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6. 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 funds
2. 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 shares
5. Explain the difference between the operating lease
and the finance lease
6. Describe the major factors affecting the choice of
funds
7. 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
8. 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
9. 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.
10. Financial Management
-Sources of Funds
Table 13-1 Sources of Funds
Sources of Funds
Internal Sources External Sources
Profit Depreciation Sales of assets
Long-term:
Share Capital
Loan Capital
Short term:
Overdraft
Leasing
Credit card…
14. 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.
15. 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:
16. 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.
17. 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 card
5. Trade credit
See the next page for details:
18. Table 13-2 External short-term sources of loans
Major 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.
19. 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
20. 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.
21. Financial Management
-Factors affecting the choice of funds
Gearing 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.
22. 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
23. 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.
24. Debt and Equity Capital: Two Basic Sources of
Funds
26. Sources of Funds
Long term Sources of Funds
Leverage—technique of increasing the rate of
return on an investment by financing it with
borrowed funds
The 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
