YEAR 8 BUSINESS

SOURCES OF FINANCE (Business Finance)

Finance is the money needed to set up business, keep it running and for expansion.
Importance of finance to a business.
• Start-up capital- money is needed to buy assets necessary for starting businesses.
Example buying computer etc. Other setup costs might include research, legal fees,
website design and marketing.
• Working capital (short- term capital) - this is money needed to fund day to day
expenditure. Example wages and utility bills
• Expansion- funds are needed to expand capacity to meet growing orders, develop a new
products, to branch into overseas markets or diversify
• Emergency funding- businesses are often forced to raise money quickly when cash runs
out to meet emergency needs.
SOURCES OF FINANCE
Sources of finance refers to different ways a business can obtain money to start or run a business.
Generally, fixed assets are financed with long-term sources of funds e.g. share capital or issue of
debentures while day to day financial needs are finance by short term sources of funds example
bank overdraft, trade creditors and short-term bank loans.
Sources of Finance are classified into two: Internal and External Sources
1.Internal sources
This is finance that is sourced from within the business. They include the following:
a). Savings
This form of finance comes from the owner. Savings are mostly used when starting up a new
business. This is because at this stage it is very difficult for the owner to find other sources of
finance since the business is considered to be very risky and with a high chance of failure.

b).Retained profit /Retained Earnings

This is the profit that is gotten from selling goods and services and after deducting all expenses.
It is when profits made out are ploughed back into the business and not paid to the owners.
It is only available to the business which has been trading for more than one year.
Advantages of retained earnings
• Retain earnings are a permanent source of funds available to an organisation.
• There are no charges involved such as interest, dividend or floatation costs.
 • As the funds are generated internally there is greater degree of operational freedom and
flexibility.
• Does not have to be repaid and like a loan.
Disadvantages of retained earnings
• Not available to a new business
• Business may not make enough profit to plough back and finance the expansion needed
• Excessive ploughing back may create dissatisfaction among the shareholders as it means
they get lower dividends.
• It is an uncertain source of funds as the profits of the business are always fluctuating.
• The opportunity cost associated with this fund is not recognized by many firms.
c). Working capital
Working capital can be used to provide extra finance with the business. This can be done by
• Reducing the Trade Credit. Example from 90 to 60 days
• Sale of stocks held
• Delaying payment to suppliers so that business holds on to cash for longer period
d). Debt Collection
A debtor is someone who owes the business money.
A business can raise finance by collecting the money owed to them (debts) from the debtors.
Advantages
• No additional costs incurred in getting this finance as it is part of the businesses normal
operations
Disadvantages
• There is a risk that debts owed can go bad and not be repaid.
• Not all businesses have debts to collect such as those who deal only in cash
e). Sale of stock
This money comes in from selling off unsold stock.
Advantages
• It's a quick way of raising finance
• By selling off stock it reduces the costs associated with holding them
Disadvantages
• It must be done carefully to avoid disappointing customers if not enough goods are held
as inventory.
• Business will have to take a reduced price for the stock.
f). Sale of fixed assets
This money comes in from selling off fixed assets such as machinery and buildings that are no
longer needed.
Large companies can sell off parts of the organizations to raise finance
Advantages
• It's a good way to raise finance from an asset there is no longer needed
• There's no increase the debts of the business
• It is also possible to sell off assets that are needed by the business and then lease them
back
Disadvantages
• Some businesses are unlikely to have surplus assets to sell
• It's can be as slow method for the raising finance as it takes some time to sell this assets
• Also the amount is never certain until the assets are sold
• Businesses do not always have surplus fixed assets which they can sell off
• There is a limit to the number of fixed assets that the firm can sell off
Note:
Given a choice, most businesses will prefer to use internal sources when raising funds. This is
because they are cheap and readily available.

2.External sources
These are finances the raised from outside the business.
They are classified into:
1.Short-term sources of finance
This is money borrowed for one year or less. It is often used to boost working capital or meet
emergency expenditure. Short-term sources may be needed for the following reasons
• Some businesses have seasonal trade. For example a farmer need to borrow money for a
few months until revenue comes in from selling the harvest.
• A manufacturer may need finance to pay for raw materials and wages to meet a large
order
• A firm may be short of money because it is waiting for a customer to pay
• A business may need to meet emergency expenditure. For example if a machine breaks
down unexpectedly the repair cost might have to be met by a short term loan.
The main sources of short-term finances are:
a). Bank overdrafts
This is where the account of the business can be overdrawn
This means they can still write cheques, even if they do not have enough money in the account
Advantages
• They are suitable source of funds because they can be granted on demand
• Overdraft amount vary each month depending on the needs of the business
• If used in the short term it is usually cheaper than a bank loan
• Interest will be paid only on the mount overdrawn
• No security is required against the overdraft facility
Disadvantages
• Interest is repayable on the amount overdrawn
• Interest rates are variable and like most loans which have fixed rate
• And overdraft limit is set by the bank
• The bank can ask for the overdraft to be repaid at a very short notice
• The business must be operating current account to qualify
• Overdraft advanced is usually repaid within a short period of time
b). Trade payable/ Trade Credit
This is a source of financing where a business delays paying its suppliers. This is when a
business takes goods on credit and pays for them later usually within 30 to 90 days
Advantages of Trade Credit
• Businesses can obtain goods and sell them first before paying for them later
• No interest charged if money is paid within a great time
• Trade Credit is a convenient and continuous source funds
• Trade Credit maybe readily available in case the credit worthiness the customer is good
and it’s known to the seller
• Trade Credit helps to promote the sales of an organization, if an organization wants to
increase inventory levels in order to meet expected rise in sales volume in the near future
Disadvantages of Trade Credit
• Not available for new businesses
• Discount given for cash payment will be lost if credit terms are not observed
• Businesses need to carefully manage the cash flow to ensure they will have money
needed when the date is due for payment.
 • Availability and flexibility of Trade Credit facilities may induce a firm to engage in over
trading which may add to the risk of the farm
• Only limited amounts of funds can be generated through Trade Credit
• It is generally a costly source of funds as compared to most other sources of raising
money
c). Hire purchase. (HP)
This method allows a business to obtain assets without the need to pay a large lump sum of
money
It involves paying an initial deposit and regular payments for a set period of time
The main difference between hire purchase and leasing is that with hire purchase, it is when all
repayments have been made that the business owns the asset
Features of hire purchase
• The business usually makes a down payment
• The remaining amount is paid in monthly instalments
• The goods bought do not legally belong to the buyer until final instalment is paid
• If the buyer fails to repay the good can be repossessed
• Agreements can be showed to term or longer
Advantages of Hire purchase
• Businesses can have the use of an up to date equipment immediately
• Payments are spread over a period of time which is good for budgeting
• Once repayments are made to the business will own the asset
• It spreads the cost of expensive item over a long period
• The seller and the buyer agree on the instalment at the time of the contract and they
remain constant
• Allows customers to own items they may not normally be able to afford
• If the item becomes outdated the customer may choose to return the item to the Seller.
• Essential for maintaining un adequate turnover of durable goods
• Helps retailers increased the market share and therefore increase the profits
Disadvantages of Hire purchase
• This is an expensive method compared to buying with cash
• During the high purchase period the item may become worthless or out of date
• Large amounts of retailer’s capital end up being tied up in debt.
 • Because of the easy payment facility consumers go in for items that may be beyond their
means. This encourages lavish expenditure
• In case of default, the item may be possessed and all the earlier payment lost
• It leads to more paperwork in terms of keeping records and letters send to remind
defaulters
• Good repossessed may lack market due to their bad conditions
d). Factoring.

It involves a specialist finance institution called a factor, providing finance to a business against
unpaid invoices. In other words, it is where a business sells its accounts receivables to a third
party (a factor) in order to obtain funding. Accounts receivables refers to the money owed to the
business by customers who had bought products on credit terms.

It ensures there is a good cashflow into the business to meet the operational costs.

However, as the factor finances the outstanding debts, a percentage charge is subtracted from the
total amount. An administrative and service fee is charged. The fees charged may range from
1.15 to 4.5 percent per 30 days.

From there, it is the responsibility of the factor to collect the outstanding debts that they bought.
The factor makes profits from the difference in what they collect with what they paid the
organization for the accounts receivables.

Many commercial banks offer these factoring services.

e). Extended credit (deferred payments)

It is similar to hire purchase but however, ownership of the goods transfers to the buyer from the
seller as soon as the credit agreement is signed and the initial deposit made.

Advantages of extended credit.

(i) The goods become the property of the buyer immediately.

(ii) The buying business can generate income with the purchased goods before making
the repayments.
(iii) Interest is not charged as long as the buyer makes the repayments by the agreed time.
Disadvantages of extended credit.

(i) Goods purchases through this method tend to be more expensive.

(ii) It is an easy method of finance and therefore it may encourage buyers to accumulate
huge credit debts that they struggle to pay.
(iii) If the regular repayments are made, the seller may take legal action against the buyer
in order to get back the money owed to them.

2.Long-term sources of finance

a). Bank loan
It is a fixed agreement between a business and a bank. This is Money borrowed at an agreed rate
of interest over a set period of time.
Advantages
• It's usually quick to arrange
• It can be of varying lengths of time
• Large companies are often offered lower rates of interest by banks if they borrow large
amounts
• If paid on time the business may qualify for another facility such as overdrafts
• Fixed repayments are spread over a period of time which is good for budgeting
Disadvantages
• Can be expensive due to interest payments
• Banks may require security on the loan
• Funds generally available for short periods and its extension or renewal is uncertain and
difficult
• Bankers make detailed investigation of the company affairs, financial structure etc. and
may ask for security of assets and personal sureties
• In some cases difficult terms and conditions are imposed by banks for the grant of loan
Note- Unsecured bank loans means that the bank lends money without any security of having a
claim on your assets if you do not pay it back. Interest rates are higher for unsecured loans
compared to secured bank loans. This is because they present too much risk for banks
b). Share capital issue
This is money raised through sale of shares
Ordinary share capital (equity)
This is provided by the real owners of the limited company. Ordinary shareholders are entitled to
dividends.
Advantages of ordinary share capital
• Doesn't have to be repaid
• No interest is payable
• Equity shares are suitable for investors who are willing to assume risks for higher returns
• Payment of dividends to the equity shareholders is not compulsory unless sufficient profit
is made.
• Equity capital is permanent capital as it is repaid only at the time of liquidating the
company
• Equity capital provides creditworthiness to the company and confidence to prospective
lenders
Disadvantages of ordinary share capital
• Profits will be paid out as dividends to more shareholders
• Ownership of the company can change hands
• The cost of equity share issue is generally more as compared to the cost to raising funds
through other sources
• Issue of additional equity shares they dilutes the voting power and earnings of existing
equity shareholders
• More formalities and procedural delays are involved while raising funds through issue of
equity shares
Preference shares/ Quasi equity
This is share capital raised through the issue of preference shares. It is called quasi equity
because it combines the characteristics of ordinary capital and those of business creditors.
Characteristics of preference share capital
• Preference cannot control the affairs of the business because they do not have voting
rights
• The shareholders enjoy fixed rate of dividends
• Preference shares are generally redeemable
• Maybe cumulative or non-cumulative
• Dividends are paid before paying the ordinary shareholders
• In the event of liquidation the claims are met first
Advantages of preference share capital
• Preference shares have fixed rate of return
• It does not affect the control of equity shareholders over the management as preference
shareholders do not have voting rights
Disadvantages of preference share capital
• Preference capital dilute the claims of equity shareholders to the company
• The rate of dividend on preference shares is generally higher than the rate of interest on
debentures.
c). Debentures
The term debentures is used to refer to a document that acknowledges that a business has
borrowed a specific amount of money from a lender. Funds raised through the sale of debentures
are used to finance long-term activities of the business such as buying a building or machinery.
Debenture holders are creditors of a company not owners.
Advantages of debentures to a business
• Holders are not entitled to part ownership of the business since they are creditors
• A business can shorten the life of redeemable debentures by buying them back after a
specified minimum period instead of waiting until maturity date
• A business is able to budget for payments if debenture is fixed since the dates of
payments are pretty determined
• It is convenient method of financing very expensive assets such as land buildings and
machinery over a loan.
Disadvantages of debentures to a business
• As fixed charge instruments debentures put a permanent burden on the earnings of the
company
• In case of redeemable debentures the company has to make provisions for repayments on
the specified date even during periods of financial difficulty
• Each company has certain borrowing capacity
• Debenture holders have legal interest in any asset that is purchased with their loans
• Debenture repayments have a high priority when a company goes into liquidation
• Debenture holders are entitled to a fixed rate of return and must be paid by the business
d). Leasing
This method allows a business to obtain assets without the need to pay large lump sum up front
Advantages of leasing
• Maintenance and repairs of the leased property are not the responsibility of the user
• Business can have the use of up-to-date equipment immediately
• A leasing agreement is easier for new business to obtain than other forms of loan finance
• Payment ore spread over a period of time which is good for budgeting
• Simple documentation makes it easier to finance assets
• It provides finance without diluting the ownership or control of the business
Disadvantages of leasing
• Can be expensive over long-term.
• The asset belongs to the leasing company
• A lease arrangement may impose certain restrictions on the use of assets
 • The normal business operation may be affected in case the lease is not renewed
• It may result in higher pay-out obligation in case the equipment is not found useful and
the business ops for premature termination of the lease agreement
e). Mortgage
This is a long time facility secured with property for the purchase of fixed assets such as land and
buildings.
Advantages of mortgages
• Interest rate the lower than those of unsecured bank loan
• Business has the immediate use of the property
• Payments are spread over a long period of time up to 25 years which is good for
budgeting
• Once all payments are made the business will own the assets
• The amount for mortgage repayment is exempted from taxation
• A mortgage allows a business to raise money in a way that avoids selling shares and
therefore avoid profit sharing and risk of losing control over the company
Disadvantages of mortgages
• This is an expensive method compared to buying with cash
• The company cannot sell the property unless outstanding amount is cleared
• Companies have to pledge or secure the mortgage on the property or land being
purchased
• In periods when interest rates are rising, a business may find it difficult to repay the loan
due to increase in monthly payments
• Even business does not keep up with repayments the property will be possessed
f). Government grants
Government gives financial help to businesses in form of grants to business, money at low
interest and provision of guarantee to both established and new businesses
Advantages
• Don't have to be repaid
• No interest to be paid
• Extra capital is given
Disadvantages
• Certain conditions may apply example location of a business
• Not all businesses may be eligible for a grant
• May take a long time to arrange
• Open to government inspection
g). Venture capital
Venture capitalists are specialist in the provision of funds for small and medium size businesses.
They invest in the business after the initial start-up and often prefer technology companies with a
high growth potential. Some venture capitalists are individuals and may be called business
angels.
Advantages of venture capital
• The business is able to gain additional finance which means that they do not have to go to
a lending institution/bank. The venture capitalist will bring knowledge and experience to
the business.
• Business often turn to venture capitalists for funding when they have been refused by
other sources.
Disadvantages of venture capital
They prefer to take a stake in the company which means they have some control and are entitled
to a share of profits
It is difficult to find a suitable angel who has common interest as the current owners and wants
the same for the future of the business
h). Crowd funding
Crown funding is a practice of funding a project or a venture by raising small amounts of money
from a large number of people, typically via internet. Crowd funding is a relatively new source
of finance for businesses. It is similar to peer-to-peer funding (where banks are excluded and
individuals can lend money via the internet to others without previous knowledge of them).
Advantages of crowd funding
• Crowd funding allows creators to attain low-cost capital
• Crowd funding can be a fast way to raise finance from many small investors when no
other lenders may be available.
• Crowd funding means a business will not have to take out bank loans to fund the
development of the new product
• By avoiding loan repayments a firm’s fixed course will be kept to a minimum
• Crowd funding is a relatively cheap way of raising finance which can be appealing to
small business startups. As a result of these, the business will be able to devote more
funds to the marketing of the business. This is important as it's a new product in the
market and will need to be well publicized
• Crowd funding is an effective source of finance because it means that finance can be
raised without any repayments being required, as would have been the case if the
business will have chosen a bank loan
• As a new business it will be required to finance to expand and grow. Crowd funding can
be highly effective for such a business as it can keep fixed costs to a minimum
• Crowd funding can help to raise the public profile of a new business. In addition to
raising the finance from a large number of investors this individuals will play an
important part in promoting the business since it is a new business with large number of
competitors, such promotional will be useful.
• As a new startup needs to keep costs as low as possible in the short term so that it can
establish itself in the market. Crowd funding is an effective way of doing this as the
people taking the risk are investors
Disadvantages of crowd funding
• This may mean that the owners cannot in the future develop products they want as the
venture capitalist will be reluctant to fund ventures they are not happy with.
• By using crowd funding, the owner with lose some of the share in the business
• Crowd funding does mean that some profits of a business will need to be shared with the
investors. This will mean that profit of a business will be shared between a large numbers
of people
i). Micro-finance Institutions (MFIs)
These are special institutions set up in most developing countries to meet the financial needs of
small businesses and the poor entrepreneurs. They focus on lending small sums of money to
people. The most famous of these is the Grameen bank in Bangladesh
Advantages of (MFIs)
• Allows businesses to borrow very small amount of loans
• They are prepared to lend to a business without security for loans advanced
• Encourage saving by advancing a loan to a business based on the amount saved with
them
• Offer financial and business management training to the businessman
• Supervise and closely monitor the use of the loan advanced thus helping the business to
avoid diversion of funds
Disadvantages of (MFIs)
• Money given may not be enough for the needs of the business
• Repayment period is often shorter than bank loans
• Strict loan conditions must be observed by the business at all costs
FACTORS TO CONSIDER WHEN CHOOSING THE RIGHT SOURCE OF FINANCE
1. The type of business, its stage in development and availability of finance
The availability of certain type of finance may be limited, depending on what type of
ownership a business has. Companies have a greater choice of sources of finance than a
sole proprietorship and partnerships
2. The intended use of finance
The general rule is that match the source of finance to the use,
High value fixed assets are financed by long-term finances such as loans mortgages or
share issue
Working capital is financed by very short-term sources of finance such as overdrafts or
Trade Credit
3. The cost of source of finance
Companies need to choose the source of finance that is least expensive to them
4. Risk associated with the source finance
Company may choose share issue as a more secure source of finance, as a company does
not have to pay dividends to shareholders if it makes losses. Taking out a loan may be
more risky as interest has to be paid on the loan whether the business is making profits or
not.
5. Amount needed
 Different sources would be used depending on the amount of money needed
6. Control of the business
Owners of the business may lose control of that business if they ask for other people to
invest in the firm. Owners have to decide what is more important, expanding the business
or keeping control of it.
Chapter review questions
1. Which of these sources of finances is internal
A. Retained profits C. Venture capital
B. Mortgage D. Crowd funding
2. Which of these is a short term source of finance
A. Mortgage C.Venture capital
B. Share capital D. Crowd funding
3. Trade payable is a suitable source of finance to fund the purchase of what
A. A new delivery vehicle C. Property
B. Inventories D. Direct labour
4. A right issue involves the sale of what
A. New shares on the stock market
B. Fixed assets
C. New shares to existing shareholders
D. Part of the business
5. (a).What is meant by internal sources of finance?
(b). Describe one advantage to a business of using internal sources of finance?
6. a). What is meant by the term crowd funding?
7. Crowd funding is an external source of finance. Explain one advantage to a business of
using crowd funding to raise finance.
8. Discuss one advantage and one disadvantage of trade payable as a source of finance.
Capital is often divided into two types. Working capital and fixed capital
9. Outline two reasons why working capital is needed.
10. Morris Obuya sets up an airport taxi services in Kenya in 2016 with KES 2 million 5 year
loan and to KES 2 million of his own savings. The interest on the bank loan was fixed at
8% per annum and he was required to repay the loan plus interest in 60 monthly
installments. Work out the monthly installment Morris will have to make in order to
repay the five year bank loan including interest.

THE END !!