Sources of Finance - notes PDF

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Sources of Finance

Internal Sources of Finance Internal sources of finance are from inside the business and are recorded under Equity in the balance sheet. These sources can include the capital contributed by owners when the business began, reinvested profits and the sale of an unwanted business asset. Owner’s capital or equity An owner can invest his or her own money into the business. This money may be: - personal savings - inheritance - gift from parents - payout from being made redundant - personal loan or mortgage loan using the family home as security The owner of a sole trader or partnership deposits cash into the business’s bank account when it is started. As the owner has contributed this money when the business began, this source of finance is called capital. This can also be called proprietorship or proprietor’s funds. If the business has an incorporated legal structure such as that of a private company, then it could be known as shareholders’ funds. Retained profit If the business makes a profit, the owner may decide to only take part of this as their reward for entrepreneurship and reinvest the remainder back into the business. In this situation the business has received finance from two internal equity types: the owner’s capital contribution and retained profit. This is also known as undistributed profits.

Sale of an unwanted or unproductive asset Additionally, the business may benefit from the sale of an unwanted or unproductive asset such as outdated machinery sold for scrap metal. The funds from the sale are paid to the business and are thus available for its use. In this case there is no interest to be paid, no repayment necessary and no loss of control for the owner.

External sources of finance There are a number of external sources of finance available to a business. These usually involve some type of loan and are therefore called ‘debt finance’. The two types of external finances are debt and equity financing. Debt financing Debt finance is any money that has been borrowed. These borrowed funds will need to be repaid within a specified period and incur interest charges and administration fees. The costs of this type of finance are a tax deduction for the business. Debt finance is generally categorised according to the term of the loan; that is, its repayment period. Generally, a short term debt would be repayable within 12 months, whereas a long-term loan would be repaid over a period longer than 12 months. Short term borrowing is used to solve short-term problems such as cash flow shortage. The three main types of short-term debt financing are: - Overdrafts - Commercial bills - Factoring Overdrafts A bank overdraft gives a business flexibility to borrow money from a bank at short notice through the business’s cheque or current account. A bank may allow a business to overdraw its current account up to a specified maximum limit as agreed between the bank and the business. This overdraft facility allows a business to have a negative value in its account. Later, when the business receives cash from sales, money is deposited into the bank account, thereby reducing the overdraft.

The negatives of an overdraft include: - Very high costs (such as a high daily interest rate). - Interest is charged on the overdrawn amount for the period of time that the account remains overdrawn - This carries a financial risk because the business must repay the interest regardless of the level of profits that the overdrawn funds could generate The positives of an overdraft include: - It provides short-term finance for business requirements such as working capital, especially where a business is affected by seasonal fluctuations, such as a winter ski resort in the summer season - Current taxation law allows interest paid to be claimed as a tax deduction. An alternative to an overdraft is that the business can acquire a credit card on which to make purchases and pay for expenses. A credit card provides a line of credit to the user as the user can borrow money for payment to a merchant or as cash advance to the user. Commercial bills A commercial bill (or bill of exchange) is a written order for a loan amount that is guaranteed by the business’s bank. The money is borrowed from other companies that have surplus funds. Businesses and governments that need funds in the short term sell these bills. The funds and the interest will be repaid to a particular person or business on a certain day in the future usually, 30 to 180 days. Commercial bills are usually for amounts in the hundreds of thousands of dollars and are used to finance expenses, such as payment to suppliers of materials and wholesale goods. These bills can be rolled over for extended time periods and they are often considered to be the cheapest form of finance. The bill needs to be reassessed each time it matures and the terms and interest recalculated for each rollover, thus retaining its short-term classification. Factoring Occurs when a business sells its accounts receivable asset to a specialist factoring firm to create cash inflow for the business. It is a source of short-term finance because it can be used to obtain cash reasonably quickly to improve cash flow. The factoring company takes over management and collection of the unpaid accounts under terms agreed with the business. The factoring company pays the seller the value of the

accounts receivable, less a commission or fee. The fee charged will vary with the amount of credit sales and the credit rating of accounts. Therefore, the greater the risk, the higher the fee. Reliable businesses can also use trade credit provided by their suppliers, which effectively allows them to use goods and services that they pay for at a later date. (Trade credit is a type of loan from a supplier, because payment to the supplier from the customer is delayed.)

Long-term borrowing is a loan that has a term repayment longer than 12 months. Businesses may take out term loans for three, five or 10 years or longer. The more common forms of long-term borrowing for businesses include: - Mortgages - Debentures - Unsecured notes - Leasing Mortgages Mortgages are the most well-known forms of debt financing. When they are obtained from a bank or business lender, they have a long repayment period (term) and can be used by entrepreneurs to purchase non-current assets such as a factory site or building. The property asset becomes the security for the repayment of the loan, therefore, a mortgage is a type of secured loan. - Monthly repayments are made to repay the loan plus the interest. - Mortgage loans are typically very long-term, some being repaid over 15 to 30 years. Debentures Large, established companies can obtain finance by issuing debentures. Finance companies and other large firms are invited to invest in these businesses by lending them large amounts of money. These loans are used to buy buildings and equipment and are for a

fixed amount, a fixed time period and at a fixed interest rate. A business that has lent the money becomes a debenture holder. Repayment is ensured by the appointment of a trustee who monitors the debenture-issuing business to ensure that it operates profitably and can therefore repay the loan and interest on maturity of the debenture. The debenture holder’s funds are invested with the business as secured loans with the security in the form of a fixed or floating charge over the assets of the business. Debentures may be private or public issued: - For a public issue, a company must issue a prospectus, which is also lodged with ASIC. - Public issue debentures may be traded on the securities exchange. Unsecured notes These are notes which are not secured i.e, are not backed by an asset and therefore, do not provide any claim over the assets of the business. Therefore, they offer higher interest rates than debentures, reflecting the greater risk to the investor. -

Unsecured notes are usually issued by finance companies to gain funds. The unsecured note issuer is only backed by its creditworthiness and good reputation/goodwill. Unsecured notes are also called bonds The borrower must pay a specified amount of interest, often quarterly or half-yearly, and repay the entire amount borrowed on maturity.

Leasing Leases are contracts allowing the use of another person’s asset (such as land, equipment or services) for a specific period of time and at a set fee. They are similar to rental agreements. Businesses lease non-current assets, such as a company car or factory space, through a leasing company in return for payments to the owner. Instead of outlying the full value of the asset in one transaction, businesses rent the asset over an agreed period of time with an ongoing, regular payment that allows it to use an asset that is owned by another business. The firm has a contractual obligation to pay another business and therefore is a type of debt finance. This agreement can provide tax advantages, as the lease payments are usually tax deductible. They are not shown in the balance sheet and do not affect the company’s gearing. At the end of the leasing period, the business may release the item, upgrade the lease for a different

or newer item, or offer to buy the leased item at the agreed ‘residual value’ negotiated at the start of the lease. Equity Financing Equity is the owner’s financial claim on the assets of the business. It is the original investment the owner made into the business by contributing capital or buying shares, plus any profit the business makes. Also called proprietorship or proprietor’s funds. Funds that are invested in a business by its ‘owners’ are called equity. Equity is divided into 2 sections: - Private Equity - Public Equity Private equity Private equity refers to the business inviting specific people to become part-owners (stakeholders) to buy shares in the business to decrease their level of debt. In order for a business to perform this, they will have to become incorporated and have a legal structure and limited liability. This is because an unincorporated business, such a sole trader and partnerships cannot sell shares. This is known as an external source of finance as the owners have gone outside of the business to seek for finance. -

The advantage of private equity is that the cost of the finance can be postponed as shareholders will not need to be paid dividends immediately so the business can take its time to pay their shareholders.

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The disadvantage of private equity is that the ownership becomes diluted and the original owners have less control because they now own a smaller share of the business. In addition, shares can be expensive and complex to organise.

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Private equity relates to a private company (having Pty Ltd after its name) because the shares are not sold through the ASX and doesn’t involve invitations to the general public to invest, hence the name, private equity.

Public Equity Public equity is also known as ordinary shares. A public company is another form of an incorporated business structure (these have Ltd after their names) and these companies can issue securities/shares to the public through the ASX. Ordinary shares are the basic form of equity capital and can be issued with or without voting rights and shareholders receive dividends as their share of the business profits. These shares can be acquired in four ways: - New share issues - Rights issues - Placements - Purchase plans New Issues The first issue of shares is known as the primary market and a prospectus is issued and shares are made available on the ASX. Shareholders receive a dividend as their proportion of the company’s profits and shares are only sold for the first time that the business actually receives the money. In the secondary market, when shares are resold, ownership of the shares changes and the previous owner receives the money. Right Issues A rights issue is when the existing shareholders of a company may be offered the purchase of additional shares in proportion to their current holdings of that company’s shares. This is done in order to raise additional funds. The shareholder is not obligated to take up the rights issue and may reject it, sell or transfer their rights to another shareholder. Placements When a company wants to raise additional funds, they will nowadays offer additional shares to specific institutions and investors. Through a share placement, a company can raise up to 15% of its current capital and do not need to create a formal prospectus to do so nor do they need to obtain general shareholder

approval. These funds can be raised quietly, often within 24 hours and in large amounts such as $500,000. The company may wish to use these funds to significantly expand its activities, such as the takeover of a competitor. Share purchase plans Share purchase plans allow existing companies to issue a maximum of $15 000 in new shares to each existing shareholder without issuing a prospectus. Each share is offered at a below-current-share price. Permission is required from ASIC, is relatively inexpensive, is quick and benefits both the company and the investor. In order to proceed with a takeover, funding would need to be acquired very quickly Additional Forms of Finance include: - Venture Capitals - Grants Venture Capital Venture Capital is capital that is acquired from a specialist venture financial institution that seeks to become a part-owner in the business. The owners of a new business may have an innovative idea but lack the capital required to act on it. Owing to the high risk, the owners are unable to acquire a loan. They could present their business innovation to a well-established business person, or entrepreneur, who will review their business plan. If the venture capitalist determines that the risk is worthwhile, they will provide the capital for the business to grow and will have minimal day-to-day involvement in the business itself

Grants Grants are financial gifts provided by government to assist businesses to establish or expand Some businesses may also be eligible for government low interest loans. To qualify, businesses need to meet strict criteria. Governments believe that certain industries will benefit the economy and therefore should be encouraged by receiving grants...