Learn about internal and external sources of finance, the building blocks of business financing, and learn to appraise the potential appropriateness of each of these sources of finance.
Businesses need capital to manage their operations and to support growth, and they usually accesses funds through external and internal sources of finance. Learn about the key sources of finance, and
Common Sources of Funds
Companies need money to run their business as well as to grow their business.
There are also a number of projects that firms wish to undertake, that will provide them with some sort of advantage. Once such projects are appraised, the firm needs funds to execute the projects.
Common Sources of Funds
Firms primarily have access to these three kinds of funds – retained earnings, debt finance and equity finance.
- Retained earnings (profit generated from business operations)
- Debt Finance
- Equity Finance
Debt and equity finance are external sources, whereas internal sources are retained earnings or funds that can be generated internally by implementing tighter credit controls, delayed payments etc.
External Sources of Finance
External sources of finance for a startup can include bank loans, grants from government, venture capital funding, angel investors, crowdfunding, equity financing.
External Sources of Finance
- Long-Term: Ordinary Shares, Preference shares, Borrowings, Finance leases, Hire-purchase agreements, Secutarisation of assets.
- Short-Term: Debt Factoring, Invoice Discounting, Bills of Exchange, Bank Overdraft.
- Total finance (from external sources) = Long-Term finances + Short-Term finances
Related: Investment appraisal methods.
Equity Finance
Raising new Share Capital
Equity financing is the process of raising funds by the sale of shares of the firm.
Raising “risk finance” by share capital (equity financing) involves giving away some share of ownership of the company in exchange for new funding.
This is one of the most important sources of long term finance.
Equity financing can come through various means such as IPO, from investors or the promoters.
Two main types of share issue:
- Public – direct offer to public, anyone can buy.
- Rights – existing shareholders can buy more
Bonus share issue: To improve the marketability of shares by reducing their price, to increase lender confidence, to signal investors the directors confidence in the future.
The stock market is the secondary market for shares that have already been issued. But movements in the secondary market do not directly finance the company!
While equity financing is commonly seen as a means to finance publicly listed companies, it can also be used to finance private companies.
Advantages for a business for Listing in the Stock Exchange:
- It is easier to raise funds.
- Funds are acquired at lower cost.
- Raises profile of the company.
- Shares valued in an efficient manner.
- Broadens investor base.
- Enables other businesses to be acquired by shares rather than cash.
- It can help attract and retain employees (share incentives).
The main advantage of using this source of fund is that there is no compulsion on the firm to pay dividend to its shareholders, and they do not have to pay any kind of interest on the amount received through the sale of shares. Raising funds through the issuance of shares is also not very difficult for a firm.
Disadvantages for a business:
- Increased cost and management time.
- Increased regulatory burden
- Close monitoring of actions and decisions
- Increased vulnerability to takeover
The biggest disadvantage being that a firm has to give away part of its ownership.
Equity financing also tend to have higher WACC (Weighted average cost of capital) as investors generally expect higher returns from shares due to the higher risk they take.
Debt Finance (Borrowings)
Firms can also resort to borrowings (debt financing) to raise funds.
Debt financing is the method in which a firm acquires money from individuals or investors and promises them to pay regular interest on that money and pay the principal amount at some time in future.
Pros and Cons
The advantage of using this source is that it is easily accessible, and in some cases, interest on debt turns out to be cheaper compared to other sources of funds.
Also, in most cases, a firm is able to claim deductions on the interest paid.
It is common for smaller and upcoming firms to rely on this source of fund to buy resources that will help them grow.
There is also no obligation on the firm to pay any dividend or share the profits with it shareholders since the money is borrowed
The downside of debt financing is that interest payment can become significant if the debt is too high. A big loan can pose financial risk to the firm as it can be difficult to pay the interest during difficult economic periods. A firm can even face bankruptcy in worst-case scenario if it is unable to service its debt
.Types of Loan Capital
Term loans, Loan notes, Eurobonds, Deep discount bonds, Convertible loan notes, Junk (high-yield) bonds, Mortgages.
Loan capital and risk
Lenders may reduce the risk of lending by:
- Requiring security (fixed or floating charge on assets)
- Including covenants in the loan contract
Debt factoring
- Recourse factoring – where the business assumes responsibility for bad debts
- Non-recourse factoring – where the factor assumes responsibility for bad debts
Long-term versus Short-term Borrowing
Considerations in Long-term versus short-term borrowing: Matching borrowing with assets held, Refunding risk, Interest rates.
Leasing assets
Leasing assets involves the same concept as any individual leasing a car. The asset is not legally owned but is used by the company for which it makes lease payments. It saves the company finding capital to purchase asset. However, the company pays more than original purchase price. This is a source of assets, not actually a source of finance, and has limited application.
Internal Sources of Finance (Retained Earnings)
Internal sources of finance are the funds that are generated from within the business.
For these funds, the company does not have to approach outside parties such as banks, shareholders, or investors.
The advantage of using internal sources of finance is that the business does not have to pay interest or share any profits with the external parties as it retains complete control over the funds.
Total Internal Finance = Short-Term + Long-Term finances
- Short-Term: Tighter credit control, Reduced inventories levels, Delayed payment to trade payables.
- Long-Term: Retained Profits
Retained earnings refers to the profit that is generated from a firm’s business operations; it is the profit left with the company after subtracting all the obligations and expenses. Firms generally use retained earnings to pay dividends or even to fund initiatives.
However, businesses may still seek external sources of finance for growth or expansion.
Weighted Average Cost of Capital
There is a cost associated with Capital.
Irrespective of the kind of finance the firm seeks, a company has to incur cost of capital, which it should consider when seeking funds for projects.
The WACC is the average after tax cost of the company’s finances. This reflects the blend of how external financing has been raised. Both debt and equity.
This is often used as the discount rate when calculating the net present value of an investment. It is therefore a vital measure for decision making. It reflects the blended average cost between equity and debt used in the firm.
Pecking Order Theory
Pecking order theory and long-term financing
The Pecking Order Theory is a concept in finance that suggests that companies have a preferred order in which they choose sources of financing.
According to this theory, companies prioritize internal sources of financing, such as retained earnings, before considering external sources of financing, such as issuing debt or equity.
- Retained profits will be used to finance the business if possible
- Where retained profits are insufficient, or unavailable, loan capital will be used
- Where loan capital is insufficient, or unavailable, share capital will be used
So the Pecking Order suggests that firms should always try to access retained earnings first, followed by debt finance, and lastly through equity financing.
This is because there is no cost incurred by the firm on retained earnings, and raising debt capital incurs lower cost compared to equity because investors expect higher returns from equity for the risk they take.
The best capital structure for a firm is the one where the cost of capital is reduced and market value is increased; this is best provided by a mix of debt and equity financing.
Capital Structure
Capital structure refers to the composition of a firm’s capital that is used to fund its operations and growth; it usually comprises of debt and equity, which may be in different proportions.
Firms always strive to have an optimum capital structure which keeps the cost of capital to an optimum level.
In general, firms avoid dependency on any one type of financing, be it debt or equity. The optimum capital structure is one where a firm uses both equity as well as debt financing so that the cost of capital is reduced; this is also known as the capital structure of the firm.
While firms may use the profits they generate for funding projects, there are times when it is practical for the firm to make use of external financing.
Firms may also seek different options depending on their financial position, whether they need the funds for short term or long term. It is a good practice to use long-term funds to finance long-term projects. This practice protects a firm from external turbulences which may cause credit supply to reduce drastically and from interest rate changes.
Financial ratios, such as Debt to Equity Ratio and Interest Coverage Ratio, tell us more about the capital structure and if the company makes enough money to service its debt.
Raising finance for smaller businesses
Small businesses nowadays have access to a range of sources. However, the ease with which those funds can be procured depends on several factors such as the business model, size and stage of the business, the industry and even the economic climate.
It is also very likely that smaller businesses may face more difficulty in raising capital compared to the more established businesses. Some of the funding options may require a good credit score, collateral, or significant equity in the business.
Having said that, with careful planning and a solid business plan, small businesses can also successfully secure funding for their ventures.
Problems of smaller businesses in raising finance
- Lack of financial management skills
- Lack of knowledge concerning the availability of finance
- Inability to provide security
- Inability to meet assessment criteria of lenders
- Bureaucratic screening processes
Long-term finance for smaller businesses
- Crowdfunding
- Alternative investment market
- Government
- Business angels
- Venture capital
Private equity – types of investment: Venture capital, Expansion capital, Replacement capital, Buy-out and buy-in capital, Rescue capital.
Business angels – Make decisions quickly, Offer useful skills and experience, Expect lower financial returns.
More Finance and Accounting Topics for Managers
References
- Atrill, P., 2020. Financial management for decision makers. Pearson Education.
- Atrill, P. and McLaney, E., 2009. Management accounting for decision makers. Pearson Education.
- Covas, F. and Denhaan, W., 2011. The Cyclical Behavior of Debt and Equity Finance, 101(2), pp.877-99
- Graham, J.R., Leary, M.T. and Roberts, M.R., 2015. A century of capital structure: The leveraging of corporate America. Journal of financial economics, 118(3), pp.658-683.
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