3.1 Learning Objectives:

  • Internal and external finance Finance in the long, medium and short term
  • Evaluate the advantages and disadvantages of each form of finance.
  • Evaluate the appropriateness of a source of finance for a given situation

Sources of Finance

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Introduction
  • Businesses need money to finance business activity
    • Include initial setting up of the business, day-to-day running or for expansion purposes
  • Finance can come to a firm in many ways and different businesses require different sources of finance
  • In general, the sources of finance can be classified in the flow chart below
Type
  • External: External sources of finance come from outside the business
  • Internal: Internal sources of finance come from within the business

Time (definitions in line with accounting terminology)
  • Short-term: refers to the current tax year
  • Medium-term: refers to the time period of more than tweleve months but less than five years
  • Long-term: refers to any period after the next five years

Below presents a table classifying the different sources of finance under two parameters, time and type discussed above.

Short-Term
Medium-Term
Long-Term
Internal Sources
Retained Profits
Selling Assets
Working Capital
Retained Profits
Investing Extra Cash
External Sources
Overdrafts
Trade Credit
Government Grants
Donations
Sponsorships
Debt Factoring
Leasing
Hire Purchase
Venture Capitalists
Government Grants
Sponsorships
Leasing
Hire Purchase
Bank Loans & Mortgages
Venture Capitalists
Preferred Shares
Ordinary Shares
Government Grants
Leasing
Hire Purchase
Bank Loans & Mortgages
Debentures


Evaluate the advantages and disadvantages of each form of finance.
Evaluate the appropriateness of a source of finance for a given situation.

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Overdrafts
Allowing a business to temporarily overdraw on its account (taking more $$ than it has) -- short term: interest is charged
on daily bases-> higher rate of interest
Advantages:
  • for company with minor cash flower problem, satisfy need
  • suitable for businesses that have sold items on credit and are awaiting payment from customers
  • flexibility for business that may face cash flow problems from time to time
Disadvantages:
  • overdrafts are repayable on demand without prior notice from the lender
  • high rate of interest (expensive for long term borrowing)
  • unable to meet repayment deadlines, business assets will be affect
Example:
Hang Seng Bank-> provide unsecured overdraft facility or asset link secured overdraft


Sponsorship
When one organization gives financial support ($$, products or services) to another company in exchange
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for prominently display

of theircompany'sAdvantages
  • reduces the cost of company (one being sponsored) for growth & expansion
  • enable small companies to increase public profile in cost-effective manners
  • the existence of sponsorship companies in events exert social responsibilities
  • compete more effectively against other firms in market

Disadvantages
  • difficult to obtain this source of finance
  • individual company problems

Example:
The term of the agreement between two companies or organization would depends on the event being held
Short term--> World Cup sponsorship =the event gets the financial funds
Long term--> individual sport teams --> the sponsoring logo is the company providing the financial funds

Bank Loaning
Borrowed money by commercial lenders like banks. A medium to long-term source of finance
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and interest charges imposed (fixed/variable). Depending onagreement between borrower and lender borrowed, the amount paid back is in installments and spans over a definite and predetermined period.
Advantage:
  • loans can be catered to meet specific needs of borrower
  • can be set up quickly

Disadvantage:
  • if borrower defaults on the loan, the lender can repossess property
  • sometimes prepayment penalty
  • payments can overtake income of borrower

Example:
Business Development Loan - Businesses can make use of flexibility of the loans to start or expand their business, purchase
equipment and assets, boost working capital

Leasing
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Leasing company (lessor) owns the equipment and hires it out to the customers (lessee pays rental income to hire assets). It is a medium term fund
Advantages
  • reduce initial capital for (new) businesses
  • added service: maintenance and upgrading
  • leased equipment is classed as 'expense'--> tax bill for lessee is reduced
Disadvantage
  • long term: leasing is more expensive then purchasing the equipment

Example:
New companies needs expensive equipments to run the business: office, equipment leasing from larger companies like Apple

Investing Extra Cash
Cash that does not need to be spent immediately => interest-bearing savings account. Companies earn interest with the extra cash from investors.
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Advantages
  • earns interest for the business
  • cash rich companies can earn a significant amount of interest on their cash deposits.
Disadvantages
  • low returns
  • opportunity cost for companies to keep cash at hand instead of the bank.
Example:

Retained Profits
Internal profits or ploughed-back profits. Value of profits the business keeps hold of to use withinexternal image retained_profit.gif the business (after paying taxes to government and dividends to shareholders). This is usually used for purchasing or upgrading fixed assets and sometimes kept in contingency funds in case of emergencies and unforeseeable expenditure in the future

Advantage:
  • no need to rely on borrowing (no interest charges)
Disadvantages:
  • may not be sufficient, so other sources may still be needed
  • less is available for distributing to shareholders

Example:
Buying new land for more factories (long term)
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Selling Assets
The selling of excess or underused assets

Advantages
  • Immediate retrieval of cash from purchaser
Disadvantages
  • Assets may grow in value
  • Transferal has cost
  • Assets possibly useful for loans

Example:

Working Capital
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The $ available for day-to-day running of business that comes from selling goods & services. It is used to pay everyday costs (ex. wages, bills, suppliers)

Advantages
  • internal source; no interest
  • easily accessible
Disadvantages
  • cannot fund larger projects
  • short-term liquidity is affected

Example:
A payment for electricity bills

Preferred Shares

Preferred Shares are shares which are held by shareholders which yield a fixed amount of dividends from a companies profits.

Advantages
  • yield a fixed amount
  • given out before Ordinary Share dividends are handed out
  • preferred Shares will have a general idea of the amount they will receive every year
  • cumulative payment, which allowed shareholders to get twice the dividend payments in two years if the first year did not yield extremely positive results
  • have a steady source of profit
Disadvantages
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  • do not have voting rights in companies and their administrative decisions

Trade Credit
A system of trade where good/service is received; payment does not have to be made until a later date

Advantages:
  • less strain on cash flow
  • trial use of product is possible
Disadvantages
  • more financial processing is required
  • easy to buy more than what the business can pay for

Example:
Such as receiving supplier goods on trade credit and paying the money back out of profits after the goods/services have been sold

Government Grants/Subsidies

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Subsidies are financial aid given by an external factor to help reduce a producer's cost of production (this does not include profit)

Advantages :
  • External but not need to be payed back
  • Allows the producer to sell the product at a cheaper price
  • reduce cost of production
  • Increase demand for their goods and services as a result of price cut
Disadvantages:
  • Is sometimes not enough
  • Very hard to obtain

Examples:
Government grants to hospitals

Donationsexternal image donation.jpg
These financial gifts from individuals or organization to a business

Advantages:
  • Charities, schools, hospitals and universities often receive donations to boost their finances
  • no direct benefit to the donor i.e. no interest or payback required
  • generally large sums
Disadvantages:
  • some donations have term and conditions (i.e. displaying the donor's name in recognition)
  • Very difficult to obtain if not a public service like schools, hospitals etc.
  • Is sometimes not sufficient

Example:
CDNIS built the art complex, Leo Lee donated $$$$$ to support the cause and now the art complex is named after him.

(Debt) Factoringexternal image golden_diagram.gif
Debtors are people who owe money to a business. Debt factoring is a financial service that allows a business to raise funds based on the value owed to them by their debtors.

Advantages:
  • reduce the probability of BAD DEBT-DEBTORS
  • non-recourse factoring allows for insurance against bad debts
  • Don't have to chase up their own debtors
  • Immediate source of finance

Disadvantages:
  • Without non-recourse factoring the company will still have to absorb losses
  • Expensive

Example:
Receiving 80% of debtors outstanding debt on selling fabric abroad

Hire Purchaseexternal image mban23l.jpg
Paying for an item in parts (installment plan) vehicles, machinery, office equipment and farming machinery. A deposit (down payment) is paid on the item.

Advantages
  • can pay for items in installments (12 or 24 months)
  • item belongs to the business once all payments have been made
  • different from leasing
Disadvantages
  • If the buyer fail to pay in time, then the lender can take the item back

Example:
Supplier sells the goods. Supplier delivers the goods to the customer who will eventually purchase them. The hire purchase arrangement exists between them.

Mortgagesexternal image snoopy-subprime-mortgage.gif
Mortgage is a secured loan specifically for the purchase of a property. The borrower use their own asset as security for loan then the borrower gets the money and pays back the loan time to time with interest. If the borrower cannot pay back the loan the bank takes the asset.

Advantages:
  • better cash flow
  • retain ownership
  • low interest rate
Disadvantages:
  • high risk for small businesses

Example:
A business seeks to expand and needs a new shop

Debentures
A type of long-term loan to a business with the promise of a fixed annual interest paymen
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t to the debenture holders. Debentures are similar to shares, however, debenture holders DO NOT have voting rights on how the business is run.

Advantages to Debenture Holders
  • they receive annual interest/ benefits (VIP status or free passes) regardless of whether or not the business is making money
Disadvantages to Debenture Holders
  • no say in how the business will run
  • greatly depends on the business' success to raise it's value

Advantages to Business
  • provides good long-term finance without losing control of the business
Disadvantages to Business
  • firm increases the amount of long-term liabilities raising the amount of interest payments to the lenders

Example:
Private Schools in Hong Kong (CDNIS), Football Clubs etc.