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LEARNING GOALS Key learning goals:This topic will introduce the major sources of fundsfor businesses, including internal and externalsources, as well as the key factors affecting thechoice of funds.1. Explain the importance for a business to raise funds2. State the internal sources of funds fro a business3. State the external sources of funds for a business4. State the difference between ordinary shares,preference and deferred shares5. Explain the difference between the operating leaseand the finance lease6. Describe the major factors affecting the choice offunds
The need for funds:No business can live without funds. Throughoutthe life of a business, money is neededcontinuously. Firms raise money mainly to meetthe following three types of need:1. To start a business as initial expenditure;2. To fund continuous business activities andmoney flowing;3. To expand the business.Financial Management-Sources of Funds
The need for funds:Question for your critical thinking:Please give some typical examples for the threetypes of needs for funds.Financial Management-Sources of Funds
Financial Management-Sources of Funds Sources of fundsIn general, a business may have two majorsources of funds which are needed for itsbusiness operations. They are internal sources offunds and external sources of funds.See Figure 13-1 for details.
Financial Management-Sources of FundsTable 13-1 Sources of FundsSources of FundsInternal Sources External SourcesProfit Depreciation Sales of assetsLong-term:Share CapitalLoan CapitalShort term:OverdraftLeasingCredit card…
Financial Management-External Long-term Sources of Funds Share capital:The most important source of funds for a limited company. It isoften considered as permanent capital as it is not repaid bythe business, but the shareholder can have a share in theprofit, called dividend.Three types of shares are:1. Ordinary shares: The most common types of shares, and themost riskiest shares since no guaranteed dividend. Dividenddepends on how much profit is made by the firm. But allordinary shareholders have voting rights.2. Preference shares: The share owners receive a fixed rate ofreturn. They carry less risk because shareholders are entitledto the dividend before the ordinary shares. But they are notstrictly owners of the company.3. Deferred shares: These shares are often held by thefounders of the company. Deferred shareholders only receivethe dividend after the ordinary shareholders have been paid.
Financial Management-External Long-term Sources of Funds Loan capital Definition:Any money which is borrowed for a long period of time bya business is called loan capital. Types:There are four major types of loan capital: Debentures,Mortgage, Loan specialists’ funds, Governmentassistance. See next page:
Financial Management-External Long-term Sources of Funds Types of loan capital:1. Debentures: The holder of a debenture is a creditor of the company,not an owner. Holders are paid with an agreed fixed rate of return, buthaving no voting rights. The amount of money borrowed must be repaidby the expiry date.2. Mortgage: These are long-term bank loans (usually over one yearperiod) from banks or other financial institutions. The borrower’s land orproperty must be used as a security on such as a loan.3. Loan specialists’ funds: These are venture capitalists orspecialists who provide funds for small businesses, especially for hightech investment projects in their start-up stage. There are alsoindividuals who invest in such businesses, which are often called‘business angels’.4. Government assistance: To encourage small businesses and highemployment, governments may be involved in providing finance for businesses.In the USA, there is an organization which is called the Small BusinessAdministration (SBA). SBA provides guarantees for small businesses’ loans andthey even offer some loans themselves.
Financial Management-External Short-term Sources of Funds Definition:Short term sources of funds are usually the funds whichare less than one year for maturity. They are less stablesources of funds for businesses. Types:The main types of external short term sources of fundsinclude:1. Bank overdraft2. Bank loan3. Leasing4. Credit card5. Trade creditSee the next page for details:
Table 13-2 External short-term sources of loansMajor types Main characteristicsBankoverdraftThis is a short term financing from banks.The amount to be overdrawn depends on the needs of the business atthe time and its credit standing.Interest is calculated from the time the account is overdrawn..Bank loan This is a loan which requires a rigid agreement between the borrowerand the bank. The amount borrowed must be repaid over a certainperiod or in regular installments.Sometimes, banks change persistent overdrafts into loans, soborrowers must repay at regular intervals.Leasing Leasing allows businesses to buy plant, machinery or equipmentwithout paying large sums of money immediately.The leasing company or bank hires or buys the equipment and for theuse of the hire company for a certain period of time. If the user cannever owns the equipment, it is an operating lease, while if it is given thechoice to own the equipment at the expiry time, it is a finance lease.Lease payments are made by the hire company yearly or monthly, etc.
Table 13-2 External short-term sources of loans (continued)Major types Main characteristicsCredit card Credit cards can be used to pay for hotel bills, meals,shopping and materials, etc. They are convenient,and secure because it can avoid the use of cash andthe payment of interests within credit periods.Cards may not be suitable for certain purchases,especially a large sum of order because they have acredit limit.Trade credit It is a common method for businesses to buymaterials and to pay for them at a later date, usuallybetween 30 and 90 days. Such trade credit given bythe seller is usually an interest free way of shortterm financing.Financial Management-External Short-term Sources of Funds
Financial Management-Factors affecting the choice of funds Costs of the fundCosts in terms of interest payments and other expenses:Long term and short term. Use or purpose of fundsFor example, the building of a new plant is usuallyfinanced by mortgage or share capital, while the purchaseof raw materials by trade credit or bank overdraft. Status and size of the businessFor a large firm, there are more sources of finance andoften with lower interest rates. Financial situations of a firmFor example, a business in poor financial situation isforced to pay high interest rate for loans. And the bankoften requires security or collaterals for their financing.
Financial Management-Factors affecting the choice of funds Gearing condition Definition:Gearing is the relationship between the loan capital andshare capital of a business. High geared companies havea larger share of loan capital to share capital. Low gearedones have a small amount of loan capital. Impact over a firm:High gearing may mean ‘no loss of ownership’ but highrisk of liquidity since interest rates may change and loansmust be repaid in time. Low gearing may mean some lossof ownership but no burden of loans and interest payments.
Question for your critical thinking:If you are the manager, do youprefer high gearing or lower gearingfor your firm? And why so?Financial Management-Sources of Funds
Sources of Funds Debt capital—funds obtained through borrowing. Equity capital—funds provided by the firm’sowners when they reinvest earnings, makeadditional contributions, or issue stock toinvestors.
Debt and Equity Capital: Two Basic Sources ofFunds
Comparison of Debt and Equity Capital
Sources of Funds Long term Sources of Funds Leverage—technique of increasing the rate ofreturn on an investment by financing it withborrowed funds The key to managing leverage is ensuring that thecompany’s earnings remain larger than its interestpayments, which increases the leverage on the rate ofreturn on shareholders’ investment