Copyright © 2002 by Harcourt, Inc. All rights reserved. Topic 13 : Financial Management: Sources of...

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Topic 13 :Topic 13 :

Financial Management: Sources of Funds

Lecturer: Zhu Wenzhong Lecturer: Zhu Wenzhong


• Key learning goals: This topic will introduce the major sources of funds for

businesses, including internal and external sources, as well as the key factors affecting the choice of funds.

1. Explain the importance for a business to raise funds2. State the internal sources of funds fro a business 3. State the external sources of funds for a business 4. State the difference between ordinary shares, preference

and deferred shares5. Explain the difference between the operating lease and the

finance lease6. Describe the major factors affecting the choice of funds

LEARNING GOALSLEARNING GOALSLEARNING GOALSLEARNING GOALS


The need for funds: No business can live without funds. Throughout the

life of a business, money is needed continuously. Firms raise money mainly to meet the following three types of need:

1. To start a business as initial expenditure;2. To fund continuous business activities and money

flowing;3. To expand the business.

Financial ManagementFinancial Management -Sources of Funds-Sources of Funds


The need for funds: Question for your critical thinking: Please give some typical examples for the

three types of needs for funds.



Financial ManagementFinancial Management -Sources of Funds -Sources of Funds


Sources of funds In general, a business may have two major

sources of funds which are needed for its business operations. They are internal sources of funds and external sources of funds.

See Figure 13-1 for details.



Table 13-1 Sources of FundsTable 13-1 Sources of Funds


Table 13-1 Sources of FundsTable 13-1 Sources of Funds

Sources of Funds

Internal Sources External Sources

Profit Depreciation Sales of assetsLong-term:Share CapitalLoan Capital

Short term:OverdraftLeasing

Credit card…


The after-tax profit earned and retained by a business which is an important and inexpensive source of finance, for example, the retained earnings of the business. A large part of finance is funded from profit.

Profit

© PhotoDisc

Financial ManagementFinancial Management -Internal Sources of Funds -Internal Sources of Funds



The financial provision for the replacement of worn-out machinery and equipment. Nearly all businesses use depreciation as a source of funds.

Profit

Depreciation

© PhotoDisc




Definition: The activity that a business sells off assets to raise funds for the business.

Reasons: When a business can not raise finance from banks or other sources, it may be forced to sell some assets, such as company cars, land property; or even subsidiary or associated company to solve its urgent financial problems (this activity is called divestment).

Profit

Depreciation

© PhotoDisc



Sales of Assets


Financial ManagementFinancial Management -External Long-term Sources of Funds -External Long-term Sources of Funds


Share capital: The most important source of funds for a limited company. It is

often considered as permanent capital as it is not repaid by the business, but the shareholder can have a share in the profit, called dividend.

Three types of shares are: 1. Ordinary shares: The most common types of shares, and the most

riskiest shares since no guaranteed dividend. Dividend depends on how much profit is made by the firm. But all ordinary shareholders have voting rights.

2. Preference shares: The share owners receive a fixed rate of return. They carry less risk because shareholders are entitled to the dividend before the ordinary shares. But they are not strictly owners of the company.

3. Deferred shares: These shares are often held by the founders of the company. Deferred shareholders only receive the dividend after the ordinary shareholders have been paid.


Financial ManagementFinancial Management - -External Long-term Sources of FundsExternal Long-term Sources of Funds

Financial ManagementFinancial Management - -External Long-term Sources of FundsExternal Long-term Sources of Funds

Loan capital• Definition: Any money which is borrowed for a long period of

time by a business is called loan capital. • Types: There are four major types of loan capital:

Debentures, Mortgage, Loan specialists’ funds, Government assistance. See next page:



Financial ManagementFinancial Management -External Long-term Sources of Funds -External Long-term Sources of FundsTypes of loan capital:

1. Debentures: The holder of a debenture is a creditor of the company, not an owner. Holders are paid with an agreed fixed rate of return, but having no voting rights. The amount of money borrowed must be repaid by the expiry date.

2. Mortgage: These are long-term bank loans (usually over one year period) from banks or other financial institutions. The borrower’s land or property must be used as a security on such as a loan.

3. Loan specialists’ funds: These are venture capitalists or specialists who provide funds for small businesses, especially for high tech investment projects in their start-up stage. There are also individuals who invest in such businesses, which are often called ‘business angels’.

4. Government assistance: To encourage small businesses and high employment, governments may be involved in providing finance for businesses. In the USA, there is an organization which is called the Small Business Administration (SBA). SBA provides guarantees for small businesses’ loans and they even offer some loans themselves.


Financial ManagementFinancial Management -External Short-term Sources of Funds -External Short-term Sources of Funds


Definition: Short term sources of funds are usually the funds which are less

than one year for maturity. They are less stable sources of funds for businesses.

Types: The main types of external short term sources of funds include: 1. Bank overdraft 2. Bank loan 3. Leasing 4. Credit card5. Trade credit See the next page for details:


Table 13-2 External short-term sources of loans

Major types Main characteristics

Bank overdraft

This is a short term financing from banks.The amount to be overdrawn depends on the needs of the business at the time and its credit standing.Interest is calculated from the time the account is overdrawn..

Bank loan This is a loan which requires a rigid agreement between the borrower and the bank. The amount borrowed must be repaid over a certain period or in regular installments.Sometimes, banks change persistent overdrafts into loans, so borrowers must repay at regular intervals.

Leasing Leasing allows businesses to buy plant, machinery or equipment without paying large sums of money immediately. The leasing company or bank hires or buys the equipment and for the use of the hire company for a certain period of time. If the user can never owns the equipment, it is an operating lease, while if it is given the choice to own the equipment at the expiry time, it is a finance lease. Lease payments are made by the hire company yearly or monthly, etc.


Table 13-2 External short-term sources of loans (continued)

Major types Main characteristics

Credit card Credit cards can be used to pay for hotel bills, meals, shopping and materials, etc. They are convenient, and secure because it can avoid the use of cash and the payment of interests within credit periods. Cards may not be suitable for certain purchases, especially a large sum of order because they have a credit limit.

Trade credit It is a common method for businesses to buy materials and to pay for them at a later date, usually between 30 and 90 days. Such trade credit given by the seller is usually an interest free way of short term financing.



Financial ManagementFinancial Management -Factors affecting the choice of funds -Factors affecting the choice of funds


• Costs of the fund Costs in terms of interest payments and other expenses: Long

term and short term.• Use or purpose of funds For example, the building of a new plant is usually financed by

mortgage or share capital, while the purchase of raw materials by trade credit or bank overdraft.

• Status and size of the business For a large firm, there are more sources of finance and often

with lower interest rates. • Financial situations of a firm For example, a business in poor financial situation is forced to

pay high interest rate for loans. And the bank often requires security or collaterals for their financing.




• Gearing condition (ratio) of the firm传动比率 :公司资本中债务的比率，即资产 (assets)与负债(liability)的比率 :

Definition: Gearing is the relationship between the loan capital and share

capital of a business. High geared companies have a larger share of loan capital to share capital. Low geared ones have a small amount of loan capital.

Impact over a firm: High gearing may mean ‘no loss of ownership’ but high risk of

liquidity since interest rates may change and loans must be repaid in time. Low gearing may mean some loss of ownership but no burden of loans and interest payments.


Question for your critical thinking: If you are the manager, do you prefer

high gearing or lower gearing for your firm? And why so?



Sources of FundsSources of FundsSources of FundsSources of Funds

• Debt capital—funds obtained through borrowing.

• Equity capital—funds provided by the firm’s owners when they reinvest earnings, make additional contributions, or issue stock to investors.


• Debt and Equity Capital: Two Basic Sources of Funds


• Comparison of Debt and Equity Capital


Sources of FundsSources of FundsSources of FundsSources of Funds

• Long term Sources of Funds• Leverage杠杆作用 , 影响力 — technique of

increasing the rate of return on an investment by financing it with borrowed funds• The key to managing leverage is ensuring that the

company’s earnings remain larger than its interest payments, which increases the leverage on the rate of return on shareholders’ investment


• How Leverage Works

Copyright © 2002 by Harcourt, Inc. All rights reserved. Topic 13 : Financial Management: Sources of...

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