 Topics  Activities 2

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1: THE ENTERPRISE ENVIRONMENT Welcome to Business

2: THE ENTERPRISE ENVIRONMENT
Enterprise Skills
3: THE ENTERPRISE ENVIRONMENT

4: ENTERPRISE FORMULATION AND GROWTH

5: ENTERPRISE FORMULATION AND GROWTH

6: BUSINESS PLANNING

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7: BUSINESS PLANNING

8: ENTERPRISE FINANCE AND ACCOUNTING

9: PEOPLE IN BUSINESS ENTERPRISES

10: ENTERPRISE FINANCE AND ACCOUNTING

11: PEOPLE IN BUSINESS ENTERPRISE

12: OPERATIONS MANAGEMENT

13: MARKETS AND MARKETING

14: MARKETS AND MARKETING

15: OPERATIONS MANAGEMENT

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 SOURCES OF FINANCE

By the end of this sub-topic, learners should be able to:

1. Identify different ways of financing a busine ss.

2. Give examples of short term and long te rm sources of finance .
3. Evaluate internal and external sources of finance .
4. Explain factors considered by a busine ss whe n choosing a source
of finance.

Sources of finance
It describes the provision of finance to a business to meet short and long term
requirements.
Many enterprisers may find it difficult to start or expand their business without
enough finance.
Finance is also needed for investments and for working capital needs.
There are different financial institutions where a business can source funds from
such as:
Family and friends- these funds is best suitable for business start-ups.
Banks- they offer credit extension to businesses.
Government- offer finance known as grants or subsidies.
Business angels- successful business people who provide finance to other
entrepreneurs in return for a share in the company's equity.
Venture capitalist- it can be general individuals who want to provide finance to a
company in return for a proportion of equity.
Sources of finance are divided into two groups, that is, internal and external.

Internal sources of finance

These are funds that are raised within the enterprise.
Internal sources of finance are quick and easy to acquire.

Examples of internal
sources of finance

Retained profits

This is the portion of net income kept in the business rather than paid out to
shareholders as dividends.
This is the most important source of finance in a business.
Retained earnings are often reinvested in the enterprise for the purpose of research
and development, purchase of fixed assets or can be used for working capital
needs.

Advantages
It is cheap to acquire- there are no additional costs such as interest or risk of
losing assets.
Very flexible- management have control on how the funds are reinvested in the
business.
There is no need to repay the profit.
There is no dilution of ownership in the enterprise since there is no additional
equity. 100%

Disadvantages
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 Retained profits are not available for new businesses and for those that are
running at a loss.
It reduces dividends available to shareholders thereby causing conflict within the
enterprise.
There is high risk of improper utilisation of funds since the funds are not kept for a
specific purpose.

Sale of assets

A business may choose to sale existing fixed assets to raise finance.

It can be assets that are no longer fully utilised by the business.
Examples of fixed assets that can be sold are building premises, motor vehicles and
furniture.

Advantages
Enables the business to free up capital by selling the asset and use it for other
needs.
Can be a quick way especially when selling assets such as motor vehicles,
furniture, machinery, etc.
Other assets can be sold at a profit, for example, assets that increase in value such
as land or buildings.

Disadvantages
Not suitable for new business as they do not have any assets to sell.
It may be difficult to find a buyer for the asset.
The assets may depreciate in value hence it can be sold at a lower value.

Personal savings

It is often used by upcoming entrepreneurs.

Entrepreneur uses his/her own savings to finance a business.

Advantages
It is cheap, they may be no interest charges.
Funds are readily available.
Enables the entrepreneur to fully control the business.

Disadvantages
The funds may not be enough for business expansion or growth.
High risk involved- the entrepreneur can lose all the money invested.

Management of working capital

Working capital is used to finance short term requirements.

A business can raise finance using working capital by:
Reducing credit period given to debtors.
Reducing level of inventory bought by the business.
Delaying payment of accounts payables so that cash can be used for other needs.

Advantages
Cash can be quickly made available to solve cash flow problems.
There is full ownership and control since there is no issue of equity.
No collateral security is needed to acquire such funds.
There is no interest charged.

Disadvantages
The enterprise may fail to acquire enough raw materials for production to meet the
demand.
Decrease in profit due to less production.
Benefits of purchasing in bulk may be lost.
Creates bad relationship between the firm and the creditors as they delay in
paying their debts. 100%

External sources of finance

f f d b df d h
 It refers to funds obtained from outside the enterprise.
It can be individuals or an organisation that provides finance to businesses.
Can be based on duration, that is, short term, medium term and long term sources
of finance.

Short term sources of finance

This is the finance used for day to day activities for a period of not more than
three years.
It is usually needed to finance working capital needs.

Trade credit

This is credit given to enterprise by suppliers.

Suppliers allow a business to purchase goods on credit and pay for them at a later
period.

Advantages
Enables the enterprise to free up cash for other uses.
Does not require any formal agreement.
It is cheap, can be at zero interest.
Allows the business to make profit before payment.

Disadvantages
Creditors can charge higher prices for the goods.
Loss of cash discount for prompt payment.
Trade credit acquired can only be used to purchase goods only.

Bank overdrafts

It is advance given by a bank to firms for a short period of time.

Firms are allowed to withdraw more than they have in their bank accounts.

Advantages
It is cheap, interest is charged on the amount borrowed only.
It is flexible, a firm can only acquire the amount of money required.
It does not require a firm to provide collateral security.

Disadvantages
The amount overdrawn needs to be paid within a short period of time.
Variable interest rate can be costly for a business.
There is limit on the amount acquired.

Debt factoring

It is the process of selling accounts receivables to a third party at a discount.

The enterprise sells their debtors to a debt factor in exchange for cash.
The debt factors charges a certain percentage on the amount to be collected.

Advantages
Guarantees cash to a business.
Ensures early payment of debts.
It reduces the risk of bad debts.

Disadvantages
The business does not get the full amount of debtors sold.
The amount acquired is only limited to credit sales.

Medium term finance

Finance obtained for over a period of three years and less than ten years.
It is used to repair or purchase expensive assets.
Can also be used to cover working capital needs and for business expansion.
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Hire purchase
 It is an agreement between the seller and the buyer in which goods are paid in
instalments.
It allows the buyer to possess the item bought before making full payment.
Interest is charged when making monthly instalments.
It is used to buy expensive assets which cannot be paid fully at once.

Advantages
No immediate cash is required to purchase the assets.
It enables the enterprise to use cash for other purposes in the business.
Allows the business to use the assets to generate income before the last instalment
is made.

Disadvantages
High interest rate is charged.
The finance company remains the owner of the assets until the last instalment is
paid.
Monthly instalment may be expensive than once off payment.
Deposit is needed before possessing the assets.

Leasing of equipment

This is an agreement whereby a lessor allows the lessee to use an asset without
purchasing it for a fee.
It is the rental of asset for a period of time.
The lessor is the one who owns the asset.
The lessee uses and controls the asset for a specific period of time.
Leased equipment is ideal for project based business, where a firm does not need
to purchase an asset only to use it for a short period of time.
An enterprise can also be a lessor, where they can rent out some of their assets in
order to earn revenue.

Advantages
Enables the firm to acquire expensive machines without purchasing them.
It reduces the risk of obsolescence when the machines are rented out.
Increase liquidity upon receiving rentals fee from the lessee.
No deposit is needed before acquiring the machine.
In the case where the business is the lessee, repairs and maintenance of the assets
remains the expense of the lessor.

Disadvantages
The lessor might limit the business on the use of the asset.
The user does not gain anything when the asset is disposed.
The lessee does not own the asset, hence he has no right of selling the asset.

Bank loans

This is the amount borrowed from a financial institute with an agreed payment
plan.
Bank loans are the primary source of finance for many businesses.
The amount borrowed should be paid back with interest.
Bank loans can be a short term source of finance depending on the amount and
duration of the loan acquired.
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A bank loan is used to finance the purchase of business assets, for growth or
operating capital.
Upon acquiring a bank loan a collateral security is needed in case the business
 Upon acquiring a bank loan, a collateral security is needed in case the business
fails to pay back the loan, the bank will seize the asset as a way of settling the
debt.
Financial institutions also prefer to borrow funds to business which are profitably
to reduce the risk of bad debt.

Advantages
There is guaranteed money for the business.
There is no dilution of ownership the bank does not have any control over the
business operations.
Interest paid is tax deductible meaning that the tax charged on business income is
reduced.
It allows the business to budget easily since the amount is paid in instalments.

Disadvantages
It is time consuming to apply for a loan because there are many legal formalities
needed.
Financial institutes prefer to give finance to already established business because
they can trace their profitability and credit history.
There is high risk of losing collateral in case where the business fails to pay back
the amount borrowed.
Interest charged can be high.

Long term source of finance

It covers a period of more than ten years.
It can be debt finance or equity finance.
Debt finance increases the liabilities of a business.
Equity finance involves the issue of shares and increases the number of owners in
the company.
Long term finance is used for large projects which can take time to complete or to
purchase very expensive equipment.

Debt finance- debentures

It is long term loan acquired without providing collateral security at a fixed rate of
interest.
A company invites the investors who are willing to pledge a loan at a stipulated
interest as shown in the prospectus.
It is a certificate of loan showing that a company is liable to pay the amount of
interest agreed on.
Debenture becomes part of the business' capital but not share capital.
The debenture holder is a creditor to the company they do not have any voting
rights.

Advantages
The loan is repayable at later date which allows the business to improve its
operations.
Debenture holders have no control of the company.
They do not get a share of profits they only receive their interests.
The interest charged is tax deductible leading to a decrease on the tax.
There is no need to provide collateral security when acquiring a debenture
especially if it is unsecured.

Disadvantages
Interest should be paid even if the company is operating at a loss.
On secured debenture, the company loses the right to control the asset, therefore
they cannot sell the asset whenever they deem necessary.
It affects the creditworthiness of the company, hence reducing the ability of the
firm to borrow funds.

Debt finance- Mortgage

Long term loan offered by banks such as building societies. 100%

It is used specifically for building or buying property.
The business should provide collateral security upon acquiring the loan
 The business should provide collateral security upon acquiring the loan.

Advantages
The interest charged is tax deductible
The loan is repaid over a long period of time.
Enables the business to own a building without making full payment on it.
Allows the business to rent out free space as source of income to the building that
they have acquired before full payment.

Disadvantages
Interest charged may be too high, hence it increases the amount to be repaid.
The company should maintain the property purchased even before full payment,
hence increase the costs of the company.
The value of the property can be affected by economic conditions.

Equity finance- issue of share capital

This is the amount of money raised by issuing shares in a company.

It is suitable for limited companies.
These shares are issued on the stock exchange to the public or within the
organisation.
The amount of finance raised depends on the number of authorised shares in a
company.
There are two types of shares available in a company, that is, ordinary shares and
preference shares.

Ordinary shares represent ownership of the company.

Ordinary shareholders are the owners of the enterprise.

They get their dividends based on the amount of profit earned.
They have voting rights- they take part in decision making.

Preference shareholders- are not the owners of the company

They earn a fixed rate of dividends.

They do not partake in decision making.

Advantages of issuing shares

There is no interest charged on the issue of shares.
No collateral security is needed, the enterprise can acquire more finance from the
banks.
Large sums of money can be raised.

Disadvantages
Only limited companies can issue shares, other types of business organisation
cannot issue shares, for example, public companies and small enterprise.
There is dilution of ownership since the number of shareholders will increase.
It reduces profit to be shared among shareholders.
It can be time consuming to raise finance through the issue of shares.

Other sources of external finance

Venture capital

It is the finance provided by investors to support new businesses.

The finance provided is not in the form of a loan rather the investors becomes part
of the business.
People who provide such funds are known as venture capitalist.
They help businesses that fail to acquire funds.
They also assist entrepreneurs with knowledge on how to run successful businesses.

Government grants
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It refers to financial aid given by the state to small businesses.
It is designed to promote growth and curb unemployment rate in the economy.
 The funds may not be repaid or it can be a loan to be paid later at a lower
interest rate.

Factors influencing sources of finance

There are of factors that a company needs to consider when selecting a source of
finance.
Such factors should answer questions like, purpose of finance, amount of finance
required, is it short term or long term and how much will it yield in return.
Businesses should consider:

The cost-

other sources of finance may be expensive to acquire and with

high interest rates, hence it is wise to evaluate such costs and
choose the most suitable source which is least expensive.

The purpose-

if the finance needed is for short term needs, then the

business should source short term finance and avoid borrowing
funds which does match with the need of it.

The size of the business-

the amount of finance depends on the size of the business,

small business may fail to pay out long term sources of
finance in the long run. It is best to use funds that will not
hinder the growth of a business in the future.

Financial position-

a business should check whether they are able to pay back the
amount borrowed, in most cases collateral security is needed
in order to secure finance. If they do not have assets, they
may fail to get finance they require.

Gearing-

this measures the number of assets invested in the company

using debt finance. High gearing may mean that a company
cannot acquire more debt finance as this would lead to an
increase in liabilities of a company.

Type of a business-

other sources of funds are only limited to certain types of

businesses, for example, issuing of shares can only be done by
limited companies. Partnership and sole traders have no rights
to issue any shares since they are unincorporated businesses.

Risk involved —

evaluate the risk associated with the source of finance

desired, if the risk is too high then it might not be a good
idea to choose that source as it may force the business to
liquidate to pay off debts.

Control-

consider whether the source of finance chosen will affect the

ownership of the business, for example, issuing of shares leads
to dilution of ownership in the business.

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