Topic 5 Sources Of Finance 2024 PDF

**Agenda:** 1. General 2. Internal Sources of Finance Short Term Long Term 3. External Sources of Finance Short Term Medium Term 4. The Stock Exchange. General ======= One of the primary functions of the financial manager is that of fund raiser. The aim is to find the right typ...

**Agenda:** 1. General 2. Internal Sources of Finance Short Term Long Term 3. External Sources of Finance Short Term Medium Term 4. The Stock Exchange. General ======= One of the primary functions of the financial manager is that of fund raiser. The aim is to find the right type, at the right place and right time[^1^](#fn1){#fnref1.footnote-ref}. There are many different sources of finance: - - - Each source affects the business in three distinct ways: 1. 2. 3. With some methods the company will give up some control over its business. Therefore, it is the financial manager's job to provide the required finance at: - Minimum risk - With minimum loss of control - While maximising the wealth of the owner. This is a very difficult task for many reasons particularly due to the range of sources of finance available. Sources of finance may be categorised as: **Internal:** - - **External:** - - - Internal Sources of Finance =========================== Internal sources of finance share the following characteristics: - Arise from management decisions only - Agreement required only from Directors and Managers. Do not require permission of other parties - Flexible - May be obtained easily and quickly. The principal sources of internal finance can be broken down into short-term and long-term sources as follows: 3. Short Term ---------- 1. Tighter Credit Control 2. Reduce Stock Levels 3. Delay Payments to Creditors 4. Accrued Expenses 5. Deferred Income 3. Long Term ========= 1. Retained Earnings Short Term ========== The following are the key characteristics of the principal internal short-term sources of finance[^2^](#fn2){#fnref2.footnote-ref}. Tighter Credit Control ---------------------- This involves having less funds tied up in Debtors/Accounts Receivable by ensuring that accounts are promptly followed up. The company must consider customer requirements and credit practices of competitors. **Advantages** - Less risk of bad debts - Better cash flow. **Disadvantages** - Risk of lost sales - Risk of loss of customer goodwill. 2. Reduce Stock Levels ------------------- This involves holding minimum levels of stock so that funds are released for other use. **Advantages** - Reduced risk of obsolescence - Lower stock holding costs - Better cash flow. **Disadvantages** - Risk of lost sales as stock is unavailable - Risk of lost customer goodwill through inability to fill orders - May require large investment in IT to manage system. 3. Delay Payments to Creditors --------------------------- Businesses can avail of 'Trade Credit' i.e. buy goods now and pay later. To avail of this source of finance suppliers are paid at the last possible moment in order to retain funds for as long as possible \['Stretch Credit'\]. **Advantages** - 'Cheap' form of finance \['Interest-free loan'\] - Available to most buyers who make regular purchases - Only reviewed periodically once initiated - Can be stretched in times of crisis =\> 'leaning on the trade' - Important source of finance. **Disadvantages** - Interest may be charged on overdue accounts - Discounts may be lost - Risk of alienating supplier - Possible loss of credit facilities - May give rise to bad reputation. 4. Accrued Expenses ---------------- Accrued expenses are those that have been incurred but not yet paid for. Payment is delayed for as long as possible in order to enjoy maximum use of the funds (e.g. Electric Ireland, Bord Gáis, Salaries, Tax, PRSI). This is normally a minor source of finance. **Advantages** - Seemingly 'costless' financing. **Disadvantages** - Interest may be incurred on overdue payments - Loss of confidence in operating capability of the business - Dissatisfaction of employees - May give rise to bad reputation. 5. Deferred Income --------------- This is where customers are asked to pay some/all of an invoiced amount in advance. **Advantages** - Reduces risk of non-payment of debt. **Disadvantages** - May lead to customer dissatisfaction. 2.2. Long Term {#long-term-1.ListParagraph} ============== The only commonly-used internal long-term source of finance is Retained Earnings. 2.2.1 Retained Earnings ----------------------- Instead of paying dividends to shareholders, a company retains funds in the company to improve and grow. Instead of selling shares to raise funds, a company retains funds in the company. **Advantages** - No issue costs (no new shares are issued) - Easy access to funds Already available - No effect on control - As they are part of equity they help reduce the financial risk =\> Lower gearing ratio - No fixed maturity - Equity is permanent finance - No increase in no. of shares any increase in return from investments made will increase EPS. **Disadvantages** - Management may not be as careful with funds as they would be if the funds were raised elsewhere - May deter potential investors - Shareholders may require a higher rate of return in subsequent years - Can be difficult to plan -- the timing and amount of profits is difficult to estimate - Opportunity cost. External Sources of Finance =========================== External sources of finance may be categorised as Short-Term (less than one year), Medium-Term (between 1 and 5 years), or Long-Term (over 5 years). Short Term ========== The following are the characteristics of the principal sources of short-term external finance. Bank Overdraft -------------- - Allows a business to operate a negative balance on its bank account - Very popular - Very flexible Subject to bank's approval - Easy and cheap to arrange - Bank may also require forecast cashflows - Variable interest rate depending on creditworthiness of customer - Repayable on demand - Banks prefer the overdraft to be self-liquidating - Subject to periodic review - Security may be required - Can continue for years Long Term rather than Short Term. 2. Term Loan --------- - Usually granted for specific reason - May be able to negotiate terms and repayment schedule - Interest may be fixed or variable - Interest payable on outstanding balance - Arrangement fee may be payable - Security/guarantee required: fixed or floating charge - Borrowers categorised: AAA, AA, A,...D - Loans may have obligations e.g. information obligations. 3. Debt Factoring -------------- - Finance company takes over sales ledger administration; may offer insurance against bad debts; may carry out credit checks on customers - Fee based on turnover (approx. 2% - 3%) - Factor may give cash advance of 80% - 85% of trade debtors but charges interest on advance - Remainder paid when debt is collected - Interest rate charged may be higher than overdraft rate - May be useful for small companies releasing staff to other duties - May be 'with recourse' or 'without recourse' - May give negative impression of company using factor. C06NF05 Invoice Discounting ------------------- - Similar to Factoring - Relates to specific invoices rather than the whole sales ledger - Company may obtain advance of 75% - 80% of invoice amount - Advance must be repaid within 60-90 days usually and is not dependent on debt being collected - Invoice discounting more important than factoring now because: - Confidential form of financing - Lower fee than factoring (0.2% - 0.3% of sales) - Companies do not have to give control over their sales ledger to factor/financial institution. See Handout relating to Factoring and Invoice Discounting on Moodle (ignore the calculation part i.e. Study Session E). Medium Term =========== The following are the characteristics of the principal sources of medium-term external finance. Leasing ------- **A lease is a contractual agreement whereby the owner of an asset (Lessor) allows another party (Lessee) economic use of the asset for a specific period of time in return for regular rental payments.** - **Wide range of assets leased: Heavy machinery to furniture** - **Many specialist firms offer leasing** - **It may be costly but payments can be tax deductible** There are two Types: Operating and Financial - - **Advantages** - Allows financing when further borrowing is not available - Less risk attached to leasing for lessor as it is easier to repossess a leased asset - Leased assets may be upgraded allowing flexibility where there are changes in technology - Large cash outflows are avoided **Disadvantages** - By leasing rather than purchasing there may be loss of capital appreciation of the asset - Effective Interest Rate can be high. 6. Hire Purchase ------------- - Purchase asset by payment of instalments - Three Parties involved: - Purchaser (Hiree), Seller (Hirer), Financier - Two types: Differ in relation to when ownership is transferred - *Hire Purchase Agreement:* - Ownership remains with seller until last payment - Agreement covers rental period with option to buy at the end for a nominal fee - *Credit Sales Agreement:* - Ownership transferred immediately - Purchaser agrees to pay for asset over a specific period - Similar to Finance Lease, excess of payments over cost is the effective interest. - - - Usually period covered is between 1 and 5 years - Hiree responsible for maintenance and insurance - Use of asset without large outlay - Asset may be repossessed by Hirer if payments not made - Can be expensive - May affect firm's ability to raise other forms of finance. 7. Venture Capital (aka Private Equity) See www.ivca.ie ---------------------------------------------------- - Medium to Long Term source of finance - Provided to small and medium sized firms who want to grow but who do not have access to stock markets - Firms must have good growth potential and committed management etc. to secure investment - Supply of Venture Capital has increased greatly - Institutional investment into companies - Investment is in shares or debentures - Venture capitalist usually takes a participating interest in the business (e.g. on the board of directors) - Popular for Management Buy Outs (MBOs) and other potentially risky projects Venture Capital is provided for different types of business situations: - Start-up capital: From concept stage to commercial trading - Other early stage capital: Have completed development work and are ready to begin operating - Expansion (development) capital: Funding for growing companies e.g. new machinery - Refinancing bank borrowings: To reduce gearing - Secondary purchases: To allow purchase of part of another company - Buy-out capital: To buy existing business using MBO, IBO - Buy-in capital: External management team want to buy business 8. Crowdfunding ------------ Crowdfunding is the financing of a new project by raising small amounts of money from a large number of people. - Typically done through an online platform allowing the fundraiser to set up a public campaign for accepting donations. - The campaign will advertise details such as the nature of the project or venture, the amount of money the company is hoping to raise and the campaign's fundraising deadline. - People can donate a specified amount through the fundraising campaign's website and often receive some sort of acknowledgement or reward in return for their donation. - Examples: fundit.ie, kickstarter.com, Indiegogo.com, etc. 9. Business Angels (e.g. Dragons' Den) ----------------------------------- - Similar to Venture Capital but in a more personal capacity - Fills the 'equity gap' - Often wealthy individuals who have been successful in business themselves - Start-up or early stage Equity stake - Knowledge and experience provided - May wish to have management involvement May accept smaller equity stake - See: [www.hban.org](http://www.hban.org/) (Halo Business Angels Network) - May help secure Venture Capital and Loans in future - Average investment is €25,000 to €250,000 - Typical characteristics of firms that Business Angels would consider investing in: - Have the potential to be successful and innovative and to achieve significant profits or growth over the next 3-5 years - Need finance to achieve their business aims - Have an innovative or unique proposition which distinguishes it from competitors - Could be helped by external expertise. - See Handout entitled "Being an Angel" on Moodle. 10. Grants ------ - May be more easily available but require detailed financial projections - Given to business for both capital and revenue purposes - Finance may be repayable and subject to certain conditions - Finance may require procedures, forms and be difficult to obtain - Examples of organisations offering grants include: Local Enterprise Boards, EU, etc. 11. Term Loan --------- This was discussed as Short-Term source and may also be used as Medium-Term source i.e. for a longer period of time. 3.3. Long Term {#long-term-2.ListParagraph} ============== The risk/return characteristics of long-term sources of finance (the higher the risk perceived by the investor the higher the return required).  There are two types of companies and their shares: - **Private:** Shares not traded. If they go to the markets to raise finance by selling shares via an Initial Public Offering (IPO) - **Public:** Shares actively traded wither on the main market (for large companies) or the secondary listing for smaller companies (AIM, ESM). There are two main types of shares; **Ordinary** shares and **Preference** shares. The following are the characteristics of the principal sources of long-term external finance (i.e. repayable after at least 5 years). 1. **Ordinary Shares** - The backbone of the financial structure of a business - Usually non-redeemable source of finance - Shares may have a nominal value and a market value - Shares carry voting rights May be of little practical use - Maximum limit on number of shares is specified in the Company's Articles - High risk as no guaranteed return but high return expected - Possible to have different categories of ordinary shares - On a winding up, paid after lenders, creditors and preference shareholders Bottom of 'pecking-order' - No tax relief on dividends paid. 2. **Preference Shares** - Shares may have a nominal value and a market value - Shares usually carry a fixed dividend % - No voting rights - Lower risk than ordinary shares Lower expected return - Right to dividend over ordinary shareholders - On a winding up, paid after lenders and creditors but before ordinary shareholders - Different categories of preference shares include cumulative, redeemable convertible, etc. - Can be viewed as similar to a Long-Term Loan - No tax relief on dividends paid. 3. **Term Loan (could also be short- or medium-term.** - Security/Collateral very important -- fixed or floating charge - May also impose Restrictive Loan Covenants - Repayment Schedule -- may be interest based (bonds) or principal + interest (mortgage) - Usually granted for a specific reason - May be able to negotiate terms and repayment schedule - Interest may be fixed or variable - Interest payable on outstanding balance - Arrangement fee may be payable - Borrowers categorised: AAA, AA, A,...D - Loans may have obligations e.g. information obligations. 4. **Debentures/Bonds** **Different types of debentures/bonds exist. The risks & returns vary. For example:** **Normal/Vanilla** - Long-term loan - Issued in blocks of €100 nominal value - Interest attaching relates to nominal value NOT market value - Year of redemption specified - Debentures /Bonds usually have a nominal value and a market value - Interest rate is fixed - May be secured or unsecured - Debentures of PLCs often traded on Stock Exchange Value fluctuates depending on expected interest rates. 5. **Sale and Leaseback (can also be a medium-term source)** - Business raises finance by selling an asset \[land (Long Term) or equipment (Medium Term)\], usually to a financial institution, and - Agrees to lease it back over a specified period - Lease payments may be tax deductible - Depending on arrangement asset may belong to financial institution at end of lease period - Company gets cash now but ends up paying for it over a longer period of time (i.e. a loan) - There may be loss of any capital appreciation if asset is a building. The Stock Exchange ================== The final sources of finance that we examine is the Stock Exchange, which is another external source of long-term finance. 4.1 Overview of the Stock Exchange ---------------------------------- The functions of the Stock Exchange are to: - Make all relevant information available to the public on a timely basis - Ensure that all investors deal on the same terms and get the same prices - Channel savings into investment - Provide a market for existing shares and debentures - Act as an indicator of the financial health of the country - Provide safeguards for investors - Advise investors. There are two markets provided on most Stock Exchanges: - **Primary Market:** Companies can raise new capital by selling shares and bonds to investors. - **Secondary Market:** When shareholders wish to sell their shares to other investors, they can do so on the Stock Exchange. 4.2 Types of securities/shares traded ------------------------------------- The following are traded on Stock Exchanges. 1. Ordinary shares 2. Preference shares 3. Debentures 4. Bonds - Government (Gilts) - Other forms 5. Other specialist securities. 3. Markets in Ireland ------------------ Euronext Dublin (formerly, the Irish Stock Exchange) is Ireland's main Stock Exchange and is comprised of two markets. The Official list, the **Main Securities Market (MSM)** is for larger companies, more information required and more expensive to list on main market and includes companies such as Glanbia, Ryanair, and CRH. The **Enterprise Securities Market (ESM)** is for smaller growth companies, specifically designed to meet funding requirements of companies at earlier stages in their development. It includes companies such as Applegreen and CPL Resources. Companies sometimes start their life on the ESM and graduate to the MSM. Markets in the UK ----------------- **The London Stock Exchange (LSE)** is the UK's main Stock Exchange and is comprised of two markets. The Official list (Main Market) is the market for larger, more established companies and includes companies such as Vodafone, Marks & Spencer, and Barclays. The Alternative Investment Market (AIM) was established in 1995 for smaller growing companies and includes Asos, Boohoo, and Fevertree Drinks. Advantages/Disadvantages ------------------------ The advantages and disadvantages of a stock market listing are as follows: 4.6.1 Advantages ---------------- - Access to capital market and larger amounts of finance which broadens investor base - Institutions more likely to invest in a plc. and additional borrowing is possible therefore an opportunity to improve debt/equity ratio - Easier for shareholders to sell shares - Higher financial standing i.e. greater prestige - Easier to acquire other companies. Can offer own shares as part/full payment - Market price provides a recognised value of shares for sale purposes - Attracting/retaining employees using shares as incentives. 4.6.2 Disadvantages ------------------- - Flotation costs are high - Plcs subject to more publicity/attention than private companies (i.e. attention from analysts, other firms etc.) - Stronger risk of being taken over as shares may be purchased more easily. This risk had led some firms to delist - Additional external shareholders may result in loss of control over business - Costs involved in reporting and complying with Stock Exchange Requirements - Smaller firms may be 'ignored' in favour of larger firms - Investors may have a short term investment view leading to adverse decisions in the long term. ::: {.section.footnotes} ------------------------------------------------------------------------ 1. ::: {#fn1} See Q1a for factors that influence the types and sources of finance chosen by a company.[↩](#fnref1){.footnote-back} ::: 2. ::: {#fn2} These methods largely tie back with what we examined in *Working Capital Management* in Topic 2.[↩](#fnref2){.footnote-back} ::: :::