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Sources Of FinanceSources Of Finance

Miss Faith Moono Simwami

1. What is a Financial Market?

2. What is the primary role of a financial intermediary?

3. What is the function of the Financial Market?

4. List 4 different types of Financial Markets.

5. In what two distinct ways can a firm or an individual obtain funds in a financial market?

6. What factors affect Security Expected Returns?

7. What’s the difference between:

- Commodity Market and Financial Market

- Direct and Indirect financing

- A bond and a stock

- Primary and Secondary Market

- Exchanges and Over the Counter Market

8. Define:

- Money markets - Commercial Paper

- Capital markets - Treasury Bills (T-bills)

-Expected Return

9. Why is shareholder wealth maximization important?

REVISION

AFTER STUDYING SOURCES OF FINANCE, YOU SHOULD BE ABLE TO:

AFTER STUDYING SOURCES OF FINANCE, YOU SHOULD BE ABLE TO:

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 The Internal Sources of

Finance Owner’s

investment Retained profits Sale of stock Sale of fixed assets Debt collection

Understand the different ways a business can obtain money

The External Sources of Finance

Bank Loan or Overdraft

Additional Partners Share Issue Leasing Hire Purchase Mortgage Trade Credit Government Grants

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Almost half of all new ventures fail becauseof poor financial management

SOURCES OF

FINANCE

DIFFERENT

WAY

S A B

USINESS C

AN OBTA

IN M

ONEY

SOURCES OF FINANCE

Sources of finance can be classified into

INTERNAL SOURCES

There are five internal sources of finance:

Owner’s investment (start up or additional capital)

Retained profitsSale of stockSale of fixed assetsDebt collection

This is money which comes from the owner/s own savings

It may be in the form of start up capital - used when the business is setting up

It may be in the form of additional capital – perhaps used for expansion

This is a long-term source of finance

Advantages

Doesn’t have to be repaidNo interest is payable

DisadvantagesThere is a limit to the amount an owner can invest

INTERNAL SOURCES:OWNER’S INVESTMENT

This source of finance is only available for a business which has been trading for more than one year

It is when the profits made are ploughed back into the business

This is a medium or long-term source of finance

Advantages

Doesn’t have to be repaidNo interest is payable

Disadvantages

Not available to a new businessBusiness may not make enough profit to plough back

INTERNAL SOURCES:RETAINED PROFITS

This money comes in from selling off unsold stock

This is a short-term source of finance

Advantages

Quick way of raising finance

By selling off stock it reduces the costs associated with holding themDisadvantages

Business will have to take a reduced price for the stock

INTERNAL SOURCES:SALE OF STOCK

This money comes in from selling off fixed assets, such as: a piece of machinery that is no

longer needed

Businesses do not always have surplus fixed assets which they can sell off

There is also a limit to the number of fixed assets a firm can sell off

This is a medium-term source of finance

Advantages

Good way to raise finance from an asset that is no longer needed

Disadvantages

Some businesses are unlikely to have surplus assets to sell

Can be a slow method of raising finance

INTERNAL SOURCESSALE OF FIXED ASSETS

A debtor is someone who owes a business moneyA business can raise finance by collecting the money owed to them (debts) from their debtorsNot all businesses have debtors i.e. those who deal only in cashThis is a short-term source of finance

AdvantagesNo additional cost in getting this finance, it is part of the businesses’ normal operations

DisadvantagesThere is a risk that debts owed can go bad and not be repaid

INTERNAL SOURCES:DEBT COLLECTION

The External sources of finance are:

Bank Loan or Overdraft

Additional Partners

Mortgage

Trade Credit

Share Issue

Government Grants

Hire Purchase

Leasing

EXTERNAL SOURCES

This is money borrowed at an agreed rate of interest over a set period of time

This is a medium or long-term source of finance

Advantages

Set repayments are spread over a period of time which is good for budgeting

Disadvantages

Can be expensive due to interest payments

Bank may require security on the loan

EXTERNAL SOURCESBANK LOAN

This is where the business is allowed to be overdrawn on its account

This means they can still write cheques, even if they do not have enough money in the account

This is a short-term source of finance

Advantages

This is a good way to cover the period between money going out of and coming into a business

If used in the short-term it is usually cheaper than a bank loan

Disadvantages

Interest is repayable on the amount overdrawn

Can be expensive if used over a longer period of time

EXTERNAL SOURCES:BANK OVERDRAFT

This is sources of finance suitable for a partnership business

The new partner/s can contribute extra capital

Advantages

Doesn’t have to be repaid

No interest is payable

DisadvantagesDiluting control of the partnership

Profits will be split more ways

EXTERNAL SOURCES:ADDITIONAL PARTNERS

This is sources of finance suitable for a limited company

Involves issuing more shares

This is a long-term source of finance

Advantages

Doesn’t have to be repaid

No interest is payable

Disadvantages

Profits will be paid out as dividends to more shareholders

Ownership of the company could change hands

EXTERNAL SOURCES:SHARE ISSUE

This method allows a business to obtain assets without the need to pay a large lump sum up frontIt is arranged through a finance companyLeasing is like renting an assetIt involves making set repaymentsThis is a medium-term source of finance

Advantages

Businesses can have the use of up to date equipment immediatelyPayments are spread over a period of time which is good for budgeting

Disadvantages

Can be expensiveThe asset belongs to the finance company

EXTERNAL SOURCESLEASING

This method allows a business to obtain assets without the need to pay a large lump sum up frontInvolves paying an initial deposit and regular payments for a set period of timeThe main difference between hire purchase and leasing is that with hire purchase after all repayments have been made the business owns the assetThis is a medium-term source of finance

AdvantagesBusinesses can have the use of up to date equipment immediately

Payments are spread over a period of time which is good for budgeting

Once all repayments are made the business will own the asset

DisadvantagesThis is an expensive method compared to buying with cash

EXTERNAL SOURCESHIRE PURCHASE

This is a loan secured on propertyRepaid in instalments over a period of time typically 25 yearsThe business will own the property once the final payment has been madeThis is a long-term source of finance

AdvantagesBusiness has the use of the propertyPayments are spread over a period of time which is good for budgetingOnce all repayments are made the business will own the asset

DisadvantagesThis is an expensive method compared to buying with cashIf business does not keep up with repayments the property could be repossessed

EXTERNAL SOURCES:MORTGAGE

Trade credit is summed up by the phrase:buy now pay later

Typical trade credit period is 30 days

This is a short-term source of finance

AdvantagesBusiness can sell the goods first and pay for them laterGood for cash flowNo interest charged if money is paid within agreed time

DisadvantagesDiscount given for cash payment would be lostBusinesses need to carefully manage their cash flow to ensure they will have money available when the debt is due to be paid

EXTERNAL SOURCES:TRADE CREDIT

Government organisations such as Invest NI offer grants to businesses, both established and new

Usually certain conditions apply, such as where the business has to locate

AdvantagesDon’t have to be repaid

DisadvantagesCertain conditions may apply e.g. location

Not all businesses may be eligible for a grant

EXTERNAL SOURCES:GOVERNMENT GRANTS

FACTORS AFFECTING CHOICE OF SOURCE OF FINANCE

The source of finance chosen will depend on a number of factors:

Purpose – what the finance is to be used for

Time Period – how long the finance will be needed for

Amount – how much money the business needs

Ownership and Size of the business

CLARIFICATIONASSIGNMENT

-Make sure the company you chose has at least 3 years of financial data

-Use the Comprehensive Statements, not the Consolidated

-Conduct Ratios on all THREE YEARS, as this will enable you to evaluate the firm’s performance over time

-Ensure that all statements are inserted into Excel under different labelled WorkSheets

HOMEWORK

-Stocks & Shares- Define the difference- Who are they sold to?- How are they sold?- When are they sold?- Then… what is the role of the

stock exchange?

-Listed Company- What are the requirements

needed to become a listed company?

RATIO

ANALY

SIS

CLARIFI

CATIO

N• Marketable Securities

• Cash & Cash Equivalents

• Net Sales

• Total Liabilities

• Total Earning

• Return on Assets

• Interest Expense

• Common Shares Outstanding

• Average Inventory

• Common Stakeholders

Revie

w a

ll th

e ca

lcula

tions

that

stu

dents

bat

tled w

ith

in c

lass

.

MARKETABLE SECURITIES

Very liquid securities that can be converted into cash quickly at a reasonable price in less than 1 year:•commercial paper•banker's acceptances•Treasury bills and other money market instruments

Investments in common stock, preferred stock, corporate bonds, or government bonds that can be readily sold on a stock or bond exchange. These investments are reported as a current asset if the investor's intention is to sell the securities within one year.

CASH & CASH EQUIVALENT

CCE' An item on the balance sheet that reports the value of a company's assets that are cash or can be converted into cash immediately.

Examples of cash and cash equivalents are bank accounts, marketable securities and Treasury bills.

TOTAL LIABILITIES

The aggregate of all debts an individual or company is liable for. On the balance sheet, total liabilities plus equity must equal total assets.

TOTAL EARNINGS

Total Earnings =

Total Income =

Gross Income =

Gross Profit

NET SALES

Net sales is total revenue, less the cost of sales returns, allowances, and discounts. If the Income statement does not account for these deductions, for the purpose of your assignments, just use the top Revenue/Sales figure.

For example:If a company has gross sales of $1,000,000, sales returns of $10,000, sales allowances of $5,000, and discounts of $15,000, then its net sales are calculated as follows:

$1,000,000 Gross sales - $10,000 Sales returns - $5,000 Sales Allowances - $15,000 Discounts= $970,000 Net sales

RETURN ON ASSETS

Measures the company's ability to utilize its assets to create profits

Beginning Total Assets –

Assets at previous year end

Ending Total Assets –

Assets at current year end

INTEREST EXPENSE

Interest Coverage Ratio (Times Interest Earned)Indicates a company's capacity to meet interest payments. Uses EBIT (Earnings Before Interest and Taxes)

Interest expense is a non-operating expense shown on the income statement. It represents interest payable on any type of borrowings – bonds, loans, convertible debt or lines of credit. It is basically calculated as the interest rate times the outstanding principal amount of the debt.

COMMON SHARES

OUTSTANDING

Outstanding shares are common stock authorized by the company, issued, purchased and held by investors.

AVERAGE INVENTORY

Definition of average inventory: An average of beginning and ending inventory. Formula: {Inventory (current period) + Inventory (prior period)} ÷ 2