Accounts and Finance

Section 3

Unit 3.1 Sources of Finance

Or where can we get money
from?
 Assessment Objectives

 Role of finance for businesses: capital

expenditure and revenue expenditure. A02
 The appropriateness, advantages and
disadvantages of sources of finance for a
given situation. A03
Why do we need finance?
1. Setting up a business
2. Need to finance our day-to-day
activities
3. Expansion
4. Research into new products
5. Special situations such as a fall in sales
 businesses need money to finance their
various activities. This could be for the initial
setting up of the business, for its day-to-day
running or for expansion purposes.
 Finance is required
for many activities
 Setting up a business will require start-
up capital of cash injections from the
owner(s) to purchase essential capital
equipment and, possibly, premises.
 Finance is required
for many activities
 Businesses need to finance their working
capital –
• the day-to-day finance needed to pay bills
and expenses and to build up stocks
 Finance is required
for many activities
 Business expansion needs finance to
increase the capital assets held by the
firm – and, often, expansion will involve
higher working capital needs.
 Finance is required
for many activities
 Expansion can be achieved by taking
over other businesses. Finance is then
needed to buy out the owners of the
other firm.
 Finance is required
for many activities
 Special situations will often lead to a
need for greater finance. A decline in
sales, possibly as a result of economic
recession, could lead to cash needs to
keep the business stable; or a large
customer could fail to pay for goods, and
finance is quickly needed to pay for
essential expenses.
 Finance is required
for many activities
 Apart from purchasing fixed assets,
finance is often used to pay for research
and development into new products or to
invest in new marketing strategies, such
as opening up overseas markets.
 Finance is required
for many activities
 Note:
• Some of these situations will need investment in
the business for many years. Others will need only
short-term funding (for around one year or less).
• Some finance requirements of the business are for
between one and five years (medium term
financed).
• All of the situations will need different types of
finance. No one source or type of finance is
likely to be suitable in all cases.
 Key Terms
 Start-up capital – capital needed by an
entrepreneur to set up a business
 Working capital – the capital needed to
pay for raw materials, day-to-day running
costs and credit offered to customers. In
accounting terms:
• working capital = current assets – current
liabilities
Working Capital (Balance Sheet)
 Current assets are all the assets of a company that
are expected to be sold or used as a result of
standard business operations over the next year
 Current assets are important to businesses
because they can be used to fund day-to-day
business operations
 Eg. Cash, Accounts receivables
 Current liabilities are a company's short-term
financial obligations that are due within one year
or within a normal operating cycle
 include accounts payables, short-term debt,
Capital and Revenue Expenditures
 Capital Expenditure – is the finance spent
on purchasing fixed assets that are expected
to last for more than one year, such as land,
buildings, equipment and machinery.
 Revenue Expenditure – is spending on all
costs and assets other than fixed assets
and includes wages, raw materials, rent and
electricity.
 Question 3.1.1
London Olympic Games
Page 220

Business & Management

 Use examples to distinguish
between revenue expenditure and
capital expenditure.
• Revenue expenditure is spending on the daily
running of a business, such as wages and materials
used in the preparation for the 2012 Olympic
Games.

• Capital expenditure, on the other hand, refers to

the finance spent on purchasing fixed assets, such
as the land, buildings and machinery used in
preparation of the Olympic Games in London.
 Examine the benefits to various
stakeholders of the Olympic
Games being held in London.
• Pre-Olympic Games, firms in the construction and
transport industries will be involved in the
infrastructure needed to host the Olympic
Games, e.g. building an Olympic stadium.
• Huge opportunities exist for job creation and
human resource planning. The development and
preparation of the Olympic Games will create jobs
and wealth in the local community, London and the
UK, thereby providing further potential benefits
to UK businesses.
 Examine the benefits to various
stakeholders of the Olympic
Games being held in London.
• The Olympic Games will attract a huge volume of
foreign visitors and tourists to London and the
UK, thereby providing many opportunities, e.g.
airlines and hotels will tend to benefit from the
influx of tourists in London.
• Homeowners near the Olympic Village are likely to
benefit from higher property prices due to the
necessary improvements in transportation links
(Transport for London) and infrastructure in the
area.
 Examine the benefits to various
stakeholders of the Olympic
Games being held in London.
• The government benefits from increased tax
revenue, e.g. higher expenditure taxes from
spending in the economy and higher corporate tax
revenues from the boost in profits of London and
UK-based businesses.
• There are huge marketing opportunities for
British multinationals, including advertising
agencies and sponsorship deals. Broadcasters and
corporate sponsors also enjoy the global
attractiveness of the Olympic Games.
SOURCES OF FINANCE - VIDEO
Sources of Finance
 Internal Sources
of Finance

Funds that come from within the

business, such as profits that have been
retained for business use or from the
sale of goods and services that earn
money for the business.
Personal Funds
 Main source of finance for sole traders
and partnerships
• Sole traders – a business in which one
person provides the permanent finance and in
return has full control of the business and is
able to keep all the profits
• Partnerships – a business formed by 2 or
more people to carry on a business together,
with shared capital investment and usually
shared responsibilities
Profits retained in the business
 If a company is trading profitably, some
of these profits will be taken in tax by the
gov’t (corporate tax) and some is nearly
always paid out to the owners or
shareholders (dividends). If any of the
profit remains, it is kept in the business
and this retained profit becomes a
source of finance for future activities.
 Sale of Assets
 Businesses could sell assets that are no
longer fully employed to raise cash.
 Some businesses will sell assets that they
still intend to use, but which they do not
need to own. Assets might be sold to a
leasing specialist and leased back by the
company. This will raise capital but there will
be an additional fixed cost in the leasing and
rental payment.
Evaluation: Advantages
 No direct cost to the business although
there may be opportunity cost
 Does not increase liabilities or debts
 There’s no risk of loss of control by the
original owners as no shares are sold
Evaluation: Disadvantages
 Is not available for all companies
 Can slow down business growth as the
pace of development will be limited by
the annual profits or the value of the
assets to be sold
EXAM TIP!
Do not assume that a profitable
business is cash rich – and that 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.
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’ it.
 External Sources of
Finance

Long-term Financing:

To purchase fixed assets that will be used

for many years, or to fund a take-over.
Issue New Shares
(Share Capital)
Available to limited companies (PLC’s and
LTD’s).
 Advantages:
• A permanent source of finance that does not
have to be repaid.
• No interest is charged.
• Large sums can be raised.
 Disadvantages:
• Shareholders will expect dividends to be paid.
• Original owners may lose control of the
company if new shareholders are created
(exception – a Rights Issue allows existing
shareholders in plc’s to maintain their %
shareholding).
• Can be expensive to organize (fees paid to
advisors etc).
• May take some time to arrange.
• Dividends paid after tax, so less money
available to shareholders.
Long-term Bank Loan
(Loan Capital)

A loan for 10 years or more.

Example: Mortgages and Business Dev. Loans
 Advantages:
• Quick to arrange (money immediately available).
• Flexibility over repayment term (eg 10 years-25
years).
• Discount rates often available if large sums
borrowed.
• Interest is paid before the profits are taxed.
Long-term Bank Loan
(Loan Capital)
 Disadvantages:
• Loans must be repaid.
• Interest is charged and must be paid, even if
the firm makes a loss.
• Interest rates may be variable which adds
risk.
• Collateral or security is often required.
Debentures (long-term loan certificates)
 Debentures are a type of long-term loan with
the promise of fixed annual interest payments
to the debenture holders and are repayable
on maturity.
Debentures (long-term loan
certificates)
 Advantages:
• Debenture holders can re-sell the debenture
(increased liquidity is an attraction for
investors).
• Interest rate is fixed. This reduces risk for the
business.
• Enables very long-term financing (eg. 25
years).
Debentures (long-term loan
certificates)
 Disadvantages:
• Must be repaid in full on the maturity date.
• A fixed rate of interest is charged throughout
the loan period.
Exam Tip!
 Students often write that a fall in a
company’s share price affects its
level of profits as the firm has less
money. It is more likely to be the
other way around; the poor
performance of a company will lead
to a fall in its value so its share price
declines.
 When share holders sell their
shares, the company does not
receive any of this money as these
shares are traded on the secondary
market of the stock exchange; no
new shares have been issued by the
company.
 Question 3.1.2
Agricultural Bank of China
Page 222

Business & Management

• Question 3.1.2 Agricultural Bank of China (ABC)
• In August 2010, Agricultural Bank of
China (ABC) completed its initial public
offering (IPO) in Shanghai and Hong
Kong, raising $22.1 billion. Despite the
weak market sentiment in Asian stock
markets and fears that Chinese bank
shares were overvalued, investors poured
money into China's third largest lender,
with more than 325million customers.
• ABC's flotation proved to be the world's largest
ever, beating the previous record of $21.97
billion set by the IPO of China's largest bank,
Industrial and Commercial Bank of China (ICBC)
in October 2006.
• (a) Define the term Initial public offering. [2
marks]
• (b) Comment on why ABC might have decided to
float its shares on the stock market. [4 marks]
• (c) Explain why investors might have been so
keen to buy shares in ABC, despite the weak
market sentiment In Asian stock markets at the
time. [4 marks]
 Define the term initial public
offering (IPO).
• An initial public offering (IPO) occurs
when a company floats its shares on a
stock exchange for the very first time.
For example, ABC floated its shares in
both Shanghai and Hong Kong. In doing
so, ABC became a public limited company.
Comment on why ABC might have decided
to float its shares on the stock market.
• The main benefit of issuing shares in a
company is the potential to raise a huge
amount of share capital. In the case of ABC, it
was able to raise $22.1 billion, significantly
improving its cash flow and sources of finance.
• The extra source of finance would allow ABC
to compete against more established global
banks such as Citibank, HSBC, Bank of China
and ICBC, especially as it would be able to
expand its operations within and
beyond China.
 Comment on why ABC might have
decided to float its shares on the
stock market.
• Expansion (funded by the IPO) allows
ABC to have a greater market presence,
thereby enhancing its corporate image.

• In addition, ‘going public’ allows a

business to have the protection of
limited liability.
 Explain why investors might have been
so keen to buy shares in ABC, despite
the weak market sentiment in Asian
stock markets at the time.

• Investors in the stock market tend to buy for the

medium to long term. Given that ABC is China’s third
biggest lender, with more than 325 million customers,
this may have provided sufficient reason (i.e. a sense
of security) for investors to pour money into the
company.
 External Sources of
Finance

Medium-term Financing:

To purchase fixed assets that will be used for

2 - 5 years (eg. equipment & vehicles).
 Medium-term Bank Loan

 Advantages:
• Quick to arrange (money immediately
available).
• Flexibility over repayment term (eg 2 - 5 years).
• Discount rates often available if large sums
borrowed.
• Interest is paid before the profits are taxed.
Medium-term Bank Loan
 Disadvantages:
• Loans must be repaid.
• Interest is charged and must be paid, even if
the firm makes a loss.
• Interest rates may be variable which adds
risk.
• Collateral or security may be required
(especially for smaller and higher risk
businesses).
 Hire Purchase
The business pays monthly installments to a finance company.
When the final installment is paid the asset becomes the
business’.
 Advantages

• Enables businesses to buy assets when they have

little cash available, or when they do not want to
commit large amounts of cash to acquire assets.
• No collateral required (the asset being purchased is
the collateral).
• Useful for businesses that have limited finance
options.
Hire Purchase
 Disadvantages
• A large cash deposit may be required.
• Interest rates are generally higher than for
bank loans.
• Failure to make a payment may result in the
asset being taken back by the HP company.
 Leasing
Businesses sign a contract with a leasing firm. They
effectively rent the assets they need from that firm
for an agreed period of time.
 Advantages:
• Firms can make use of assets without the need for large
sums of money.
• Frees money to be used elsewhere in the business (helps
cash flows).
• Gives the firm flexibility. It can lease assets only when it
needs to use them (reduces costs).
• The care and maintenance of the asset is the responsibility
of the leasing company.
• Assets are kept up to date (ideal for computers and other
equipment that become obsolete quickly).
Leasing
 Disadvantages:
• In the long run, total costs will be higher than
buying the asset outright.
• Businesses are committed to lease the asset
for the length of the lease agreement.
Sell and Lease-back
Businesses raise money by selling assets
that they need, then lease them back.
 Advantages:
• Frees money tied up in assets for use by the
business.
• The business is still able to make use of the
assets in return for monthly payments to the
leasing company.
Sell and Lease-back
 Disadvantages:
• The firm will have fewer assets to provide as
collateral for loans in the future.
• Day to day costs will be higher as there will be
an extra monthly payment for using the asset.
• The firm will be committed to lease the asset
for the length of the lease agreement.
 External Sources of
Finance

Short-term Financing:
Provides the working capital needed for the
day-to-day expenses of the business.
Covers the period from a few days to 12
months.
Bank Overdraft
The bank allows the current account of the
business to become ‘overdrawn’. This means
that it will have a negative balance. A facility to
become overdrawn should be arranged with
the bank before the money is required.
 Advantages:
• The most flexible form of financing as the amount of
money needed can change day-to-day.
• Interest is only payable on the amount overdrawn.
• Can be cheaper than a loan if overdrawn period is
kept short.
Bank Overdraft
 Disadvantages:
• Interest rates are generally higher than for a
loan.
• A fee is often charged for having the facility.
• Not generally available for a long period of time.
• The bank can ask for repayment at any time
which could cause the business to be made
bankrupt.
• There will be an upper limit to the facility. The
firm cannot be overdrawn more than this.
Trade Credit
When a business delays paying its
suppliers for an agreed period of time
(usually 30 or 60 days).
 Advantage:
• Is like the business receiving an interest-free
loan for a month or two.
• Allows the business to sell goods before
paying for them.
Trade Credit
 Disadvantages:
• Suppliers may refuse to send more supplies if
payments are left too long.
• The firm cannot usually obtain a discount for
paying the supplier quickly.
• Is generally limited to a period no longer than
60 days.
Debt Factoring
Debt Factors buy the debts of firms for
cash.
 Advantages:
• The business receives most of the money
owed to it (around 80-85%) immediately.
• Helps businesses that give their customers
long trade credit periods.
• The risk of non-payment is taken on by the
Factor.
Debt Factoring
 Disadvantage:
• The firm only receives a % of the money
owed to it (around 80-85%).
External Sources of
Finance

Grants & Subsidies

Grants
Money usually given by the government to
assist firms with important expenditures.
Advantages:
• Enables businesses to fund important
projects like training, or the purchase of new
equipment / technology.
• Encourages businesses to adopt new
methods / technologies eg. alternative energy
generators.
Grants
 Disadvantages:
• There are often ‘strings’ attached, eg firms
must locate in a certain area, create a certain
number of jobs, or purchase a specific item.
Subsidies
Payments made by governments in order
to keep businesses operational.
 Advantages:
• Money does not have to be returned.
• No interest is charged.
 Disadvantage:
• Only available to businesses in certain
industries.
Question 3.1.3 – 3.1.5
(answer in groups)

Business & Management

Venture Capital
vs.
Business Angels

Sources of Finance
Venture Capital (VC)
 Is a high-risk capital invested by venture
capital firms, usually at the start of a
business idea. The finance is usually in
the form of loans and/or shares in the
business venture.
 Venture capitalists seek to invest in small
to medium-sized businesses that have
high growth potential.
Business Angels (BA)
 Are wealthy entrepreneurs who risk their
own money by investing in small to
medium-sized businesses that have high
growth potential.
 They take proactive role in the setting up
or running of the business venture –
owner loses some control to the BA
 By contrast, venture capital is typically a
pool of professionally managed funds.
 Criteria for VC and BA
 Return on investment – business has to
have good potential to be highly profitable.
 The business plan – should outline the LT
aim and purpose of the business venture.
 People – must have good team of people.
 Track record – Investors will assess the past
track record of the business and its
management before investing any capital.
Question 3.1.6
MG Rover
Page 226

Business & Management

 Describe why the members of
the Phoenix Four might be
classed as business angels.
• Business angels are private individuals who
invest their own money in business ventures
that offer potentially high returns. The
Phoenix Four ‘rescued’ MG Rover by putting in
60,000 GBP each after having bought the
company from previous owners BMW with the
expectation that MG Rover would reap them a
reward.
Explain the dangers outlined in the
article concerning the use of
business angels.
• Lack of experience in the field, i.e. the Phoenix Four
were not familiar with the motor manufacturing
industry. This can lead to gross mismanagement of the
organization.
• Conflict of interest – it is stated that the Phoenix Four
gave themselves ‘extravagant financial rewards’.
• As business angels, the Phoenix Four may not have had
their hearts truly in the business. Business angels tend
not to make follow-on or continual investments in the
same firm.
 Analyze how the profitability of a
business, such as MG Rover, affects its
ability to raise external sources of
finance.
• External sources of finance are those that are
obtained from outside the organization, e.g.
overdrafts, bank loans and debentures. The
profitability of a business is likely to have a huge
impact on its ability to raise external finance because:
 banks and other creditors tend not to lend to high-risk
customers with a low credit rating, i.e. those that are
unlikely to be able to repay their debts
 Analyze how the profitability of a
business, such as MG Rover, affects its
ability to raise external sources of
finance.
 debt factoring service providers are unlikely to take on
clients with poor credit ratings
 by contrast, firms with high profitability have
collateral (security) to offer to lenders in case they
default on their loans
 trade creditors are more likely to grant preferential
credit terms to clients with a good record of
profitability
 Analyze how the profitability of a
business, such as MG Rover, affects its
ability to raise external sources of
finance.
 shareholders tend not to hold onto shares of companies
that have low profitability, and this indirectly affects
the firm’s ability to raise finance through external
methods
 highly profitable firms can also enjoy financial
economies of scale, i.e. borrowing more and at a
relatively lower rate of interest
Managers consider a number of
interlinked factors when
examining the strategic choice
between alternative sources of
finance

STAGE PC
Size and status of firm
 A well-known and large MNC will find it
much easier to raise finance from a
wider range of sources than a sole
trader.
 Large organizations are also able to
obtain cheap finance due to financial
economies of scale.
Timeframe
 If finance is needed for a long period of
time, then long-term loans such as
mortgages or debentures are suitable.
 If finance is needed to help fund working
capital, then short-term sources such as
trade credit and overdrafts are more
appropriate.
Amount required
 Large amounts of finance might be
raised through IPO or through secured
long-term loan from banks.
 If only a small amount is needed then
retained profit or an overdraft might be
sufficient.
Gearing
 Lenders assess a firm’s existing gearing
(LT external borrowing of a firm as a % of
its capital employed) before approving
any finance.
 Firms with high gearing are relatively
high risk as they have existing debt
commitments and more vulnerable to
any increase in interest rates.
External factors
 Factors beyond the control of a business
can have a huge impact on the strategic
choice of finance.
 Businesses will be affected by the state
of the economy and consumer
confidence levels.
Purpose of finance
 The choice of finance depends on
whether it is intended for the daily
running of the business (ST purposes) or
for the replacement of fixed assets over
a longer time period.
Cost of finance
 Managers need to consider the purchase
cost of assets and the associated costs,
such as administrative fees and
maintenance charges.
 Higher costs tend to require longer term
sources of finance.
Key Terms

Business & Management

 Business angels
• Are wealthy entrepreneurs who risk
their own money by investing in small
to medium-sized businesses that
have high growth potential.
 Capital expenditure
• Is investment spending on fixed
assets such as the purchase of land
and buildings.
 Debt Factoring
• Is a finance service whereby a factor
(such as a bank) collects debts on
behalf of other businesses, in return
for a fee.
 External sources of
finance
• Means getting funds from outside
the organization, e.g. through debt
(overdrafts, loans and debentures),
share capital, or the government.
 Grants
• Are government financial gifts to
support business activities. They are
not expected to be repaid by the
recipient.
 Initial Public Offering
(IPO)
• Refers to a business converting its
legal status to a public limited
company by floating (selling) its
shares on a stock exchange for the
first time.
 Internal sources of
finance
• Means getting funds from within the
organization, e.g. through personal
funds, retained profits and the sale
of assets.
 Leasing
• Is a form of hiring whereby a
contract is agreed between the
lessor and the lessee.
 Loan capital
• Refers to medium to long-term
sources of interest bearing finance
obtained from commercial lenders.
Examples include mortgages, business
development loans and debentures.
 Overdrafts
• Allow a business to spend in excess
of the amount of its bank account, up
to a predetermined limit. They are
the most flexible form of borrowing
in the short term.
 Retained profit
• Is the value of surplus that the
business keeps to use within the
business after paying corporate
taxes on its profits to the
government and dividends to its
shareholders.
 Revenue Expenditure
• Refers to spending on the day-to-day
running of a business, such as rent,
wages and utility bills.
 Sale-and-leaseback
• Is a source of external finance
involving a business selling a fixed
asset (such as its computer systems
or a building) but immediately leasing
the asset back. In essence, the
lessee transfers ownership to the
lessor but the asset does not
physically leave the business.
 Share Capital
• Is the money raised from selling
shares in a limited liability company,
from its IPO and any subsequent
share issues.
 Share Issue
(share placement)
• Exists when an existing public limited
company raises further finance by
selling more of its shares.
 Sources of Finance
• Is the general term used to refer to
where or how businesses obtain their
funds, such as from personal funds,
retained profits, loans and
government grants.
 Subsidies
• Are funded by the government to
lower a firm’s production costs as
output provides extended benefits to
society, e.g. farmers are often
provided with subsidies to stabilize
food prices.
 Trade Credit
• Allows a business to ‘buy now and pay
later’. The credit provider does not
receive any cash from the buyer until
a later date (usually allow between
30-60 days),
 Venture Capital
• Is high-risk capital invested by
venture capital firms, usually at the
start of a business idea. The finance
is usually in the form of loans and/or
shares in the business venture.