3.1 Sources of Finance

For this chapter, you should be able to...

1. explain the PURPOSE OF FINANCE FOR BUSINESS in terms of capital expenditure and revenue expenditure
2. comment on INTERNAL SOURCE OF BUSINESS
3. comment on EXTERNAL SOURCE OF BUSINESS
4. define SHORT-, MEDIUM-, AND LONG-TERM FINANCE

1. purpose of finance for business

All forms of business need funding for the business activities, so they always need to ascertain on the purpose of their finance.
The purpose of finance = either capital expenditure or revenue expenditure

Capital expenditure

= Firms' investments in new equipment, items that will last for more than a year
= Also known as money spect to acquire fixed assets
e.g. machinery, vehicles, office buildings, and land

Revenue expenditure

= Payments for goods and services which have already been consumed or will be in the near future
= Also known as money spent on the day-to-day running of a business
e.g. wages, raw materials, insurance, and fuel

TIP! : Try not to use "Money" in your exam!
"Money" is a vague term and can refer to different concepts like profit, investment, payment, and more. Use these terms
instead of "money" to make your answers more specific and knowledgeable.

2. Internal sources of finance

Internal finance = obtained within the business (usually earned through business activities)

Types of Internal finance:

Personal Funds

= Key source of finance for sole traders
+) cheap and easily available, no interest will be paid
- ) have a great risk as it is investing own personal life savings

Retained Profit

= Profit that remains after a business has paid tax and dividends
+) cheap because it does not charge interest, flexible and permanent source of finance
- ) high retained profit = very little was paid out to shareholders as dividends

Sales of Assets

= When a business sells its unwanted or unused assets to raise finance
+) can tie up assets that are not being use without any interest or borrowing costs
- ) may lack excess assets to sell, may be time-consuming to find a buyer

3. External sources of finance

External finance = obtained from sources outside the business

Types of External finance:

Share Capital

= Raised from the sale of shares of a limited company (LTD, PLC). Also known as equity capital
+) permanent source of capital, no interest payments
- ) have to pay dividends to shareholders when the business makes a profit

Loan Capital

= Sourced from financial in financial institutions such as banks. Also known as debt capital
+) accessible, can be arranged quickly
- ) have to be redeemed, high interest may be a burden

Overdrafts

= When a lending institution allows a firm to withdraw more money than it currently has in its account
+) provides opportunity to spend more than a business has in its account, flexible form of finance
- ) banks can ask for paying back at very short notice, banks may charge high interest rates

Trade Credits

= An agreement between businesses that allows the buyer of goods or services to pay the seller at a later date
+) delaying payments to suppliers -> businesses have a better cash-flow position, an interest-free means of raining funds
- ) delaying payments can lead to having poor relations -> suppliers may refuse to engage in future transactions

Grants

= Funds usually provided by a government, foundation or other agency that do not need to be repaid
+) no need to pay back
- ) competition for grants is fierce, most grants are short-term

Subsidies

= Financial assistance granted by a government or NGO to support business enterprises that are in the public interest
+) helps businesses to increase their demand for goods by charging lower prices for their products
- ) subsidies are often marred by political interference in the subsidization process

Debt Factoring

= When a business sells its invoice to a third party known as debt factor
+) business gets immediate cash , risk of collecting the debt is passed onto the factor
- ) business loses % of its profits because it does not receive the full debt repayment

Leasing

= A source of finance that allows a firm to use an asset without having to purchase by cash
+) no large sums of money allocated for purchasing the asset, useful when equipment is used occasionally
- ) interest rates are higher, not able to secure any loans with another institution on assets that are leased

Venture Capital

= Financial capital provided by investors to high-risk, high-potential start-up firms or small businesses
+) venture capitalists provide funding to businesses that other institutions might regard as too high a risk
- ) venture capitalists may set very high profit targets for the start-up businesses they invest in

Business Angels

= Provide financial capital to small start-ups or entrepreneurs in return for ownership equity in their businesses
+) more favorable than other institutions -> because they invest in the person rather than how viable a business venture is.
- ) may assume a good degree of control in the business they invest in = diluting the ownership of the business

4. Short-, medium-, and long-term finance

Short-term finance

= needed for day-to-day running of a business
= finance that lasts for one year or less (external short-term finance is expected to be paid within 12 months)
e.g. bank overdrafts, trade credit, and debt factoring

Medium-term finance

= needed for purchasing assets that have lifespans for specific period of time (equipment, vehicles)
= finance that lasts for 1 ~5 years
e.g. leasing, medium-term bank loans, and grants

Long-term finance

= needed for purchasing long-term fixed assets or other expansion requirements
= finance that lasts for more than 5 years
e.g. long-term bank loans and share capitals