell specified assets of the organisation
to recoup its’ debt.
Debentures or bonds These are long term loans (usually 25 years), and
receive a fixed rate of interest. These are often sold on by the lender, in
the same way shares are bought and sold.
DEBT Vs EQUITY
Which is right for which organisation?
Debt
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


As no shares are sold, the ownership of the company is undiluted.
Loans will be repaid eventually
Lenders have no voting rights on company policy
Equity
 It never has to be repaid, unlike a loan
 Dividends do not have to be paid, unlike interest on a loan, which
MUST be repaid. This makes equity more suitable for risky projects, if the
returns are less certain.
Venture Capital
These are firms (often funded by the Government), which specialise in raising finance for
more risky ventures. They are prepared to invest in organisations that banks are not willing
to lend to because, as well as lending money to the business, they usually take a stake in
the ownership of the business (shares). This means if the business is successful, their
shareholding will be extremely valuable (If the business fails it will be worth stuff all!).
These possible high rewards mean they can take greater risks. They also take a part in
running the business (advice; contacts; support), which may be an added attraction (or not)
to start-ups. It is not without its’ risks for the business. If it fails to meet targets set by
venture capitalist, then the VC will take bigger and bigger slices of the firms equity. They
may also look to float on the stock exchange more quickly than the original owners would
want in order to get their money back.
Medium term
See loans above, as these are often for 5 years.
Hire Purchase: Similar to a loan, used for purchasing assets, provided by the firm selling
the asset, rather than say a bank. You do not actually own the asset until the final payment
is made. This means the asset can be repossessed with ease if you fail to keep up the
payments.
Leasing: Again, to purchase assets, commonly company cars, but could be anything. You
pay a regular sum to the lease company and then get to use the asset. You never own the
asset. But, because you never actually own it, when something goes wrong you can just
phone the lease company and they will sort it out for you. It stops you having to worry
about depreciation, or investing loads in an asset and then it becoming obsolete 20 minuets
latter.
Short term
Overdraft: Spending more in your bank account than you have ( a negative bank balance)
up to an agreed limit. This is expensive. Banks charge a lot for this, especially if you don’t
ask their permission first. It is handy for short-term problems.
Trade Credit:
Stock purchased for sale and not paid for until a month or two latter. This
has no interest cost, and so is excellent for buying raw materials, especially as most firms
would aim to have sold the goods on to their customers before payment is due.
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Factoring: If a firm sells goods on credit it may run into cash-flow problems while waiting for
payment. This is where factoring comes in. You ‘sell’ the debt to a factoring firm who pay
you, say, 80% of the value of the debt now1. Then, when payment is made, the factoring
company receives 100% of the debt. That is how they make their profit. This is expensive
as well.
So what?
This is a perennial topic for exam questions. It is not
difficult, but you do need to link the source of finance to the business in the
case study. For example, will the owners be willing to tolerate less control
over ‘their’ business? What is important for the business? What will the
finance be used for? How long is it needed for? How much is required?
Also do not forget things like joint ventures, and franchise agreements if a
firm is short of cash and wants to expand rapidly. The same questions as
above need to be asked.
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