Managing Finance and Budgets
Lecture 8
Sources of Finance
Session 8 -Sources of Finance
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LEARNING OUTCOMES
Understand and choose relevant investment decision
techniques to critically analyse situations typically found in
SMEs and VCOs and to inform decision making.
Key Concepts
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Characteristics of Finance
Share Capital
Loans, Bank Finance
Leasing
Structure of the Lecture
A : Limited Companies
 B : Financing a Limited Company
 C: Sources of Finance
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Section A:
The Nature of Limited
Companies
The Different Types of Organisation
In lecture 1, we discussed:
 Sole Trader
 Partnership
 Limited Company (Ltd)
 Public Limited Company (PLC)
 Voluntary organisations
 Central and local government
 Quasi-governmental bodies
(See M & A Chapter 1)
Limited Companies
In this lecture, we will concentrate on two of these:
 Limited Company (Ltd)
 Public Limited Company (PLC)
These organisations are similar, in that
 A limited company is an artificial legal person
 They are normally owned by at least two people
called shareholders
 A shareholder’s investment (shares) in the company
is called the share capital
 The shares may be sold or given to another person.
Limited Company (Ltd)
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Subject to strict regulatory framework
Owned by shareholders, run by Directors
Separate legal entity to those who own it or run it
Limited liability (may be limited by guarantee)
Pays Corporation Tax on profits
Profits distributed to shareholders through dividends
Registers with Companies House
Governed by Articles/Memorandum of Association
Public Limited Company (PLC)
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Similar to Limited Company but shares traded publicly
through Stock Exchange
This provides a method of raising finance (e.g. through
sale of ‘new’ shares)
Must adhere to specific legislation (e.g. 6 monthly
accounts, qualified accountant as Company Secretary)
Original owners can realise some of the value of their
shares
Section B:
Financing a Limited Company
Where does the money come from to
finance a a limited company?
Looking at a company’s Balance Sheet, we can detect how a
company’s finances are deployed, and what is the source of
their financing. The headings for a limited company are:
 Fixed Assets
 Current Assets
 Creditors: amounts falling due within 1 yr
(i.e. current liabilities)
 Creditors: amounts falling due after more than 1 yr
(i.e. long-term liabilities)
 Capital & Reserves
Balance Sheet: Sheer Fiction PLC
Fixed Assets
Current Assets
Stock
Debtors
Creditors: Amounts falling due within 1 yr.
Trade Creditors
Tax
Creditors: Amounts falling due after 1 yr.
Long Term Loan
Capital & Reserves
Share Capital
Capital Reserves
Retained Profits
Profit for the Year
£800,000
£500,000
£50,000
-£100,000
-£50,000
-£200,000
£1,000,000
£500,000
£250,000
£200,000
£50,000
£1,000,000
Financing for a Limited Company 1
If we take these in turn,
Fixed Assets
Current Assets
Stock
Debtors
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£800,000
£500,000
£50,000
This section shows what the company owns.
There are several important ways a company can use
to raise finance through its assets, which we will see
towards the end of this lecture.
Financing a Limited Company 2
In the middle section of the balance sheet we have:
Creditors: Amounts falling due within 1 yr.
Trade Creditors
Tax
Creditors: Amounts falling due after 1 yr.
Long Term Loan
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-£100,000
-£50,000
-£200,000
£1,000,000
This is what the company owes, and each item can be
viewed directly as a source of finance.
They are items that we have either borrowed, or not yet
paid. Therefore in some sense they represent money
which is not ours, but we currently have in our possession
and can deploy to our benefit.
Financing a Limited Company 3
On the final section of the Balance Sheet is:
Capital & Reserves
Share Capital
Capital Reserves
Retained Profits
Profit for the Year
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£500,000
£250,000
£200,000
£50,000
£1,000,000
This section again can be viewed as what the company
owes, and so it is a source of finance.
In this case, the money is owed to its shareholders, the
investors who have chosen to lend money to the company in
return for a ‘share’ in the profits.
Financing a Limited Company
Share Capital
The amount of money invested in the company represented by
the ‘face value’ of the shares.
Capital Reserves
The additional amount of money generated by the share capital
from special transactions: e.g. upwards valuation of fixed assets,
selling new shares for a price above their face value.
Retained Profits
The total amount of profit made prior to this year, but which has
not been distributed to shareholders.
Profit for the Year
The amount of profit generated this year.
Section B:
Sources of Finance
Sources of finance - characteristics
Important issues we need to consider are:
 Degree of permanence of the finance
 Whether it is redeemable
 Type of return required - e.g. fixed, variable,
guaranteed, discretionary or none!
 Rates of return anticipated
 Security - specific charge or floating charge (a charge
levied out of particular assets if the company defaults)
Sources of finance - characteristics
In addition we need to consider:
 The length of financing period –
 short-term (1 year),
 medium-term (2 to 5 years),
 long-term (over 5 years)
 The different types of Risk –
 investment risk (short or long-term, secured or not),
 finance risk (mix of finance),
 business risk - higher risk should bring higher returns
(probably longer term)
Capital Structure
Capital Structure is a term used to describe the mix of
share capital, reserves and long-term loans etc. used to
finance the company
 The long term elements of Capital Structure are invested
in Fixed Assets, with some left over for working capital
 The short term elements come from items such as trade
creditors and bank overdraft. They are normally used to
cover seasonal or cyclical fluctuations
 Long term finance incurs costs even when not needed
 Short term finance is flexible but may be more
expensive
Capital Structure – Long Term Elements
Shares
 Ordinary
 Preference
 Reserves
Long Term Loans
 Fixed Term Loans
 Debentures
Shares and Shareholdings
We will examine the following issues:
 Types of Share
 Dividends
 Bonus Shares & Rights Issues
Shares
Shares are the basic units of ownership of a business.
 The number of shares that are issued and their nominal
(or ‘face’) value are at the discretion of the people who
start up the company.
 For example, a company may have an initial capital
requirement of £10,000. This could be obtained by
issuing:
 10 shares at £1,000 each,
 10,000 shares at £1 each
 1 million shares at 1p each.
 All shares must have the same value
Shares and the Stock Exchange
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Shares in a PLC may be traded at the Stock Exchange.
This is simply a marketplace for the buying and selling of
shares.
Prices on the stock exchange are subject to the law of
supply and demand.
The Market Price of a share is simply what another
investor is prepared to pay for it. This may be well above
(or below) the face value of the share.
No money from this buying or selling of shares goes to
the company.
Dividends
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A Dividend is the amount earned by the shareholder’s
investment over a period of time.
The term comes form the ‘dividing up’ of the profits so that
each person get their ‘share’.
Companies will declare ‘dividends’ on each share. For
example a dividend of 6.8% on a share with face value of
50p means that each share will earn 3.4p.
Types of Shares
There are two different types of share that we need to
consider:
Ordinary Shares
 All companies issue these type of shares.
 The total of the amount invested in these is normally
referred to as the equity of the company.
Preference Shares
 These shares guarantee that if a dividend is paid,
preference shareholders get the first part of it.
Rights of Shareholders
A shareholder in a company has the right to:
 Share in any profits
 Share in any funds remaining if business is wound up
(after all other liabilities paid off)
 (Usually) Vote at shareholders’ meetings over electing
directors & auditors, and accepting corporate report
 Vote to accept or reject takeover bids
Ordinary Shares: Technical Details
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The money invested is not refundable (normally) unless
organisation wound up. There is no security.
Issued Share Capital = amount actually issued
Authorised Share Capital = Amount which can be issued
Shares may be sold to another party but are not
redeemable (cannot be sold back to the company)
Shareholders are rewarded by dividends and the increasing
value of their shares
Normally each ordinary share carries one vote
Shareholder rights are explained within the Memorandum &
Articles of Association
Preference Shares: Technical Details
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Preference shareholders are entitled to the first part of
dividend payments (up to a maximum value)
e.g. 10,000 preference shares, value £1 at rate of 6% first £600 of dividends goes to preference shareholders
Forms include: cumulative preference shares (which
accumulate if a dividend is missed one year); convertible
preference shares and redeemable preference shares
These shares do not normally carry voting rights
Changing the number and value of shares
Companies may
 Issue new shares
 Offer ‘rights issues’
 Issue bonus shares
 Revalue shares
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Each of these may have implications for current
shareholders and may require changes to be made to
the ‘Capital & Reserves’ section of the Balance Sheet.
New Share Issues
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A company may offer new shares for sale on the market,
in order provide additional finances.
These shares must have a nominal value equal to the
shares currently available.
The price for the shares must reflect the current value of
the company.
New Share Issues – example
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A company started up with 1 million shares each with
nominal value £1
Currently the company has net assets of £2 million.
Each share now has an actual value of £2.00
If the company issues another million shares at £1 each,
the company’s wealth will be:
£2m + £1m = £3 million
There will now be 2 million shares.
This means that each share is now actually worth
£3million  2 million = £1.50
The original shareholders have lost 50p per share, the
new shareholders have gained 50p per share.
New Share Issues
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The sale price for new shares must therefore be
calculated to safeguard the original shareholders’
investment.
The sale price will therefore be higher than the nominal
value: for example a share with a nominal value of 10p
may be sold for as much as £6.50
The capital generated from the sale will be entered into
the balance sheet under Capital & Reserves
 The income from the nominal value is entered as
Share Capital
 The income from the “excess” or premium is entered
as Capital Reserves
New Share Issues - Example
Balance Sheet
Share Capital 100,000 shares @ 50p each
Capital Reserves
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£50,000
£25,000
The company issues 20,000 new shares at the market value of
£1.50 per share.
This gives 20,000 x 50p = £10,000 new Share Capital
In addition we have and additional premium of £1
This gives 20,000 x £1 = £20,000 Capital Reserves.
New Balance Sheet
Share Capital 120,000 shares @ 50p each
Capital Reserves
£60,000
£45,000
Rights Issues
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Used by established companies to raise additional share
capital for expansion, or to solve liquidity problem
Existing shareholders have “right” of first refusal on new
shares (in proportion to existing holding)
Ideally, existing shareholders purchase all new shares, so
that control remains with same people, and costs are kept
to a minimum
Selling price tends to be below current share market price
to encourage take up
Bonus Shares (1)
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A company may take their Reserves and turn them into Share
Capital
New shares are known as Bonus Shares (“freebies”)
Example Balance Sheet
Share Capital
50,000 x £1 share
Capital Reserves
£50,000
£78,000
---Additional 50,000 shares issued---
New Balance Sheet:
Share Capital
100,000 x £1 share
Capital Reserves
£100,000
£ 28,000
Bonus Shares (2)
Net Effects of issuing bonus shares:
 Locks up reserves in share capital
 Lowers ‘actual’ worth of each share, although the nominal
value of each share is the same, and the market price may
not reflect this.
 Provides a “feel-good” factor - shareholders may now “sellon” their part of the reserves.
Revaluation of Shares
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Companies are free to alter the nominal value of their
shares in two ways:
Share Splitting – for example a company with 1 million
shares each having nominal (face) value 10p, could split
each old share into two new shares, each worth 5p.
Consolidation – the company could choose to reduce
the number of shares to 500,000 million by increasing
their nominal value to £1 each.
Neither of these methods alters the actual amount of
capital invested.
Revaluation of Shares - Example
Share Splitting
Balance Sheet
Share Capital 100,000 shares @ 20p each
Capital Reserves
£20,000
£10,000
The company decrees that each 20p share becomes 2 shares
each worth 10p
New Balance Sheet
Share Capital 200,000 shares @ 10p each
Capital Reserves
£20,000
£10,000
Venture Capitalists
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Individuals or Institutions looking to help business exploit
a profitable opportunity, e.g. start-ups, buy-outs, new
product lines.
Source of long-term finance through equity purchase,
normally in the form of ordinary shares
They will be looking for an exit route and a return
commensurate with risk
They may require a management input through nonexecutive director
Management Buy-out
This occurs when:
 Managers of a division or subsidiary purchase it from the
parent company
 Managers take large risk by inputting their own funds
 Financial institutions or Venture Capital companies
provide additional funds secured on company’s assets,
with conversion to shares when the business is
successful
Implications for the Balance Sheet
On the balance sheet, we find these items related to shares:
 Share Capital - The total amount of money invested in the
company represented by the nominal value of the shares.
This includes both the original and new shares issued.
 Retained Profits – these are the cumulative undistributed
profits - owned by shareholders but retained by company
 N.B. Retained Profits do not equate to cash - cash may
already have been used to fund the business (as working
capital or to obtain assets)
 Reducing dividend payments will increase Retained Profits
and avoid need to seek additional outside finance (from
share issues, loans, banks etc)
Implications for the Balance Sheet
Revenue Reserves.
 Retained Profits are sometimes shown under the heading of
Revenue Reserves. These are simply the funds which arise
from trading profits or from the disposal of fixed assets.
Capital Reserves arise from two sources:
 Issuing shares at a value above their nominal price. In this
case the total nominal value of the shares would be
allocated to Share Capital, and the excess to Capital
Reserves (sometimes under a heading called the Share
Premium Account)
 Revaluation of assets (This is sometimes entered under the
heading of Revaluation Reserves)
Activity One
On commencement of trading a company issues 50,000 ordinary
shares at a nominal value of £1 each. 2 years later, the Company
wishes to raise additional funds for expansion. The net assets of the
Company are now worth £150,000. An additional 25,000 shares are
to be issued.
What are the implications of issuing them at £1 per share?
What price should the shares be issued at to ensure that the current
shareholders do not see the value of their investment diluted?
How is the premium received on the share price shown on the
Balance Sheet?
Activity One – Solution (1)
A company issues 50,000 ordinary shares, nominal value £1 each.
Net assets of the Company two years later are worth £150,000.
An additional 25,000 shares are to be issued.
What are the implications of issuing them at £1 per share?
£1 is the minimum stake in the company.
If it grows to 100 times its current size, the minimum stake
would then be worth £100. This might cause problems in
finding small investors.
Activity One – Solution (2)
What price should the new shares be issued at?
The shares should be issued at £3.00 each
The 25,000 shares carry a a nominal face value of £1.00
Each share carries a premium of £2.00 above this value.
The additional funds generated (total premium) will be:
25000* £2 = £50,000
How is the premium received shown on the Balance Sheet?
This will be shown under Capital Reserves
i.e.
25,000 x £1
25,000 x £2
… is recorded as … Share Capital
… is recorded as … Capital Reserves
Other Long Term Financing
We will look briefly at
 Long Term Loans
 Debentures
 Leasing
 Sale & Lease Back
 Government Grants
Term Loans
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There are equivalent to the Hire Purchase or Bank Loans
agreements used by individuals to finance a new car, or a
holiday etc.
They are arranged with an individual institution such as
pension fund, insurance company, bank or finance house
Low set up costs compared to issues of equity
Tend to be secured (e.g. a mortgage)
Terms usually incorporate repayment of capital and
interest
The timescale is usually fixed (e.g. 5 or 10 year loan)
May incorporate restrictive terms and will be subject to
financial status
Loan Shares or Debentures
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Composite Loans - a loan denominated in blocks (usually
with a nominal value of £100)
Common forms include “bonds” or “debentures”
Debentures tend to be secured against organisation’s
assets (in UK) - sometimes called mortgage
Investors hold loan certificates and receive interest at a
stated rate (fixed or variable)
Interest is paid before tax is calculated on profit
Convertible loan shares may convert (at shareholder’s
option) into shares after specific period
May be transferred at different value to nominal value,
and may be sold on the stock market.
Leasing
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Method of acquiring finance to purchase assets
Cost of assets fully deductible (immediately) from profits
for tax purposes
Operating Lease - manufacturer or stockist of equipment
provides a short-term contract to use the equipment
subject to payment of lease charges (or subject to
ongoing purchase of “consumables”)
Finance Lease - finance house provides cash to purchase
capital item, but remains the owner
Off balance sheet borrowing - lease previously did not
have to appear as Long Term Liability so Balance Sheet
appeared to be stronger. Now changed.
Sales and Lease Back
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Existing (owned) assets sold to finance house or Pension
Fund and leased back over number of years
Organisation benefits from cash injection whilst Finance
House has secured loan plus interest payments
Government Grants
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Funds provided by government grant initiatives in return
for relevant outputs (jobs created, people trained,
buildings renovated etc)
Organisation likely to be asked to provide “matching
funding” (which may be “in kind”)
Initiatives run by variety of agencies (Government Offices,
Euro-funding, SRB, Lottery)
Funds repayable if organisation fails to supply outputs (or
changes its activities, closes down etc
Short Term Financing
The following represent six ways in which a company can
increase their level of finance in the short term:
 Sales of Assets
 Revaluations of Assets
 Bank Overdraft
 Debt Factoring/Credit Control
 Stock Control
 Delaying Payment
Sales of Assets
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Selling Current Assets (stock) is simply part of the dayto-day business, and may yield cash immediately or in
the near future.
Selling Long-Term Fixed Assets can also provide
financing in the short term. This is normally done where
assets have reached the end of their useful life, or
where they are no longer required.
Some Assets may have a market value which is above
their ‘book’ value. The profit from such sales is entered
on the balance sheet under “Revenue Reserves”
Revaluation of Assets
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Where an asset is worth more than its historic cost,
assets may be re-valued to reflect their current market
value.
For example land purchased for £100,000 five years
ago, in the current market may well be worth an
additional £50,000.
Revaluing an asset does not provide additional ‘cash’,
but does increase the funds available to the company.
Such amounts are entered in the Balance Sheet under
“Revaluation Reserves”
Bank overdraft
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Overdraft - repayable on demand
Suitable for working capital, but not all funding
requirements
Likely to require security
Almost certainly will involve a variable higher interest rate.
Sometimes will require personal guarantees of Directors
Debt Factoring
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Balances owed by customers may be “sold” to a factor
who collects money directly from debtor when due
Factors will tend to purchase low-risk debts only
Sometimes factors bear the cost of “bad debts”, otherwise
the money is reclaimed from the company
The company receives a proportion of the value of the
invoice (dependent on the arrangement)
Also known as invoice-discounting
An arrangement can be difficult to exit from as company
becomes dependent on cash from factor
Credit Control
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If a high proportion of a company’s assets are in the form
of debtors, there is an opportunity cost, since the funds
cannot be used for more profitable activities.
Tighter credit control: e.g. discounts for early payment,
(i.e. penalties for late payment!), cash-sales, credit
references etc. may release some of these funds.
Stock Control
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If a high proportion of a company’s assets are in the form
of stock, here too there is an opportunity cost, since the
funds cannot be used for more profitable activities.
Stock control methods such as ABC or just-in-time
techniques can lead to lower stock levels. This releases
more funds to the company in the form of working capital.
Delaying Payment to Creditors
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Items bought on credit effectively represent a ‘free’ source
of finance. The amount owed is money currently being
utilised by the company to generate profit.
Increasing the amount owed, or extending the payback
period effectively generates more of this free finance’.
However, there may be other penalties: penalties for late
payment, refusal to supply etc.
Principles of finding finance
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Match funding to need
Balance shareholders funds against long-term liabilities.
Be aware of effect on capital structure
Be aware of tax implications
Activity Two
A Company is looking to raise additional funds to finance expansion into
a new market. It believes it will need an additional £50,000 to use as
working capital, £250,000 for purchase of equipment, and £75,000 to
spend on marketing activities.
Which possible sources of finance should the Company investigate to
finance each area of the project and what are the various issues it needs
to consider before deciding on the way forward?
Activity Two -Solution
An additional £50,000 to use as working capital:
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This might possibly be achieved through efficiency gains (lowering current
stock levels, tighter debt control, extension of credit – or possibly debt
factoring). If not, this would need to be included in the equipment purchase.
£250,000 for purchase of equipment.
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This will need to be funded either through additional share capital (New share
issue - look for Venture Capital), or if this is not possible, other long-term
financing, such as a long-term loan, or debentures. Explore whether a
Government grant is available.
£75,000 to spend on marketing activities.
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This is revenue expenditure, and will therefore be accounted against profits in
the year in which it occurs. If retained profit levels are high, the company
could consider taking reduced profits or even a loss in the next financial year,
although this would not go down well with the new shareholders! Alternatively,
the company could consider an overdraft.
Activity Two - Issues
The main factors to be taken into account are:
Risk:
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If the company borrows, there is a risk that there may not be sufficient funds
at the maturity date to cover the repayment, and will not be able to find a
replacement loan.
Matching:
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The company may wish to match the life of the long-term asset with the
maturity date of the loan.
Cost:
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Interest rates for long-term loans are generally higher than those for shortterm loans.
Flexibility:
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Short term loans may be more flexible and responsive.
Financial Gearing:
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What is the current gearing ratio and how will the proposed funding alter this?
What would the effects be if the sales were less than expected?
Follow-up Activities
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Preparation: read Chapters 4 & 15 (Both editions),
Describe key concepts:
Characteristics of Finance
Share Capital
Loans, Bank Finance
Leasing
Other sources of finance
Exercise 15.7 – page 508-9
Revision Seminar (Week 10) - Case Study A
John Richards and Sons Ltd is a well-established family
business. The managers are considering expansion of
their operations but they estimate that £2 million of
additional capital will be needed to finance their plans.
The latest balance sheet for the business is shown on
the following page.
1.
2.
Summarise the Balance Sheet with headings,
subheadings totals and subtotals.
Discuss the company’s capital structure, using ratios
where appropriate and evaluate alternative sources of
finance open to the company.
Case Study - Balance Sheet Entries
£ 000
Land & Buildings
Plant & Equipment
Stock
Debtors
Cash
Trade creditors
Long Term Loans - 12% repayable in 10 years time
Ordinary Shares of £1 each
Retained profits
8% Preference Shares
1600
3600
2000
1600
200
(1000)
(2600)
2000
1200
1200