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3.

1 Sources of
finance

IB BUSINESS MANAGEMENT
3.1 Sources of finance
By the end of this chapter, you should be able to:
Explain the role of finance for businesses in terms of capital
expenditure and revenue expenditure
Comment on the internal sources of finance
Comment on the external sources of finance
Define short, medium and long term finance
Discuss the appropriateness, advantages, and disadvantages
of sources of finance for a given situation
Why is financial information so important?
Finance is the language of business.
Money is the unit that provides a means to compare and
understand businesses, to judge their successes and their
failures.
Profit is the goal that inspires entrepreneurs and drives them
to take risks.
Financial information can show:
where the money to set up a business has come from
how this money has been used
how much money is owed to others
what a business is worth
how much cash is available to pay off debts
how much it costs to make a product
how much profit or loss is being made
Using financial information is vital because it:
allows business success or failure to be measured
makes it easy to compare performance over time, and with
the performance of other businesses
helps business managers to make decisions about their
prices, their production and their investment
enables a business to keep control of its spending and use of
other resources
makes it possible to plan ahead so as to ensure cash is
available when it is needed
Who needs to use financial information?

Internal users
Management
Owners
Employees
External users
Potential investors
Lenders
Suppliers
Government
Customers
Competitors
Main types of financial information and
documents
Financial accounting
It is the recording and publishing of financial information to
meet the necessary legal requirements.
The accounts published will allow the external and internal
users to assess the businesss financial position.
Management accounting
It is for the use of managers to help them plan, make
decisions and control the business effectively.
It shows managers what is going on within the business and
allow them to monitor and review the impact of their
decisions.
Financial accounting
Balance sheet
A summary of a firms financial position at a specific point in
time
Profit and loss account
A record of the costs and revenues of a business over a period
of time
Cash-flow statement
A summary of the cash that has come into and out of the
business over a period of time
Cash-flow forecasts
A plan of the expected movements of cash into and out of the
business in the year ahead
Management accounting
Budget
A financial plan for each unit or department within the
business
Breakeven forecast
By calculating the different types of costs and the revenue to
be gained from different levels of sales
Investment appraisal
A calculation of the expected costs and revenues arising from
a new investment
Sources of finance
All businesses require funding for their activities.
For example a loan to purchase a new computer system, or a
bank overdraft to pay suppliers before the receipt of
customers cash.
Just like people, organizations require a variety of funding for
a range of purposes.
These purposes can be classified
as either capital expenditure or
revenue expenditure.
Sources of finance can come
from within a business (internal
sources) or from outside of it
(external sources).
Capital expenditure
Money spent to acquire items in a business that will last for
more than a year and may be used over and over again.
Such items are known as fixed assets.
Fixed assets include machinery, land, buildings, vehicles, and
equipment.
Fixed assets are needed for the purpose of generating
income for the business over the long term. Capital
expenditures are therefore long-term investments intended
to assist businesses to succeed and grow.
Fixed assets can be used as collateral (financial security
pledged for repayment of a particular source of finance such
as bank loans).
Revenue expenditure
Money spent on the day-to-day running of a business.
These payments or expenses include rent, wages, raw
materials, insurance, and fuel.
Does not involve the purchase of longer-terms, fixed assets.
Needs to be covered immediately to keep the business
operational and should therefore provide immediate
benefits, unlike capital expenditure which has a long-term
focus.
Businesses need to be cautious not to have consistently high
revenue expenditure as this will make it difficult for them to
build sufficient capital in order to make long-term
investments.
Factors to be considered
A business should match the source of finance to:
Its specific use
The cost of the source
The organizations objectives
The flexibility and availability to the finance
The impact the new funding would have on the
organizations current financial structure
The state of the external environment
The type of business structure it is
Activity
Be a researcher
Match the sources of finance for an individual to the best
possible uses listed.

Source of finance Use of finance


Savings in a bank Buying a car
Store card Starting up a business
Secured loan, for Going on a holiday
example a mortgage
Bank loan Buying new clothes
Friends cash Buying furniture
Bank overdraft Buying a house
Internal sources of finance
Personal funds
Retained profit
Sale of assets
Personal funds
Key source of finance for sole traders and it comes mostly
from their own personal savings.
By investing with their personal savings, sole traders
maximize their control over the business.
In addition, this investment
shows commitment to the
business and is a good signal to
other investors or financial
institutions that the business
might need to approach for
additional sources of finance.
Personal funds
Advantages
It is cheap
Easily available.
No interest will need to be paid.
Disadvantages
It poses a great risk to the owners or sole traders because
they could be investing their lifes savings.
If these savings are not large, it may prove difficult to start or
maintain a business, especially if this is the only source of
funding.
Retained profit
One of the most important sources of business finance.
Represents the profits generated from sales once interest
payments to lenders, tax to government, and dividends to
shareholders have been accounted for.
It is the cash, once received from customers, which is not
spent on day-to-day needs.
The remaining profit is then retained or ploughed back into
the business and available for future spending by the
organization.
Retained profit
Advantages
There are no associated borrowing costs.
Businesses do not see a rise in the debt levels.
The owners control is not diluted.
Decisions are not vetted by lenders.
Disadvantages
Start-up businesses will not have any retained profit as they
are new ventures.
The owners may take out all the organizations spare cash.
Some businesses are more focused on investment decisions
when borrowing money.
Exam tip
Do not assume that a profitable business is cash rich and it
can use all of its profits as a source of finance for future
projects.
In practice, profits are often tied up in money owed to the
business by debtors or have been used to finance increased
stocks or replace equipment.

Coca-Cola finances most of its global


expansion from retained profits.
Sale of assets
When a business sell off its unwanted or unused assets to
raise funds.
Businesses can sell machines that no longer match their
needs or are inefficient given the existence of new
technologies.
Such funds can be used to part finance new machines or
fund other requirements.
Businesses could also sell off any excess land or redundant
buildings they may not be using.
In some cases businesses may adopt a sale and lease back
option, which involves selling an asset that the business still
needs to use. In this case, the business will sell the asset to a
firm that then leases the asset back to the business.
Sale of assets
Advantages
Good way of raising cash from capital that may be tied up in
assets that are not being used.
No associated borrowing costs or debt.
Disadvantages
It may be time-consuming to find a buyer to sell the assets
to, especially in the case of obsolete machinery.
A business can only sell off
the asset once.
Internal sources of finance An evaluation
This type of capital has no direct cost to the business,
although there may be an opportunity cost, and if assets are
lease back after being sold, there will be leasing charges.
Internal finance does not increase the liabilities or debts of
the business.
There is no risk of loss of control by the original owners as no
shares are sold.
However, it is not available for all companies, for example
newly formed ones or unprofitable ones with few spare
assets.
Internal sources of finance An evaluation
Solely depending on internal sources of finance for
expansion can slow down business growth, as the pace of
development will be limited by the annual profits or the
value of assets to be sold.
Thus, rapidly expanding companies
are often dependent on external
sources for much of their finance.
Activity
Be a thinker
In each of the following cases, explain briefly why internal
sources of finance might be unavailable or inadequate.
Business A needs to pay creditors after a period of making
losses and the value of its assets has fallen.
Business B has expanded rapidly, which requires expenditure
several times greater than current profits.
A start-up business uses all of the owners personal savings
to purchase all the assets required to start operating.
External source of finance
Share capital
Loan capital
Overdraft
Trade credit
Grants
Subsidies
Debt factoring
Leasing
Venture capital
Business angels
Share capital
Limited companies may raise funds through the sale of
shares.
Should be used for long-term needs, such as purchasing
machines or computer systems, or acquiring businesses.
When a business expands it can ask existing shareholders to
put more money into the business and therefore new shares
are issued in proportion to the size of the increase in share
capital.
Note that when people buy and sell existing shares, usually
via a stock exchange, this does not help the business with
raising new capital as it is simply swapping ownership
between people.
Share capital
Advantages
There are no interest payments and so no drain on company
profits.
If existing shareholders increase their investment by buying
new shares in proportion to their current levels there is no
change in control.
Disadvantages
Shareholders still require rewards in the form of dividends,
and this is paid for from profits.
If the business doesnt make a profit and doesnt have a
reserve of past profit it cannot be compelled to pay a
dividend.
Exam tip
Do not make the mistake of suggesting that selling shares is a
form of internal finance for companies. Although the
shareholders own the business, the company is a separate
legal unit and, therefore, the shareholders are outside of it.
When answering case study examination questions, you
should analyse what type of legal structure the business has
and what sources of finance are available to it.
Unincorporated businesses sole traders and partnerships
cannot issue shares, for example.
Loan capital
Loan capital or debt is provided for more than one year.
Funding provided by banks and other lenders.
Usually provided for a fixed period of time, with repayments
evenly spread out over the length of the loan.
Interest is paid on the loan at regular intervals.
Interest rate holidays is where the lender agrees not to take
interest for a short period of time.
Loan capital
Advantages
It is often easier to access and use for specific purpose and
so payment is spread out over the useful revenue-earning
life of the asset.
If interest rates rise in the economy, the loan interest does
not change as it is fixed at the outset.
Disadvantages
The lenders have to be paid even if the business does not
make a profit.
If the loan is secured against an asset, then the asset can be
seized if repayments are missed.
If interest rates fall, the business will pay the agreed rate,
although renegotiating loan interest is quite common.
TOK discussion
Is there a moral obligation for financial institutions to lend to
every start-up business?
Bank overdraft
Is a short-term bank loan.
A bank will allow a business to
withdraw from its account more
than it has deposited.
It is a flexible way for businesses to
borrow small sums of money as
and when required.
Interest is paid only when the
account is overdrawn.
Overdrafts are often used to cover
cash shortages, so a business may
be overdrawn only for a matter of
days.
Bank overdraft
Advantages
Changes in overdraft limits can be increased quite easily and
it is a flexible source of finance.
Disadvantages
The cost will vary as interest rates change in the economy,
making budgeting costs a little difficult.
It is often secured on a personal guarantee from the owners
and/or on the assets of the business.
Trade credit
Most business-to-business transactions are completed on a
credit basis.
Goods purchased are not paid for immediately.
Using trade credit, a business can get stock even if it does
not have the cash to pay for it at the time.
It is intended that, by the time payment is due, the stock will
have been sold and the necessary cash generated to pay the
bill.
Trade credit
Advantages
By delaying payments to suppliers, businesses are left in a
better cash-flow position than if they paid cash immediately.
It is an interest-free means of raising funds for the length of
the credit period.
Disadvantages
Debtors (trade credit receivers) lose out the possibility of
getting discounts rather than if they pay in cash.
Delaying payment to creditors after the agreed period may
lead to the development of poor relations and suppliers may
even refuse to engage in future transactions with the
debtors.
Grants
Governments, successful entrepreneurs and large
corporations keen on promoting their social responsibilities
are all increasingly seeking to help the smaller business
sector with grants and soft loans.
In most cases grant makers are very selective on who
receives the grant.
While sums may be small they can make a difference to a
projects viability.
Often the problem is identifying
what grants are actually
available.
Grants
Advantages
It does not have to be paid back by the recipient.
Disadvantages
It mostly comes with strings attached depending on the
objective of the grant maker.
Subsidies
Financial assistance granted by a government, a non-
governmental organization (NGO) or an individual to support
business enterprises that are in the public interest.
Farm subsidies are common subsidies given to domestic
farming industries.
In most cases the cash subsidies are given to help these
industries survive in a very competitive environment by
being able to sell their product at low market prices, while
still being able to reap financial gain.
In situations where the market price goes below the cost of
production, this is known as subvention.
Subsidies
Advantages
It helps businesses to increase their demand for goods by
charging lower prices for their products.
Do not need to be repaid.
Disadvantages
Government subsidies are often
marred by political interference
in the subsidization process.
Debt factoring
When working capital is tight or when a business is
struggling to get paid by customers, it may consider using a
third party agency to help.
A factor agent or debt-factoring company is a company that
buys the current unpaid invoices of a business with a
percentage discount. It pays that cash immediately to the
business and hopes that it can recover more than the value
paid of the debts in order to make a profit.
Debt factoring
Advantages
The business receives cash upfront and can use this money
to fund expansion and working capital needs more generally.
The administration cost to the business of chasing up its
customers unpaid bills is immediately removed.
Disadvantages
The business is really giving up some of its profit margin.
A factor agent ringing up your biggest customer and
demanding immediate payment otherwise the customer
may be taken to court could mean that you lose vital sales in
the future.
Leasing
By leasing an asset instead of purchasing it, a business can
reduce the amount of finance it needs to raise.
A business pays a set fee to lease the asset for a set time.
After this, the asset is returned to the leasing company.
The business might then renew the leasing contract and
receive a new asset.
Leasing is useful for equipment such as computers, which
quickly become outdated.
Leasing
Advantages
The business does not need to
find a large initial lump sum to
buy the equipment, and thus
pay for the asset from its own
revenue.
Disadvantages
The ownership of the asset
does not pass to the business.
The business will probably be
paying a reasonable high level
of interest.
Venture capital
Financial capital provided by investors who are most
prepared to share the risks of business enterprise.
They invest in the share capital as well as providing loan
capital for businesses with expansion potential.
Venture capitalists usually fund start-ups that find it difficult
to access money from other financial institutions or capital
markets.
They own a stake in the businesses they invest in with the
expectation of benefiting from future profits.
Due to the high risks involved, they expect the firms needing
the funds to produce a thoroughly researched business plan
to help mitigate the risk of investment.
Venture capital
Advantages
They often provide business help and contacts for export
drives or for identifying new technologies or partners.
They sit as non-executive directors.
Disadvantages
Profit or sales targets are imposed.
If the business fails to expand, they increase their equity
stake.
Business angels
Also known as angel investors.
Very affluent individuals who
provide financial capital to small
start-ups or entrepreneurs in
return for ownership equity in
their businesses.
Invest in high-risk businesses that
show good potential for high
returns or future growth.
May provide a one-time initial
capital injection or continually
support the businesses through
their lifetime.
Business angels
Advantages
They give more favourable financial terms than other
institutions or lenders of small or start-up businesses.
They are known to invest in the person rather than how
viable a business venture is.
They focus on helping a business succeed by using their
extensive business experience coupled with good financial
capital.
Disadvantages
They may assume a good degree of control or ownership in
the businesses they invest in, therefore diluting the
ownership of the entrepreneur.
External sources of finance
Time frame Possible usage
Short-term Under 1 year Working capital
Medium-term 1 5 years Capital expenditure (vehicles, refurbishment, etc.)
Long-term Over 5 years Major capital expenditure (buildings, land, etc.)
External sources of finance
Short-term Medium-term Long-term
Bank overdraft Leasing Share capital
Trade credit Bank loans Loan capital
Debt factoring Grants Venture capital
Factors influencing the choice of a
source of finance
Purpose or use of funds
Cost
Status and size
Amount required
Flexibility
State of the external environment
Gearing
Key concept link
Selecting appropriate sources of finance is an important
strategic choice for businesses.
Selecting inappropriate sources can impact on ownership
and control and the ability of managers to meet the needs
and wants of stakeholders.
Sources
Stimpson, P., Smith, A. (2015) Business Management for the
IB Diploma. Cambridge
Lomin, L., Muchena, M., and Pierce, R. (2014) Business
Management. Oxford
Clark, P. and Golden, P. (2009) Business and management
Course Companion
Gutteridge, L. (2009) Business and Management for the IB
Diploma
Thompson, R. and Machin, D. (2003) AS Business Studies