Lecture Notes - Sources of Finance

Sources of Finance

Companies need funds to bridge the gap between paying for the production of finished goods and receiving money from their customers (working capital). They also need money to buy their fixed assets with which they operate, such as machinery, land and building (fixed capital)

The major source of finance for companies is retained earnings, which can be used for both working capital and fixed capital (FTC Foulk Lynch 2005)

Short or medium

Short or medium term finance is obtained from the money market and long term finance is from the capital market

Short term = up to 1 year- e.g.  Trade credit, overdraft

Medium term = up to 7 years- e.g.  Leasing, Hire purchase

Long term = 7 years or more – e.g.  Debentures, preference shares

Internal source of finance

The main type of internal source of finance is

Internally generated funds and this comprises of retained earnings plus non -cash charges against profit (e.g. depreciation) (FTC Foulk Lynch 2005)

External source of finance

This is mainly made up of long term finance. Long term finance can be defined as those that are due for payment after one year. The main forms of long term finance are the following

Equity finance- Equity relates o ordinary shares only and it is the investment in a company by ordinary share holders.

Equity capital is raised through the sale of shares to individuals or groups. Ordinary shares in the equity of a business entitled the holders to all distributed profits.

Share holders expect to be rewarded for their investment in two ways these are

·         Receive a dividend after holders of debentures and preference shares have been paid

·          They may be able to make capital gain on their investment by selling their share holding at a later date when the price increases. ( FTC Foulk Lynch 2005)

Preference shares- These are designed for investors who do not wish to take the degree of risk associated with being an ordinary share holder.

Ordinary share

This is the most valuable form of finance and forms the backbone of the financial structures of businesses. It also represents a risky finance and it also gives shareholders control over the business (Peter Atrill et al 2002)

Issuing of share

New shares can be issue by any of the following

·         Private negotiation

·         Placing or offer for sale

·         Right issues

Loans

Many businesses rely on loan capital to finance their operations. Lenders would enter into a contract with the company in which the rate of interest dates of interest payment and capital payment and the security of the loan are clearly stated (Peter Atrill et al 2002).

Types of loan

Debentures- These are written acknowledgement of a debt by a company. It usually contains a provision of payment of interest and also terms for the repayment of the principal. Debentures are often referred to as bonds or loan stocks

·         Debentures are traded on stock markets just like shares. They may be secured or unsecured, redeemable or irredeemable ( FTC Foulk Lynch 2005)

Characteristics of debentures

·         Debts are regarded as low risk

·         Debts holders do not have voting rights, only when interest is not paid will the holders take control of the company

·         They are cheap because it is less risky for investors. Debentures holders would accept a lower rate of return than share holders ( FTC Foulk Lynch 2005)

Convertible loans

This is a traded debt which gives the holder the right to convert to other securities usually ordinary shares at a given future price date at a given price.

The investor remains a lender to the business and would be paid an interest. The investor is not obliged to convert the loan into ordinary shares.

Mortgages

This is form of a loan that is secured on a freehold property and could be over a period of 20 years

Loan covenants

Accounts - Lender may require access to the financial accounts of the business

Other loans- business may have to ask permission from lender before taking other loans

Dividend payment- lenders may require dividend to be limited during the period of the loan

Liquidity – lender may require business to maintain certain level of liquidity during the period of the loan

Sources of short term loans

Overdraft

Trade creditors

Debt factoring

Invoice discounting

Debt factoring

 This is service provided by financial institutions known as factors. The factor takes over the debt collection of the business. It also makes advance payment to the business to the maximum of 85% of the approved trade debtors and also charges between 2-3% of the business turnover (Peter Atrill et al 2002).

Any advance made to the company attracts an interest rate similar to bank overdraft

The capital market

Capital markets deal in long term finance through the stock exchange. The major types of securities dealt on the capital markets are as follows:

·         Public sector stocks

·         Foreign stocks

·         Company securities

·         Eurobonds

The capital market provides the following sources of long term finance

·         Equity – ordinary shares, preference shares

·         Debentures

Euro bonds

·         Eurobonds are bonds dominated in a currency other than that of the national currency of the issuing company. It has nothing to do with Europe. They are also called international bonds. ( FTC Foulk Lynch 2005)

The money markets

Money markets deals in shorter –term funds which are in the forms of bank bill, trade bills, certificate of deposits, unsecured loans etc. No physical location exists, transactions are conduct by the phone, internet etc.

The money market is not one single market but a number of different markets are closely inter-connected with each other.

The main participants in the money markets are central banks and the commercial banks. Other participants include the financial houses, building society, investment trusts, unit trusts, local authorities, large companies and some private individuals

The money market provides the following source of short and medium term finance

·         Leasing

·         High purchasing

·         Trade credit

·         Overdraft

·         Special (government grants) ( FTC Foulk Lynch 2005)

Stock market

The stock market is a market which issued securities of public companies. Government bonds, loans issued by local authorities and other public owned by institutions and some overseas stocks.

The stock market assists the location of capital to industry. If the market thinks highly of a company, the shares of that company will rise in value and it would be able to raise fresh capital through the new issue market at a very low cost. (FTC Foulk Lynch 2005)

Sample question

Ken Wong Ltd approaches a financial institution for a long term loan. What do you think would be the main factor that financial institution will take into account when considering the application.

References

1.       Atrill, Peter et al, 2002, 2^nd edition - Accounting: An Introduction, Prentice Hall, England

2.       FTC Foulk Lynch 2005- Financial Management and Control.

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