Sources of Finance

Introduction
Financial managers have to raise enough capital (funds) to support the organisation`s operations and
investment objectives. Financial managers have to choose when financing their businesses from three
major sources namely: existing profits that are reinvested to provide an internal source of financing for
future activities, external equity finance raised from existing or new shareholders, or external funds
borrowed from financial institutions or other investors. The financing decision forms one of the three key
financial management decisions that any business has to undertake. After financial managers have
identified and evaluated viable and profitable businesses they need to decide on how to fund these
business ventures. Financial managers need to consider a number of factors when deciding on the best
source of finance for a particular investment, such as the cost of finance, availability of the funds,
characteristics of the funds, risk associated with those funds and the effect on the business’s financial
performance and position. These sources of finance have a cost associated with them which the financial
managers have to match the cost associated with each source of finance to the benefits accruing from
the same sources of finance. Financial managers have to make finance decisions such as choosing
between the two main types of long-term capital, which are namely the owners` equity and the debt
equity. The acquisition of any of long-term capital (finance) is linked to the cost related to its acquisition
and the time frame of that source. In case of long-term investments, the financial managers will need
source funds with relative long-term maturity such as shares and long-term debt. While if the company
wants to finance short-term investments for example working capital, financial managers will have to
acquire short-term sources of finance. When managing well the firm`s liquidity position, the financial
managers can also ensure that the business has sufficient cash resources available to fund its
operations. Regardless of the source of finance, there is always a cost related to it, and financial
managers have look for the cheaper and easy to acquire source of finance. The providers of the capital
(funds) all require a return on their investment in the business and this required return will help financial
managers to choose the most appropriate source of funding. Adding debt into the firm`s capital structure
has some intriguing advantages over equity as debt has lower required rate of return owing to more
certain cash flows, lower issuing costs and tax benefits that further reduce the cost of debt. Although
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debt has such significant advantages it has also distinct disadvantages which include reduction of
earnings available to shareholders through the interest and increased financial risk. While debt seems
to be the cheaper source of finance, too much of debt could increase the financial risk to the point where
the cost of equity and cost of debt start to increase, ultimately increasing the entity`s weighted average
cost of capital. Understanding financial markets and being familiar with the financial institutions and other
providers of capital is a necessary pre-requisite to discuss the different forms of finance.

Financial institutions and markets

The business world operates in a large and complex financial environment made up of financial markets,
financial institutions and securities involved in the transfer of funds between individuals, firms and
governments. Individuals, firms and governments do earn or raise and spend or invest money. The
financial markets and financial institutions act as intermediaries between borrowers and lenders,
between buyers and sellers of financial securities where funds flow within the economy. Whenever a
business is starting it needs funding and financial managers have to acquire funding from financial
markets and financial markets.
Financial markets
A financial market is any place where entities or financial institutions that require capital to finance their
investment come in contact with investors and institutions with money to invest. These are markets
where economic units with excess funds can transact with economic units in need of funds. The financial
markets bring together the suppliers of funds and those seeking funds. The financial managers need to
have a thorough understanding of how local and global financial markets work. The financial markets
consist of two markets, namely the money markets and the capital markets:
Money markets
This is a market where short-term debt securities (those with a maturity of one year or less) are bought
and sold. Money markets do not have a physical address, but participants are connected electronically.
The main aim purpose of a money market is to enable participants that temporarily have extra funds to
earn interest on those funds. Those in need of short-term financing approach money markets get funds.
The short-term debt securities that are provided by money markets are called marketable securities
which comprise treasury bills, NCDs, commercial paper and banker`s acceptances. The government

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treasury bills are the short-term debt obligation with an issue date, maturity date and nominal value
payable within 91 or 182 days from the issue date.
Capital markets
This is a market where long-term debt securities (those with a maturity of more than one year) are bought
and sold. The main securities found under this category are the shares, derivatives, corporate bonds
and corporate debentures. The Johannesburg Stock Exchange (JSE) is a good example of a capital
market. Financial markets can be subdivided into primary and secondary markets.
Primary and secondary markets
A primary market is a market in which listed companies and governments sell securities for the first
time. There are two types of primary market transactions: The first is a private placement, where the
securities are only for sale to specific buyers. The second is a public offering, which is available to the
general public.
The secondary market is the one in which the original securities that were bought in the primary market
can be traded. An investor who bought the shares in the primary market can decide to sell them to the
public in the secondary market. The secondary market requires buyers and sellers so that the transfer
of securities can be transferred. The JSE act as both a primary and a secondary market. There are two
types of secondary markets, namely auction and dealer markets.
The auction market also known as broker market, is where the broker does the transactions. The dealer
or over-the-counter market brings the sellers and buyers of securities together. The traders or securities
dealers offer to buy or sell securities at fixed rates.
Financial institutions
Financial institutions play the role of the intermediary, taking the deposits from investors who want to
earn a return on their investment and lending these funds to entities that require funding. These are
institutions such as commercial banks, insurance companies, pension fund companies, collective
investment schemes, unit trust that bring savers and lenders together in an effort to efficiently allocate
funds within the economy. Examples are commercial banks such as ABSA, FNB, Nedbank and
Standard Bank, life assurance companies such as Old Mutual and Sanlam, pension funds, unit trusts,
and the South African Reserve Bank (SARB). The financial institutions charge interest for the work they
do which become their revenue. The financial institutions also charge more interest than it pays to

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investors, resulting in a margin that compensates financial institutions for their services rendered.
Financial institutions are important when examining the business environment, as individuals,
businesses and governments cannot act in an efficient manner without them. Financial institutions are
governed and regulated by the act in accordance with the established ethical and operational guidelines
with specific regulations.

Different types of short-term finance

Short-term finance is used to finance short term requirements which are usually the organisations working capital. There are for a
period of twelve months and below where there has to be a match between the cash expenses of that period and the cash revenues
of the same period. It therefore follows that short term finance is required for financing the day to day operations of the organisation
(i.e. working capital). Financial managers have to appreciate that they cannot use short-term finance to finance long-term assets
that would result in what is called financial mismatch and this will create problems for the entity. The following are the most ideal
sources of short-term finance:
Accounts payable (Trade credit)
This form of financing is different from other forms of short-term credit, in that it is not associated with a financial institution. This is a
spontaneous short-term finance that is granted on an informal basis to businesses without being asked to provide any security, and
payment follows at a later stage.
Accruals/Owings
Financial managers are required by law to set aside funds in order to pay accruals for items like taxes (such as income tax and sales
tax collected and paid on a weekly, monthly, quarterly, half yearly or yearly basis. For some of the accruals services have already
been rendered to firm but then payment will be required at a later stage or the financial manager decides not to pay. The financial
managers should avoid some items like rentals, salaries and wages and electricity as these things will put the firm into serious
trouble. In essence this particular source of finance one needs to exercise extreme caution. The said funds that should have been
paid out are then invested somewhere even on short-term investments where they can earn a good return.
Bank loans
Commercial banks are traditionally the major providers of unsecured short-term loans to the businesses. Banks provide non-
spontaneous funds to the businesses as financing needs increase. Businesses specifically request additional funding from their own
banks that they have been relating with for a long time.
Bank overdraft
This type of financing arises when the financial manager sees that there is going to be cash shortage at a certain stage and then
negotiate with the business`s bank to be allow to overdraw the firm`s bank account. The bank will then allow to firm to overdraw its
bank account but being charged interest. Most business will always apply for a bank overdraft even during the good times so that
when that moment arise the facility is already available.
Single- payment notes
Businesses who need more funding on a short-time basis can obtain a single-payment note from a commercial bank. This note must
be signed by the borrower specifying the amount borrowed, the percentage interest rate, the repayment schedule, the collateral

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required and other terms and conditions agreed by the borrower and the bank. The notes typically have a maturity of 30-90days.
Interest charged may be fixed or floating and is normally tied to the prime rate, and the note may either be a discount note or an
add-on-note.
Line of credit
A line of credit is an agreement between a commercial bank and a borrower in which the bank agrees on a specified maximum
amount of credit that will extend to a borrower for a specified period. A credit check is done on applicant for the line of credit. The
borrower may be required to submit documents such as projected income statement. Lines of credit are normally extended for a
period of one year and may be extended depending on the customer`s creditworthiness. Interest rates on both new and outstanding
borrowings are adjusted automatically using the prime rate exchange. Banks may impose certain operating restrictions on entities
with line of credit.
Revolving credit agreement
A business can also enter into a revolving credit agreement in a formal way where the line of credit is extended by the bank or other
lending institution and is often used by large firms. The main difference between a line of credit agreement and a revolving line of
credit agreement is the legal obligation of the bank to honour a revolving credit agreement. The bank will receive a commitment fee
for the revolving credit agreement.
Commercial paper
This is an unsecured, short-term promissory note issued by large, financially sound firms to raise funds. Firms often purchase
commercial paper, which is held as a marketable security, to provide an interest-earning reserve of liquidity. The maturity of a
commercial paper varies from one to nine months. The rate on commercial paper fluctuates with supply and demand conditions.
Rates on commercial paper are typically lower than prime rate.
Banker`s acceptance
The bank`s acceptance (BA) is created when an enterprise sells a bill of exchange to the bank to be settled on a predetermined
date, usually 90 days later. A bill of exchange is defined as an unconditional order in writing addressed by one person to another,
signed by the person giving it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable future
time, a certain sum of money to order or bearer. Banker`s acceptance is commonly used to finance overseas trade transactions.
The BA rate is regarded as possibly the most important stable indicator of prevailing short-term money market interest rates, since,
since banker`s acceptances are generally seen as short-term securities issued by private sector financial institutions carrying the
least risk with the greatest liquidity.
Short-term secured loans.
These type of loans are obtained by pledging specific assets as collateral if one has to obtain them. The collateral for the short-term
borrowing normally takes the form of current assets such as debtors and inventory. The security agreement is drawn up between
the lender and the borrower in which the collateral held against the loan is specified, as well as the terms of the loan against which
the security is held.
Factoring
Factoring involves the sale of the entity`s debtors to a third party (known as the factor). The factor will charge a commission for
purchasing the debtors by paying a discounted amount of cash to the entity. The entity benefits, in that it converts its debtors into
liquid cash and the factor benefits by paying a discounted price. Factoring may take place in one of two ways, namely with recourse

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or without recourse. Factoring with recourse means that if the debtor defaults on the amount owing to the factor, then the entity must
bear the bad debt and not the factor. In the case of factoring without recourse, the factor bears the risk of the debtor defaulting. As
the factor bears additional risk in factoring without recourse, it charges a higher commission in the form of the discount calculated
Invoice discounting
Invoice discounting involves a factor advancing approximately between 75% to 80% of the face value of the approved sales invoices
outstanding to an entity. The entity. Is therefore, able to access liquid cash relatively easily. The entity needs to repay the factor once
the debtor has repaid the entity. Invoicing is different from factoring, in that the trade receivables are not sold to third party. This
means that the customer avoids having to deal directly with the factor.
Negotiable Certificate of Deposit (NCD)
The NCDs is a financial instrument issued by bank, acknowledging the deposit of a specific sum of money for a period of time and
at a certain interest rate. The NDC is promissory note that states the name of the lender and the percentage interest on the negotiated
amount at a given date and the name of the bank giving the interest and of course the amount that has been deposited. It is negotiable
in the secondary market as a financial asset, and is thus a traded private sector money market instrument. The bearer of the NCDs
can use them in place of cash whenever they are short of cash as they represent near cash items. The issuing bank guarantees to
repay principal plus interest to the holder of the certificate on maturity date. NCDs are issued in bearer form at par value and
redeemed at par plus interest. NCDs are therefore a good example of interest add-on money market securities. NCDs are mainly
issued to attract deposits to supplement the funding requirements of a bank.
Notice Accounts
These are very active financial instruments that are used nowadays by many business ventures who need to invest money on a
short notice and then earn interest. The money is deposited in the bank but, you can’t withdraw it until the required period has
elapsed. The financial institute requires a certain period e.g. 30 days’ notice before you can withdraw your money and if you need
it earlier than the stipulated period say 24 hours you then pay a penalty fee. The penalty you pay is so huge to the extent that it
discourages those who might attempt to withdraw their money before the stipulated agreed period. Most financial managers use this
form of finance as a way to raise quick and easier finances for their organisations.
Call Accounts/ Investment
A call account is where one can investment funds for any period in that whenever the entity or individual wants their money they can
call for the funds without an y charges preferred against the one withdrawing the funds. The call account offers the advantages of
both a savings and a checking account in that a call account has no fixed deposit period, provides instant access to funds and allows
unlimited withdrawals and deposits. A call account is a bank account in which you can invest money that earns a higher rate of
interest than in an ordinary account, and from which you can withdraw your money whenever you need it, as longer as you give
them a notice or a call to withdraw your funds. The interest on our call accounts is calculated on the daily cleared balance and paid
monthly to the account. The disadvantage of the call account is that is for large sums of money as little moneys will not earn the
entity any significant amount in the interest form.
Call Bonds/ Bills
Call bonds are short-term negotiable commercial paper issued by large corporates or parastatals. They simple approach the bank
and negotiates a call bond facility for say, R50million, for a period of 12months. The bank supplies the R50million to the parastatal

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and in confirmation of this debt the parastatal would issue 50 call bonds, par value of R1 million each. These bonds are tradeable
documents. The nominal value amount and the method on which interest is calculated are shown on each certificate.
Medium-term sources of finance are:
1. Medium-term Loans: While short-term financing provides bank loans up to 3 years, medium-term loans are offered for 3-10 year
periods. The loan interest is usually set as a margin dependent on the riskiness and credit rating of the borrower. The loan interest
can be variable or fixed. It can be adjusted periodically throughout the life of the loan at an amount above the bank's base rate.
2. Lease Financing: Banks can also issue finance leases, which are more competitive and thus sometimes preferred by some
foreign supporters over traditional loan financing. It is also a useful option when other financing sources are unavailable. For example,
the Export Import Bank of the United States (Ex-Im) will provide up to $10 million to creditworthy foreigner investors, which must be
repaid in a seven-year period.
3. Currency Bonds: Medium-term currency bonds are issued to investors through foreign and domestic entities. Maturity bands for
medium-term investors range from periods of 9 months to up to 30 years. Government bonds also have the benefit of being
scrutinized regularly by policymakers for better yields and interest rates.
Ranging between 1-3 years normal and it moved up to 5 years and recently it has moved up to 7 years. This makes it difficult to
classify your finances in the Balance Sheet. Now what is being used is 1-10 years.
Intermediate finance is mainly used for acquiring Fixed Assets (ownership) and the use of Fixed Assets (leasing).
Leasing
1. There are two types of Leasing
1. Financial leasing
2. Operating leasing
A lease is a contract between two parties for the rental or use of a specific asset for a given period of time at a given payment level.
The legal owner of the asset is the lessor while the legal user of the asset is the lessee. The use of the asset is called rental. The
lessee must pay a deposit that is equivalent to the monthly rental in the first month of the commencement of the lease. Deposit is
refundable if you leave the premises as you found it. The lessee can make reports and get his refund after the repairs are done and
the lessor is aware of the repairs. Payment of a deposit is material aspect of a lease.
1. Financial Lease
The contract must clearly state that the lessee will pay the lessor the full price of the asset. The lessee will also pay all the costs
associated with that asset e.g. interest on the mortgage and anticipated transfer fees.
The asset is rented out for its entire economic life-alternatively known as the rent-to-buy option
2. Operating Lease
a) The rentals have no relationship what-so-ever to the cost of the asset.
b) The lease expires and is renewable
c) The rentals for the operating lease are higher than those of a financial lease
Financing a Leased Asset
Option 1 – Direct Financing – using 100% owners’ equity (shareholders’ funds to purchase the asset).
Option2 – Leveraged Financing – using part debt and part equity to buy the leased asset.

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The owner of the asset (lessor) will have used either of the above to acquire the asset before leasing it. The rentals he charges must
be above monthly repayment instalments if part of the funds is debt finance. You can actually use the lessee to pay your instalments
so that you don’t use you own money.
As a firm we consider ourselves to be in the position of the lessee. Why?
Advantages of Leasing
1. Leasing is very convenient
a) Some industries are capital intensive hence this forms an entry and exit barrier. The exit barrier would come in the sense
that; you’ll have invested so much into your business that you cannot just leave before getting the right price.
Disadvantages of Leasing
a) There is the problem of lack of ownership so continuity is threatened. Lack of ownership might call for relocation of
your business, changing Letterheads etc. if you constantly move to offer premises your customers will begin to doubt
your credibility.
Hire - purchase
You have to pay a deposit which is determined by the current monetary and fiscal policy. After the deposits you then pay monthly
instalments, and the asset can be taken for use by the purchaser. Ownership of the asset remains with the seller. Ownership of the
asset passes to the buyer upon payment of the last instalment. The change of ownership is silent (option exercise) Option exercise
or exercise of an option is when the buyer chooses either to accept or not to accept ownership of the asset. Payment of the last
instalment will automatically pass ownership to the buyer. So payment implies acceptance of the ownership of the asset. At the stage
just before the payment of the last instalment the buyer can decide to return the asset, but he will not get his money back.
The event of failing to pay instalments, the item on hire-purchase will be repossessed by the seller. Because of this requirement,
goods bought on hire-purchases must be kept at the address written on the higher-purchase form ‘domicilian citande at address’. If
the buyer changes address he must inform the seller because if the asset is stolen the buyer will then be liable, and even the
insurance company will refuse to pay if the buyer had insured the asset. Insuring the asset on the part of the buyer is optional and
not compulsory buy many people don’t know this.

Long-term finance
Long-term sources of finance are broadly classified into debt and equity financing meant to finance the entity`s non-current assets
or basically for capital expenditure. Debt financing entails acquiring borrowed funds from financial institutions or individual investors.
The lender will charge interest on the sum being borrowed, which must be paid back at some stage in the future. Equity financing is
regarded as long-term financing provided by the owners of a firm. The mixture of debt and equity is one of the decisions that the
financial managers have to make depending on the needs of the entity. A firm is highly geared when it obtains a substantial proportion
of its finance from debt, be it short-term, medium-term or long–term. The extent that a firm borrows funds from outsiders, gives the
right for these debt holders to claim before the owners (shareholders). Choosing the most appropriate financial structure is one of
the most difficult decisions for financial managers to make. Before choosing the most appropriate financing for the business one has
to answer the following questions:
• For how long are the funds needed?
• What is the cost of each source of finance?

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 • What is the cash-flow position of the firm like?
• What is the availability of the different sources of finance?
• What are our needs in terms of cash-flow from instruments?
• What is the risk related to the instrument?
• How much risk do we want to take?
• What are the alternatives?
Equity financing:
Equity simply means ownership. Equity financing refers to the finance provided by the owners of the entity and consists of either
external and internal sources. The external sources of equity consist of ordinary shares, preference shares while the internal sources
of equity consist of reserves and retained earnings.
Ordinary shares
Ordinary shares are the ultimate owners of an entity. The ordinary shareholders take on the highest risk of any of the providers of
capital and, therefore expect a return commensurate with this risk. The entity can raise equity finance in the form of ordinary share
capital on a financial market like the JSE, where investors buy and sell shares. The ordinary shareholders receive a return in the
form of capital growth in the share price and also in the form of dividends.
Preference Shares
Preference shares are issued as a special breed of shares in comparison to the ordinary shares. Preference shares carry part
ownership of an entity and the holders of these shares receive a fixed rate of dividend in return for the finance provided to the entity.
Preference shares and their dividend rank higher and ahead of the ordinary shares in the event of liquidation, but behind debt finance.
The preference shares tend to be expensive when issued because of the non-tax deductibility of the dividend. Preference shares
may be redeemable or the shareholders may only receive their fixed dividend and not share in additional profits.
Reserves and retained earnings
Reserves include retained earnings, revaluation reserves, and share premiums. The retained earnings are profits that remain after
all the operating and finance expenses had been paid by the entity. The retained earnings have become an important source of
finance for many entities and are the cheapest source as they are the available cash. They are not a free source of finance as they
have an opportunity cost associated with them.

Debt financing:
Debt represent the funds that is borrowed from outsiders that should be paid back at a later date in the future. Debt may be classified
as fixed rate or variable rate as this refers to the interest that will be charged on the debt instrument. Repayment of the debt is done
through the interest and the principal amount. With the fixed interest-rate loan, the interest rate does not fluctuate on the debt for
the duration of the period. With the variable rate, the interest rate may fluctuate during the period in issue. Debt instruments may be
classified as secured if the entity offers an asset as security for the payment of the debt. The debt is classified as unsecured if the
lender does not provide security in case of failing to pay back the debt. With the unsecured debt the lender will demand higher rate
of interest to satisfy the additional risk taken on.
Long-term loans
When issuing a long-term loan, the financial institution will have to evaluate the entity’s activities and the current financial position in
order to be satisfied if this business will afford to repay the loan when it becomes due. The company in need of funds will approach

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the bank and then adhere to the conditions where they will pay periodic interest payment over the lifetime of the loan together with
capital amount. For this type of loan, the bank will require some form of collateral or some form of security before disbursing the
loan. The loan has a fixed amount for a specific term or fixed repayment schedule.
Bonds and debentures
A bond is a generic term that refers to a number of long-term debt instruments including debentures. A debenture is a marketable
security that arise out of a contract between the entity issuing the debenture g-term and the investors. Debentures usually pay a
fixed rate of interest and are often secured over certain assets belonging to the entity. A bond is a debt instrument issued either by
government or a corporation that requires to raise funds. The bond pays interest on the nominal amount (coupon payments) The
bond has a fixed maturity and when it reaches maturity, the nominal value is repaid.
Leasing
A lease is an agreement between the lessor and the lessee in return for a lease payment or a series of lease payments over the
agreed period. When an entity finances its assets or use assets over a period of time this is considered either as an operating lease
or a finance lease. The finance lease is a lease agreement in which the risks and rewards incidental to ownership are substantially
transferred from the lessor to the lessee. Finance leases are essentially term loans. An operating lease is any lease other than the
finance lease which usually does not last for the entire life of the asset and entities have an option to cancel the lease.
Venture capital
Venture capital is the term used to describe finance provided to new, often high-risk, ventures. Venture capitalist investing in start-
up entity consider them as high risky and they always require a higher return for their investment. Venture capitalists provide funding
in stages in order to limit their potential loses if the business fails. The venture capitalist always consider the financing provided at
the outset as seed money. Thereafter, if certain targets and milestones are reached then more finances are provided for more
development or expansion projects. In order to protect their big funds, the venture capitalists will always want to be represented on
the board of directors of the entity in order to safeguard their investments. Finance is only provided once certain targets are reached
and this always act as motivation for the company owners to perform above targets.

Business angels
Venture capitalists do not generally invest in small businesses because of the significant amount of administration and monitoring
that needs to take place. The term “business angels” refers to very wealthy private individuals who have both time and money to
invest in small start-up businesses. Business angels are very wealthy private individuals that take their time to teach and monitor the
small businesses they are investing in. The use of business angels for financing is popular in the United States.

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