Fundamentals of Accounting Business Finance 13. Sources of Finance of Business Businesses run on finance. It forms the basic element that runs through any business and thus it becomes extremely essential to properly plan its flow. It is therefore important to have a broad understanding of the various sources from where businesses can raise finance. Subsequent lessons will cover in greater depth the different kinds of sources.
13.0 Objectives After going through this lesson you will be able to: i. Understand why businesses need finance ii. Understand the difference between short – term & long - term financing iii. Understand the various sources from where businesses can raie finance
13.1 Introduction This topic will help you understand the various options that companies use to finance their short-term and long-term business requirements. The various sources of finance would be covered briefly here, while subsequent lessons will detail out the more important ones. Going through this lesson is one of the foremost activities that you should complete. In addition to this you should also scan annual reports of a few companies and try to identify the various sources of short-term and long-term finances that they are using. Then try forming small groups and discussing what all sources can a company revert to for finance. Also discuss these with your facilitator.
13.2 Why do business’s need finance? From the day, someone has a business idea, finance is required. Required to start , required to grow, required to expand and required to run the business. Some of the key reasons why a business needs finance are:
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Start a business : Funds are required for purchase of assets, (ex. land, building etc.) materials and employing people. Some funds will also be required for day-to-day running of the company. It will be some time before the business starts generating enough cash from sales to meet these costs. Expand and Grow Production Capacity : As the business grows it may need to expand its production base, to introduce new products or to reduce per unit costs. All these require significant funds and would entail investments by the business. New Products/ Markets : As the business grows it may want to reach to newer customers. This could either be through newer product or through newer markets or both. Acquisitions: Business may sometimes decide to grow inorganically i.e. from outside. This they usually do by acquiring a company which the area where they want to grow. Day-to-day running of business: A lot of day-to-day activities like paying a supplier for raw materials to paying wages require funds on a day-to-day basis.
13.3 Short v/s Long term Financing Short-term funds are usually required to meet the day-to-day needs of the business such as payment of the wages to employees, inventory ordering and supplies. Let us understand this using an example. A company which manufactures and markets clothes pays for the raw material and also incurs the production cost, before even a single garment can come to the market. Then to recoup these costs the company has to wait until the customer buys those clothes off the shelf. Thus the company needs funds to support the production of clothes in the meanwhile. Finance requires for this would fall under the short-term category. Long Term Finance on the other hand are funds which are required for period of over one year. These may be required creating long-term investment such as fixed assets making large equipment purchases, or expanding production capability etc. You will learn more about long-term finance in the next lesson. Another way to understand this is to consider any business as a continuous flow of money in and out of the company in the form of income and expenditure. Expenditure can be classified as : •
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Capital Expenditure: This indicates purchase of fixed assets and spending on items which are to be held by the business in the longer-term. Funding for these falls under long-term finance. Revenue Expenditure: This relates to purchase of goods and services which will or have already been consumed in day-to-day operations of the business. Funding for this usually falls under the short-term category.
Self-Check Questions Answer True or False 1. Inorganic growth means acquiring a company (T / F) 2. Wages to employees are met through long-term funds that a business has (T / F) Fill in the Blanks 3. Long Term Finance are funds which are required for period of over ________ year. 4. Expenditure can be classified as __________ and ___________.
13.4 Internal v/s External Sourcing It is very critical for the business to tap the right source of funds at each stage in its growth cycle. The sources can be segmented into two broad categories based on their origin. These are internal and external. Let us briefly understand what each one of these represents. Internal Source of Funds: These are usually preferred over external financing options as they are usually cheaper and easier to arrange at short notice. However the possibility of raising large amounts usually may be somewhat limited. Some of the key internal sources are: •
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Profit: The business can retain the profit (after tax, interest and dividend payments have been deducted) to finance the future expenditure. But for this option to be viable the company has to be profitable. Depreciation: By deducting depreciation from profit, the business makes provision for external replacement of worn out machinery/plant. This thus is another form of profit retention which can be used later to fund expansion etc. You will learn more depreciation in the next unit. Sale of Assets: Companies may choose to or be forced to sell off assets to raise finance for the business. Reduction in working capital: The finance may be able to save money for investment if they can reduce their stock level, or improve their credit control by ensuring that they collect their debts more promptly and delay payment to creditors for as long as possible. External Sources: For a better understanding, we will regret the external source of funds into short-term and long-term.
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The various type of resources available for the short term are: •
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Trade credit: This represents one of the many sources of short-term finance for nearly all businesses. Current assets like raw-material s etc. may be purchased on credit with payment terms normally varying between 30 to 90 days. Thus this takes the form of a short-term interest free loan. Loans and Overdraft: Overdrafts are also an important source of short-term credit and can be arranged relatively quickly and offer flexibility with regard to the amount borrowed at any time. Interest is paid only when the account is overdrawn. Loans on the other hand are not flexible as they involve regular installment payments and usually also involve higher rate of interest. Factoring Debts: The business may be able to sell its debt to a specialist debtfactoring company. When a business sells its debt, the factoring company pays the business a proportion of the debt immediately. The factoring company pays the business makes money by collecting the remaining proportion of the debit when it becomes due. Now let us look at the more common methods of financing the available for long-term. As most of these are covered in the next lesson, we will here only touch upon them briefly.
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Leasing: This enables a business to acquire the use of assets such as plant and machinery without having to pay large sums of money for ownership of the equipment initially. The business pays the leasing company for the use of the equipment over a certain period of time. Hire Purchase: This allows a business to acquire ownership of an asset from a supplier. The business usually gives a down payment to the supplier while a finance company pay the rest. The business then makes regular installment payments to the finance company. An example of this is readily seen in everyday life where people use loans from banks to finance the purchase of their car or motorcycle. Share Capital: This is raised through sale of shares to individuals or institutions. The price at which shares can be sold depends on the profitability and future growth prospects of the company. The shareholders may receive dividends which constitutes a share in the profits the company makes and may also be able to make capital gain on the investment by selling their shares at a later date. Long–Term Loans: Here the bank lends the business a sum of money for a set period of time at an agreed rate of interest. Debentures: This is a specialized form of a loan. It is effectively a loan from people to the business that will be repaid at a fixed date. Between the issue date of the debenture and the maturity date, the business has to pay a fixed level of interest. Venture Capital: Venture capitalists offer finance to business ventures which other financial institutions/ investors might consider too risky. Usually in return the venture capital firm will require shares in the business and influence in the running of the company at a strategic level, so as to protect their investments.
Self-Check Questions Answer True or False 5. Internal source of funds are usually preferred over external source of funds (T / F) 6. The business may be able to sell its debt to a specialist debt-factoring company (T / F) Fill in the Blanks 7. The price at which shares can be sold depends on the ________ and future ________ prospects of the company
13.5 Raising Finance – Which is the best source? The choice of source of funds, that a business makes, depends on a lot many factors. The key ones include: •
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Cost: This is the most important factor that businesses need to consider while making a choice. Using an overdraft over the short-term may prove to be very expensive. Outlook: The financial outlook of the business is another important factor while deciding on the source. If a business already has a high debt to equity ratio, then looking for internal source of funds may be a much better strategy than going for more borrowing. Further the weaker the financial position of the company, the lesser willing financial institutions and invertors may be to lend to the company. Time Period: The duration for which funds are required also needs to be carefully ascertained. Borrowing based on actual durations can help selection of the right source and thus reduce the borrowing cost significantly.
13.6 Summing Up In this lesson you have learnt about why businesses need finance and how they can go about getting it. You also learnt the differences between internal & external sourcing of funds and the various options available to a company under each one of them.
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13.7 Answers to Self-Check Questions 1. 2. 3. 4. 5. 6. 7.
True False One Capital, Revenue True True Profitability, Growth
13.8 Terminal Questions 1. Detail out the two types of expenditure giving examples of each. 2. List out the various external methods of financing available for the short-term. 3. What are the factors that need to be considered while deciding the source of finance for a company?
13.9 Glossary • • • •
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Asset: anything owned by a business or individual that has commercial or exchange value Capital Expenditure: This indicates purchase of fixed assets and spending on items which are to be held by the business in the longer-term Revenue Expenditure :This relates to purchase of goods and services which will or have already been consumed in day-to-day operations of the business Depreciation: Depreciation can be defined as a non-cash expense that reduces the value of an asset. This may happen due to wear & tear, age or obsolescence Working Capital: The excess of current assets over current liabilities of the business at any time Leasing: Contract granting use of real estate, equipment, or other fixed assets for a specified time in exchange for payment, usually in the form of rent