3.2 Sources of finance

Full video class on YouTube, summary and notes on Instagram, class extracts on TikTok, text below. Have fun!

The main point of this class is to learn to choose the right source of finance in the given situation.

Sources of finance (SOF) are different ways to obtain monetary support for the enterprise. Internal SOF refer to the finance that comes from within an organisation. We will learn 3 types of internal finance:

1. personal funds,
2. retained profits,
3. sale of assets.

In order to make sure you understand sources of finance systematically, I suggest you will in the table below as you read through the chapter.

Personal funds are personal savings or money provided by family or friends. This type of finance is easy to acquire (there is no need to apply for it formally), there is no interest rate and the entrepreneur has full control over funds (there are no requirements about how these funds have to be spent). However, usually personal funds are too small and using this type of finance is too risky because in case the business does not go well, someone risks losing all personal (or family’s or friends’) savings. Personal funds are an appropriate source of finance for unlimited liability businesses (sole traders and partnerships) who are willing to take the risk.

Retained profits refer to profits that remain within an organisation after all costs and dividends are paid. On the one hand, the use of retained profits is free (there is no interest rate to be paid) and entrepreneur maintains full control over finance. On the other hand, retained profits are not usually available to startups (there is not much to retain at early stages of business development…), may be insufficient and may dissatisfy shareholders (if profits are retained at the expense of paying dividends). Retained profit works as a relevant source of finance for limited liability organisations (companies) that can retain sufficient funds without having to deprive shareholders of dividends.

Sale of assets refer to selling unnecessary equipment and/or premises (buildings, land). There is no interest rate in sale of assets as well, which means that obtaining this type of finance is free of charge. In addition, entrepreneur, again, retains full control over how finance is spent. However, funds obtained through sale of assets are usually insignificant and it takes quite a long time to find a buyer for the assets. Sale of assets is usually appropriate for any business that is about to shut down or relocate some of its parts.

External sources of finance (SOF) refer to the finance that comes from outside of an organisation. We will learn 8 types of external finance:

1. share capital,
2. loan capital,
3. overdrafts,
4. trade credit,
5. crowdfunding,
6. leasing,
7. microfinance providers,
8. business angels.

In order to make sure you understand sources of finance systematically, I suggest you will in the table below as you read through the chapter.

Share capital refers to funds raised through the sale of shares. This applies to privately held and publicly held companies. The difference between them is that the former sell shares privately whereas the latter sell shares publicly on stock exchange. Read more about companies in 1.2. On the one hand, share capital is usually relatively large sums of money that have no interest rate. Unlike banks that provide loans, shareholders do not require interest payments. However, shareholders usually have to be paid dividends. What’s more, founders of publicly held companies may lose control over their enterprise if they sell most of their shares. And lastly, the process of incorporation (becoming a company) and issuing shares is quite a difficult and time-consuming bureaucratic procedure so this source of finance is not the easiest to obtain. It works well for limited liability organisations that have shares (i.e. companies).

Loan capital is finance obtained from commercial lenders (banks). On the one hand, as opposed to share capital, there is no risk of losing control over organisation. Bank loans come with interest payments, but they do not have any ownership and decision-making rights in the organisation. However, bank loans usually have to be secured with some property that guarantees that it will be taken by the bank in case of inability to pay back the loan. This kind of guarantee with property is called collateral. In addition to that, loans come with interest, which means that in the long-term you will have to repay more than what was loaned. Bank loans are appropriate when a large sum is needed without dilution of control in exchange for long-term payments.

There are many types of loans. Even though they are not included in IB Business Management course, I encourage you to find out more about different types of loans, especially debentures and mortgages. You don’t have to, but it definitely wouldn’t hurt to know more.

Overdraft is an opportunity to take more money than a business has on its account. For example, let’s say your business’s bank account balance is currently $0 but you have just received an order from a client and you need raw materials. If the bank that keeps your business bank account has an overdraft limit of $10.000, it means you can buy raw materials for up to $10.000 and there is no need to spend time applying for bank loans and no need to go through complicated procedures. So, on the one hand, overdrafts are really convenient and easy to acquire. However, the credit period (time when you have to pay back to the lender) for overdrafts is usually really short (shorter than for traditional bank loans) and the interest rate is really high if you do not manage to top up your bank account before the end of the credit period… Thus, overdrafts work well as a solution to minor cash flow problems (i.e. insufficient funds to purchase materials for a special order) when you are certain that you can pay back in a short time.

Trade credit is, simply speaking, a kind of “buy now, pay later” situation. It is an opportunity to pay back to your supplier at a later date, within credit period (usually 30 to 90 days, depending on the industry). For example, if you produce apple juice, then local apple farm could be your supplier and give you a chance to get apples today, but pay for them next month. In this relationship, there are two parties: you (the firm that produces apple juice) are a debtor, and your supplier (the apple farm) is a creditor. The advantage is obvious: no payments made at the time of purchase, you can get supplies of raw materials right here right now but pay for them later. However, usually creditors (suppliers) give a choice to debtors: either pay now for a lower price with a discount, or take a trade credit and pay later, but for a full or higher price. This makes trade credit an appropriate source of finance for purchasing materials from suppliers that a business has good relationships with. This way, trade credit and discounts are all negotiable.

Crowdfunding refers to obtaining small amounts of money from a large group of people (usually users of crowdfunding platforms, such as Kickstarter and Indiegogo. On the one hand, crowdfunding is available to literally everyone and it provides access to a community of donors. Usually it’s free, there is no loss of control (as in the case with share capital) and, on top of that, you can get direct feedback from the potential target market: if people donate actively, then your product/idea is a success, if not — you might want to change it. On the other hand, crowdfunding platforms usually charge commission, so a certain portion of your donations will go to the crowdfunding platform. In addition, these platforms have a lot of rules to comply with, and the competition among businesses who try to lure people to donate is quite high. This source of finance works well for small businesses with outstanding ideas and no start-up capital.

Leasing is a source of finance whereby lessee hires an asset from the lessor. For example, if you opened a pizza delivery but you don’t have money for purchasing a delivery car, you can lease it. It means you’ll pay once a month (or once a year) for using the car, but you won’t become the owner of it. What’s great about leasing is that you don’t have to pay for maintenance, because you are not the owner of the leased asset! But of course if you break the leased asset and it’s your fault, you will bear all the costs… In addition, leasing is a business expense. The higher the expenses are, the lower the profits are, but also the lower the tax is, because only profit is taxed. This way, you can use an asset, register it as an expense, and free up some cash by paying less taxes. On the other hand, leasing does not give you ownership rights and if you lease an asset for a long term you will end up paying more money than you would have if you just purchased the asset right away. Thus, leasing is perfect when a business needs an asset for short-term use but cannot afford its purchase.

There is also a way to lease an asset and pay for it regularly and eventually have ownership rights when you make the last payment: this source of finance is called hire purchase. In addition, there is a way to get some cash by selling some of your assets to another organisation/person and immediately leasing the assets that you've just sold: it’s called sale-and-leaseback. The assets literally don't have to leave your premises, you just sell them lease-back immediately! It allows you to get significant cash inflows without having to say goodbye to the assets that you need in exchange for small short-term payments. Hire purchase and sale-and-leaseback aren’t included in IB BM syllabus, but again, it wouldn’t hurt to know more.

Microfinance providers are organisations that provide microcredit (very small loans) to low-income individuals/businesses. Microcredit is usually really easy to obtain (there is no collateral) and it helps to alleviate poverty in low-income economies. However, the interest rates are really high, because microfinance providers usually take bank loans that they have to pay back for themselves. Microfinance works in less developed economies for businesses that are not able to obtain finance from traditional lenders.

One person that you just have to know about is Muhammad Yunus. He is a founder of Grameen Bank and he won the Nobel Prize for starting that microfinance organisation in Bangladesh that helped to kickstart many small businesses and alleviate poverty. Please watch Muhammad Yunus’s TED Talk where he explains in detail his ideas about alleviating poverty with the help of microcredit.

Business angels are wealthy individuals investing into high-risk business in exchange for ownership. On the one hand, this source of finance is free, because there are no interest payments and no dividends to be paid. However, since business angels provide financial help in exchange for a stake in business, it might result is a loss of control for founders… Business angels are helpful for businesses with high growth potential that can appeal to a business angel.

Another “non-IB-compulsory” source of finance that is worth exploring is venture capital. Spend a minute exploring what that is and thinking about how it is different from business angels.

In the end of this chapter, I’ll give you a list of sources of finance that are not included in the IB Business Management course, but that are worth exploring. Please spend a moment reading about them, if you’re interested, and make motes in the table below (Figure 3).

1. Grants
2. Subsidies
3. Debt factoring
4. Sale-and-leaseback
5. Hire purchase
6. Venture capital
7. Debentures
8. Mortgages

First of all, let’s try to distinguish between short-term sources of finance and long-term sources of finance. I wish I could just tell you “these SOFs are short-term and those SOFs are long-term”, but I just can’t because it’s quite a nuanced issue. The simplest way to distinguish between them is the one-year rule: usually (usually!) if finance is obtained and paid back within one fiscal (financial) year, it’s short-term. If it takes more than one year, then it’s long-term. That would be a good starting point for distinguishing between short-term and long-term sources of finance — one-year rule.

In addition, the timescale of different SOFs depends on what they are supposed to fund. If finance is used to fund short-term (current) assets (that last less than a year), then that would refer to short-term SOFs. If finance is used to acquire long-term (non-current/fixed) assets (that last more than a year), then it refers to long-term SOFs.

The typical examples of short-term sources of finance are short-term loans, overdrafts, trade credits, retained profits. The typical examples of long-term sources of finance are loan capital, share capital, leasing and retained profit. You might ask “how come retain profits are both short-term and long-term?” or “how about the other sources of finance that we learnt in part 2 of this class?”. I will just repeat again that it is a really nuanced question and the “short- or long-term-ness” depends on legislation, relationship with the lenders and many other factors that are different in different situations, so a closer look at every individual case is required to make an accurate judgement about the sources of finance. It’s completely okay that it’s a little bit ambiguous, because as long as you can apply the one-year rule in a given situation, you should be fine.

Now let me remind you that the objective of this part of class is to justify the appropriateness of different short-term and long-term sources of finance. Basically, we are learning to suggest different SOFs in different situations. In order to do that successfully, you might want to consider the following tips:

1. Use the comparison table from part 2 of this class: pros, cons and “works best when” is exactly what you need to make judgements about the appropriateness of different sources of finance.
2. One and the same SOF can be short-term for one business in one situation but long-term for another business in a different situation, so use the one-year rule to distinguish between them and consider all situations carefully. “One size fits all” approach will not work here.
3. Keep in mind that “short/long-term-ness” depends on the type of SOF, legislation and agreement with lenders.
4. Consider other factors that impact the appropriateness of different sources of finance (see below).

Some other factors that should be considered when it comes to choosing the appropriate source of finance are the following:

• Availability: what’s available to MNCs isn’t available to sole traders. If you are to make a decision about which SOF to use, then shortlist the options that are actually available, first of all.
• Cost: some SOFs are free, some require interest, fee or dividend payments. Prioritise what’s important for you as a manager at a given point in time, and make the corresponding decision. If you are not sure that you are able to return the loan at a given interest rate, it is not a good idea to consider it as a source of finance.
• Control: some SOFs result in loss of control, some are not. For example, if retaining control is the priority, then share capital might not be the best idea. As an alternative, loan capital would be a more suitable option.
• Time: is finance needed to fund current or non-current assets? For example, if you would like to purchase land for a new factory, then a mortgage (long-term loan) is clearly the best option.
• Gearing & risk: gearing is a ratio of share capital to loan capital (we’ll learn more about it later in Unit 3). High-geared organisations (the ones who rely mostly on loan capital) are less likely to be lent loans, because in the eyes of lenders they already have a lot of loans so the chances to get loan repaid are lower than for low-geared organisations.

And lastly, the most important thing here is common sense. There is no one right way to make decisions about sources of finance. If anyone knew how to do that, we would live in a different world… However, it is up to you to develop a good understanding of various sources of finance and of various cases when one source works better than the other. If you understand how different sources of finance work (which is the ultimate goal of this class), then you have already done half of work. The rest is practice and experience. Good luck!

PS. Please note that sources of finance and revenue streams are two different things. We'll learn revenue streams later in Unit 3, but now just remember that they have nothing to do with SOFs.

Make sure you can define all of these:

1. Source of finance
2. Internal sources of finance
3. Personal funds
4. Retained profits
5. Sale of assets
6. External sources of finance
7. Share capital
8. Loan capital
9. Collateral
10. Overdraft
11. Credit period
12. Trade credit
13. Debtor
14. Creditor
15. Crowdfunding
16. Leasing
17. Lessor
18. Lessee
19. Microfinance provider
20. Muhammad Yunus
21. Business angel
22. Short-term sources of finance
23. Long-term sources of finance