3.

FINANCE AND ACCOUNTS

3.1. SOURCES OF FINANCE

Finance is needed for:
 Start-up capital is the capital needed by an entrepreneur to set up a business
 Business need working capital, which is the capital needed to pay day-to-day running
costs
 Possible business expansion, take-over, or merger
 Research and development of new products and new marketing strategies

CAPITAL EXPENDITURE AND REVENUE EXPENDITURE

 Capital expenditure is the purchase of assets that are expected to last for more than
one year
 Revenue expenditure is spending on all costs and assets other than fixed assets

SOURCES OF FINANCE
Businesses can raise money from many different sources, which can be classified in:
 Internal finance source: raised from the business’s own assets or from retained profits
 External finance source: raised from sources outside the business
Another classification: according to the time period (length of time that the money is
needed/used for):
 Short-term finance: maximum 1 year
 Medium-term finance: between 1-5 years
 Long-term finance: more than 5 years

INTERNAL SOURCES
A firm using its profits or assets as a source of capital to fund a new project or investment
 Personal finds (for sole traders): Sole trader finances the business using his/her own
resources
o Advantages:
 No interest is paid the bank or any other financial institution
 Gives him/her more control over the business as he/she is the source
of finance
o Disadvantages:
 Adds risk for the sole trader
 Finance is limited to the saving the owner has
 Profits reinvested in the company: Financing using retained profit: the amount of a
business's net income that is kept within its accounts after paying dividends and taxes.
 Sale of assets: Sale of assets the no longer useful for the business or they have no
need of owning them, thus, raising cash.
 Managing working capital more efficiently: tool that helps companies effectively
make use of current assets, freeing up cash that would otherwise be trapped on their
balance sheets, thus, helping companies to maintain sufficient cash flow to meet short
term goals and obligations.
Overall advantages:
 No direct cost to the business
 No increase in liabilities or debt
 No risk of losing control (no shares are sold)

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 3. FINANCE AND ACCOUNTS

Overall disadvantages:
 Not available for all companies
o Newly formed ones or unprofitable ones with few ‘spare’ assets and no
retained profit.
 Slow down business growth  pace of development will be limited by the annual
profits or the value of assets to be sold

EXTERNAL SOURCES
Funding acquired from sources outside the company.
Short-term finance:
 Bank overdrafts: bank overdraft is a line of credit that covers your transactions if your
bank account balance drops below zero designed to cover short-term cash flow
shortfalls.
o Advantages:
 Very “flexible”: adapts to the day-to-day financial needs of the
business.
o Disadvantages:
 Often has very high interest rates.
 If bank is concerned about the business liquidity, it can ‘call in’ the
overdraft and force the firm to pay it back
 Trade credit: a business-to-business agreement in which a customer can purchase
goods on account without paying cash up front, paying the supplier at a later
scheduled date.
o Problem: lose the discounts for quick payment and supplier confidence are
often lost if the business takes too long to pay its suppliers.
 Debt factoring: Debt factoring is when a business sells the credit offered to a costumer
to a third party. That third party pays the business a percentage of the total amount
originally charged to the client and usually takes full responsibility for collecting the
payment from the buyer.
Medium-term finance:
• Hire purchase: a form of credit for purchasing an asset over a period of time.
• Leasing: obtaining the use of equipment or vehicles and paying a rental charge over a
fixed period. the leasing company will repair and update the asset as part of the
agreement. The ownership remains with the leasing company, but the option of
purchase is given to the costumer at the end of the contract.
They are not a cheap option, but they do improve the short-term cash-flow position of a
company compared to buying the asset cash up front.
Long-term finance:
• Long-term bank loans: loans that do not have to be repaid for at least one year.
Companies provide collateral (asset that will be given to the bank if the company can’t
repay the debt).
o Fixed interest rates  more certainty, but can be more expensive if agreed at
a time of high interest rates.
o Variable interest rate.
• Debentures (or bonds): debt instrument that is unsecured by collateral sold to the
general public. Both corporations and governments frequently issue debentures to

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raise capital. They pay periodic interest payments to the holder of the bond as well as
paying back periodically the amount borrowed.
• Sales of shares - equity finance: the capital raised will be used to purchase essential
assets. Both private and public limited companies are able to sell further shares – up to
the limit of their authorised share capital – in order to raise additional permanent
finance. This capital never has to be repaid unless the company is completely wound
up as a result of ceasing to trade. This would obviously have the potential to raise
much more capital than from just the existing shareholders – but with the risk of some
loss of control to the new shareholders.
• Debt or equity finance: Some businesses will use both debt and equity finance
for very large projects.
o Debt finance advantages:
 No shares sold —> ownership of the company does not change +
is not ‘diluted’ (by additional shares)
 Loans repaid eventually —> no permanent increase in the
liabilities of the business.
 Lenders have no voting rights at annual general meetings.
 Interest charges —> expense of the business + are paid out
before corporation tax. While dividends on shares have to be
paid from profits after tax.
 The gearing of the company increases + gives shareholders the
chance of higher returns
o Equity capital advantages:
 It never has to be repaid (permanent capital)
 Dividends do not have to be paid every year.
Other sources of long-term finance:
• Grants: financial “help” that a person/entity receives from an official body. Normally,
they are given to small businesses or those who are expanding to developing countries
• Venture capital: venture capitalists are small companies that invest in start-ups or
purchases shares in them. Venture capitalists helps start-ups to raise their capital
because it is difficult for them to gain finance from other sources
• Business angels: they are very similar to venture capitalists, but the have some
differences. Business angles are wealthy individuals who put their own money in a
variety of businesses and seek for a better return than they would obtain from
conventional investments.

ADVANTAGES OF BUSINESS ANGELS DISADVANTAGES OF BUSINESS

ANGELS
• Can easily make an investment decision • They will want to share ownership and
without difficult assessments. will require a certain part of the profit
• Personal experience can help when taking of the business.
critical decisions. • Business owners still need to gain
• Angels concentrate their investments investors’ trust.
within a small geographical area.

• Subsidies: financial benefits given by the government to a business to reduce

costs and encourage increased production. These are given to businesses that:
o Might fail causing significant unemployment and regional imbalances
o Need assistance to start up

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 3. FINANCE AND ACCOUNTS

o Produce strategically important products e.g., agriculture

o Need help to reduce costs
 Microfinance: provision of very small loans by specialist finance businesses, usually not
traditional commercial banks

CHOOSING APPROPRIATE SOURCES OF EXTERNAL

FINANCE
Short-, Most Least
Source of
medium- or Advantages Disadvantages appropriate appropriate
finance
long-term for for
Buying
Some loss of Long-term
inventories
Permanent control by original expansion of
(stock)
Sale of capital owners the business
Long Temporary
shares No interest Dividend will be Taking over
increase in
charges expected by another
working
shareholders business
capital needs
Long-term uses
such as
Must be repaid at
expansion or
end of term Short-term
Sale of Fixed purchase of
Long Interest payable financing
debentures interest paid equipment
has to be needs
expected to
competitive
last several
years
Gives
businesses
Major
full use of an Asset is never Vehicles
expansion or
Leasing Medium asset owned/purchased Equipment
takeover
without need Expensive Computers
project
to finance
purchase
Releases Short-term Major
The full value of
liquidity liquidity needs expansion or
accounts receivable
Debt from such as takeover
Short will not be
factoring accounts financing project
recovered by the
receivable increase in Purchase of
business
(debtors) sales on credit equipment
Major
High interest expansion or
When the
Flexible Bank can call in takeover
amount of
Bank amount can overdraft if they project
Short finance needed
overdraft vary with are concerned Purchase of
varies on a
daily needs about liquidity of equipment
regular basis
the business (too
expensive)
Financing a
To make long-term
production of a commitment
Time period No interest
Can be withdrawn product viable of the
Subsidies fixed by No
at short notice that would business –
government repayment
otherwise be because the
unprofitable subsidy could
be withdrawn
Venture Long Provides Some loss of To finance a A profitable

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relatively risky
finance when family
business start-
other ownership business in
up or
sources Share of profits which the
capital expansion of a
might not be payable to venture family owners
recently
available due capitalists want to retain
formed
to risk full control
business
Finance
expansion that
is expected to
Purchasing an
Interest payments lead to higher
increase in
Fixed must be made on revenue to
Ten-year inventories to
Long interest time or security allow for the
bank loan meet expected
(usually) assets might be loan to be
demand over a
sold repaid in the
festival period
time limit
agreed with
the bank
To finance an
increase in
inventory held Purchasing
Finances or sales – land on which
May be loss of
purchase of especially to build an
Trade discounts for rapid
Short inventories when the sales extension to
credit payment of
with no are on credit the factory or
invoices
interest costs and cash will offices of the
not be business
received
quickly
MAKING THE FINANCING DECISION - FACTORS TO
CONSIDER
The size and profitability of the business are clearly key considerations when managers make a
financing choice. But there are other factors influencing:

FACTOR
INFLUENCING SIGNIFICANCE
FINANCE CHOICE
Use and time period o Short-term needs require short-term funding. (match
for which finance is funding sources to requirements).
required. o Permanent financing for the expansion of the company.
o Obtaining financing have always a cost.
Cost o Loans can be very expensive.
o An IPO cost millions of dollars.
o For large companies, large financing is needed
Amount required
o To pay small suppliers/creditors, small loans are needed.
o In public limited companies you can sell shares to the
Legal structure and
public, and therefore lose control of the company, unless
desire to retain
you use the right of issue. In limited companies, the sale of
control
shares is not public.
Size of existing o The more debt a company has, the more difficult it is to
borrowing obtain loans for financing. (gearing)
o Flexible financing for one-off variable needs is better than
Flexibility
inflexible, long-term financing.

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3. FINANCE AND ACCOUNTS