3.2.

Sources of Finance- Notes

Learning Objectives:

Source of finance

Internal sources of finance: External sources of finance:

. Personal funds (for sole traders) . Share capital
. Retained profit . Loan capital
. Sale of assets . Overdrafts
. Trade credit
. Crowdfunding
. Leasing
. Microfinance providers
. Business angels

REVIEW QUESTIONS
1. What is meant by sources of finance?
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, loan capital and share capital.
 2. What are internal sources of finance?
Internal sources of finance are funds generated from within the organization, namely
through personal funds, retained profits and the sale of assets.

3. How are internal sources of finance differing from external sources of finance?
Internal sources of finance are funds generated from within the organization, namely
through personal funds, retained profits and the sale of assets.

External sources of finance are the funds from outside of the organization, such as
through debt (overdrafts and loan capital), share capital and business angels.

4. What are personal funds?

Personal funds are a source of internal finance, referring to the use of an entrepreneur's
own savings. Personal funds are usually used to finance business start-ups for sole
traders.

5. What are retained profits?

Retained profit is the value of the surplus that a business keeps to use within the
business after paying corporate taxes on its profits to the government and dividend
payments to its shareholders

6. How is the sale of assets a source of internal finance?

Existing businesses can sell their dormant assets (unused assets), such as selling obsolete
machinery and old computer equipment that has recently been replaced. If a business has
chosen to relocate, it might be able to raise finance through the sale of land and buildings.

7. What is share capital?

Share capital is the money raised from selling shares in a limited liability company.

8. What is an initial public offering (IPO)?

Initial public offering (IPO) refers to a business converting its legal status to a publicly traded
company by floating (or selling) its shares on a stock exchange for the first time.

9. What is a share issue (or share placement)?

Share issue (or share placement) means an existing publicly held company raises further
finance by selling more of its shares.

10. What is loan capital?

Loan capital (or debt capital) refers to medium- to long-term sources of interest-bearing
finance obtained from commercial lenders. Examples include mortgages, business development
loans and debentures.

11. When is it appropriate to use an overdraft?

Overdrafts are commonly used when businesses have minor cash flow problems. Overdrafts are
suitable when there is a need for a large cash outflow, such as retailers stocking up for peak
seasonal trading periods. They are also suitable for businesses that have sold products on trade
credit and are awaiting payments from their customers.

12. What is trade credit?

Trade credit allows a business to postpone payments or 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).

13. How does a creditor differ from a debtor?

Organizations/Businesses that offer trade credit are known as creditors, whereas customers who
pay are called debtors.

14. What is crowdfunding?

Crowdfunding is the practice of raising finance for a business venture or project by getting
small amounts of money from a large number of people, usually through online platforms.

15. What is leasing?

Leasing is a form of hiring whereby a lessee pays rental income to hire assets from the lessor,
the legal owner of the assets.

16. How does sale and leaseback differ from hire purchase?
Sale-and-leaseback involves a business selling a particular fixed asset (to raise finance) and are
often financed by leasing immediately leasing the property back.

Some firms use hire purchase (HP), which the business. allows them to pay their creditors in
instalments, perhaps over 12 or 24 months. The asset is legally the property of the creditor until
all payments have been made.
17. What is microfinance?
Microfinance is a type of financial service aimed at entrepreneurs of small businesses,
especially females and those on low incomes.

18. Who are business angels?

Business angels are extremely wealthy individuals who risk their own money by investing in
small to medium sized businesses that have high growth potential.

19. How do short term sources of finance differ from long term sources of finance?
Short-term sources of finance are those available for a period of less than one year, used to pay
for the daily or routine operations of the business, such as overdrafts and trade credit.

Long-term sources of finance are those available for any period of more than 12 months from
the accounting period, used for the purchase of fixed assets or to finance the expansion of a
business.

20. What factors do managers need to decide on before choosing their source(s) of finance?

These factors can be remembered by the acronym SPACED:

a) Size and status of firm - An established and large multinational company 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 cheaper finance due to financial economies of scale,
especially as they are able to offer higher levels of collateral than smaller firms.

b) Purpose of finance - The choice of different sources of finance depends on whether the
funds are intended for the daily running of the business (short-term purposes) or
fo r the replacement of fixed assets (long-term purposes). For example, overdrafts are
more suitable for improving short-term cash flow problems (see Chapter 20), whereas
leasing might be more appropriate for financing new and expensive capital equipment.
 c) Amount required - Large amounts of finance might be raised through an initial public
offering (IPO) or through secured long-term loans from commercial banks. If a small
amount of finance is needed, then retained profit or an overdraft might be sufficient.
Lenders also assess the fi rm's existing gearing ratio (long-term external borrowing
expressed as a percentage of the firm's capital employed).

d) Cost of finance - Managers need to consider the purchase cost of assets and any associated
costs, such as administrative fees and maintenance charges. Higher costs tend to require
long-term sources of finance, such as mortgages for the purchase of land and buildings.

e) 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 (see Chapter 46). Interest rate and stock market volatility also
affect the level of consumers and producer confidence levels, thereby affecting the level
of business investments. Low interest rates tend to stimulate investment expenditure because
borrowing costs are lower.

f) Duration - If the finance is needed for a long period of time to fund capital expenditure, such
as for the purchase of a new factory or production facility, then long-term loans such as
mortgages or debentures are suitable. If finance is needed to help fund working capital for the
day to day running of the business , then short-term sources of finance, such as trade credit
and overdrafts, are more appropriate.

Q. Explain the difference between price and cost.

Cost is typically the expense incurred for making a product or service that is sold by a company.
Price is the amount a customer is willing to pay for a product or service.
The cost of producing a product has a direct impact on both the price of the product and the
profit earned from its sale.

Q. Distinguish between fixed, variable, direct and indirect of production, costs of

production.

● (Examples based on a store like Reliance)

● Fixed – costs that do not increase or decrease based on quantity of goods produced or
capacity of production.
Examples: Rent, electricity, utilities, Telephone and internet costs, Insurance, Salaries,
Loan Payments

● Variable – costs that increase as more products are produced or if a service is at a higher
capacity of production
● Labor wages, commission, taxes.

● Semi-variable – costs that contain both fixed and variable cost elements
 ● Salaries (fixed = regular hours, variable = overtime hours)
● Direct – costs that can be directly attributed to the production of a good or service in a
specific aspect or department; can be fixed or variable
● Direct (fixed) – salary of chick enjoy fryer

● Direct (variable) – cost of raw chicken

● Indirect/Overhead – costs that aren’t directly part of the product or process of the
product/service being sold; can also be fixed or direct
● Advertisements, franchise fee, etc.

Variable cost
Fixed cost

Q. What are semi-variable costs?

Semi-variable – costs that contain both fixed and variable cost elements
Salaries (fixed = regular hours, variable = overtime hours)

Examples: Electricity costs, Monthly telephone charges

Q. How are total costs calculated?

Ans) TC (total cost) = TFC (total fixed cost) + TVC (total variable cost)
(Or)
Total Cost = Total Fixed Cost + (Average Variable Cost Per Unit * Quantity of Units Produced)
Total Cost = $10,000 + ($5 * $5,000).
Total Cost = $35,000.

Q. What is revenue and how is it calculated?

Total revenue:
Total amount of sales generated through different product lines/services offered, without
subtracting any costs. e.g., sale of all food, beverages, and toys

Q. Explain, with the use of examples, the meaning of revenue streams.

Revenue streams:
• One source of sales or revenue that a business has
• A business can have several revenue streams
• e.g., payment from franchisees, revenue from company owned stores

Definitions / KEY TERMS:

Business angels are extremely wealthy individuals who risk their own money by investing in
small to medium sized businesses that have high growth potential.

Crowdfunding is the practice of raising finance for a business venture or project by getting
small amounts of money from a large number of people, usually through online platforms.

External sources of finance are the funds from outside of the organization, such as through debt
(overdrafts and loan capital), share capital and business angels.

Initial public offering (IPO) refers to a business converting its legal status to a publicly traded
company by floating (or selling) its shares on a stock exchange for the first time.

Internal sources of finance are funds generated from within the organization, namely through
personal funds, retained profits and the sale of assets.

Leasing is a form of hiring whereby a lessee pays rental income to hire assets from the lessor,
the legal owner of the assets.
Loan capital (or debt capital) refers to medium- to long-term sources of interest-bearing
finance obtained from commercial lenders. Examples include mortgages, business development
loans and debentures.

Long-term sources of finance are those available for any period of more than 12 months from
the accounting period, used for the purchase of fixed assets or to finance the expansion of a
business.

Microfinance is a type of financial service aimed at entrepreneurs of small businesses,

especially females and those on low incomes.

Overdrafts allow a business to spend in excess of the amount in its bank account, up to a
predetermined limit. They are the most flexible form of borrowing for most businesses in the
short term.

Personal funds are a source of internal finance, referring to the use of an entrepreneur's own
savings. Personal funds are usually used to finance business start-ups for sole traders.

Retained profit is the value of the surplus that a business keeps to use within the business after
paying corporate taxes on its profits to the government and dividend payments to its
shareholders.

Sale of assets means selling existing items of value that the business owns, such as dormant
assets (unused assets) and obsolete assets (outdated assets).

Share capital is the money raised from selling shares in a limited liability company.

Share issue (or share placement) means an existing publicly held company raises further
finance by selling more of its shares.

Short-term sources of finance are those available for a period of less than one year, used to pay
for the daily or routine operations of the business, such as overdrafts and trade credit.

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, loan capital and share capital.

A stock exchange is a highly regulated marketplace where individuals and businesses can buy
and/ or sell shares in publicly traded companies.

Trade credit allows a business to postpone payments or 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).
Common mistake
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 round; the poor performance of a company
will lead to a fall in its value, meaning its share price subsequently declines.

Exam tip!
When shareholders 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.

Key concept:" In the context of an organization of your choice, discuss to how different sources
of finance influence change and creativity.

Key concept Is creativity compromised due to the lack of access to sources of finance for many
businesses

Case studies:
Question 15.1 - Agricultural Bank of China (ABC)
Exam tip!
3.2 Sources of finance
When shareholders 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.
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 shares were generally overvalued at the time, investors poured
money into one of China's largest lenders. Today, ABC has over 320 million customers across
24,000 branches. ABC's flotation proved to be the world's largest ever at the time, beating the
previous record of $21 .9 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) Explain why Agricultural Bank of China (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. [6 marks]

Question 15.2 - Kellett School

Debentures - These are long-term loans issued by a business. Debenture holders (individuals,
governments or other businesses) receive interest payments even if the business makes a loss
and before shareholders are paid any dividends. The interest payment can be fixed or variable
depending on the type of debenture. They are used by a vast range of organizations, from
Arsenal Football Club for its Emirates Stadium in London to private schools in Hong Kong (see
Question 15.2). However, unlike shareholders, debenture holders do not have ownership or
voting rights. Debentures provide a long-term source of finance for businesses, without the
business losing any control. However, issuing debentures increases a firm's gearing ratio (see
Chapter 19). This means the business has more borrowing as a percentage of its total capital
employed, so this makes the firm more vulnerable to risks if interest rates increase.
In 2013, Kellett School in Hong Kong introduced record-breaking debentures up to the value of
HK$10m (US$1.29m), being refundable when students eventually leave the school. Parents with
more than one child at the school would get a small discount. Its school fees ranged from
HK$123,500 to HK$168,800 per year (US$ l 5,930 to US$21,775). The timing coincided with the
school's move to a new HK$200m (US$25.8m) campus with its much-improved facilities such as
a large auditorium, swimming pool, Astroturf multisport areas, an extensive library and state-
of-the-art classrooms. Critics argued the enormous cost of education would diminish Hong
Kong's competitiveness by putting off highly skilled expats and their families from moving to the
Hong Kong Special Administrative Region of the People's Republic of China. Rival school Harrow
International offers non-interest-bearing debentures of up to HK$3m (US$387,000). Capital
expenditure and the costs of land construction mean that debentures are common in
international schools in Hong Kong.

a) Define the term debentures. [2 marks]

(b) Outline why Kellett School might have decided to sell debentures. [2 marks]
(c) Despite the high price, suggest why most parents might agree to purchase Kellett School's
debentures. [4 marks]
(d) Explain two potential drawbacks to a fee-paying school like Kellett School that chooses to
raise finance through the sale of debentures [4 marks]
(e) Examine two alternative sources of finance that Kellett School could have used to finance its
capital expenditure. [6 marks]

Question 15.3 - Wizz Air

12 or 24 months. The asset is legally the property of the creditor until all payments have been
made. Quite often, a deposit (or down payment) is required to secure a HP deal from the
lender.
Also, if the buyer defaults on the agreement (falls behind on repayments) then the lender can
repossess the asset. HP is a form of buying on credit, so interest is charged by the lender on the
amount borrowed. It is different from leasing because the buyer eventually owns the asset on
payment of the last instalment.
In late 2013, Hungary's low-cost airline carrier Wizz Air signed a sale-and-leaseback agreement
with China's COB Leasing Co. to finance six Airbus A320 aircraft. The deal raised $549 million to
finance Wizz Air's expansion plans with new routes to Barcelona, Bologna, Dortmund and Rome
from 2014.
The COVID-19 pandemic devastated all airline companies. In 2020, Wizz Air registered a total of
16.6 million passengers, which was only 42% of the 40 million passengers who flew with the ai
rline during the previous year. The airline's CEO said the company hoped that air transport
would be restored to pre-pandemic levels by 2024 or 2025. Established in 2003, the airline flies
to 150 destinations in 44 countries. As is common with low-cost budget airlines, Wizz Air
operates a 'buy on board' system whereby food and beverages are paid for on board rather
than included in the ticket price.
(a) Describe the meaning of sale-and-leaseback as a source of finance. [2 marks]
(b) Explain two advantages to businesses such as COB Leasing Co. opting to lease expensive
assets to established companies such as Wizz Air. [4 marks]
(c) Explain two advantages to Wizz Air choosing to lease some of its aircraft. [4marks]

Question 15.4 - Tawfeer Market

Tawfeer Market is an Egyptian online grocery retail business founded in 2020. The business
delivers groceries to customers in Alexandria, Egypt's second most populated city. In early
2022, Tawfeer Market raised $500,000 from business angels.
Online grocery retail is expected to grow exponentially in Egypt. Ahmad Fasseeh, co-founder
and CEO ofTawfeer, reported that Egypt's grocery retail market exceeds $50 billion, so the
owners expect more competitors to enter the market. The co-founders used the name
"Tawfeer" as it means "savings" in Arabic.

(a) Define the business angels. [2 marks]

(b) Explain two limitations of using business angels as a source of finance. [4 marks]
(c) Explain how the profitability of a business, such as Tawfeer Market, affects its ability to
obtain external sources of finance. [4 marks]