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0 Introduction
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2.0 Sources of Finance
Internal sources of finance are the funds readily available within the
organisation. Internal sources of finance consist of:
• Personal savings
• Retained profits
• Working capital
• Sale of fixed assets
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Retained profits are the undistributed profits of a company. Not all
the profits made by a company are distributed as dividends to its
shareholders. The remainder of the profits after all payments are made
for a trading year is known as retained profits. This remainder of finance
is saved by the business as a back-up in times of financial needs and
maybe used later for a company’s development or expansion. Retained
profits are a very valuable no-cost source of finance.
Working capital refers to the sum of money that a business uses for
its daily activities. Working capital is the difference of current assets and
current liabilities (i.e. Working capital = Current assets – Current
liabilities). Proper working capital management is also vital as it is also a
source of finance for a business.
Current assets
Current assets are also known as cash equivalents because they are
easily convertible to cash. Current assets consist of Stock, Debtors,
Prepayments, Bank and Cash. These assets are used up, sold or keep
changing in the short run.
Stock – this refers to the stock of goods available to the business for
sale at a given time. It is very important to maintain the right amount of
stock of goods for a business. If stock levels are too high it means that too
much of money is being held up in the form of stock and if stock levels
are too low the business will lose possible opportunities of higher sales.
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Prepayments – these are the expenses paid in advance. The
payment being made even before the expense occurs is a prepayment.
Bank and Cash – Bank is the cash held in banks and cash is money
held by the business in the form of cash. Having too much of money in
the form of cash is also not good for a business since it can use that
money to invest and earn a return but however a business should have
healthy current ratio (current assets : current liabilities) of 2:1.
Current liabilities
Dividends proposed – are the dividends payable for the year that is
not yet paid.
Fixed assets are the assets a company that do not get consumed in
the process of production. Some examples of fixed assets are land and
building, machinery, vehicles, fixtures and fittings and equipment.
Sometimes where the fixed asset is a surplus and is abandoned, it can be
sold to raise finance in demanding times for the business. Otherwise
businesses may choose to stop offering certain products and sell its fixed
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assets to raise finance. Selling fixed assets reduces the production
capacity of a business affecting a business’s return.
• Ownership capital or
• Non-ownership capital
○ Ordinary shares
○ Preference shares
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Preference shares are another type of shares. Preference
shareholders receive a fixed rate of dividends before the ordinary
shareholders are paid. Preference shareholders do not have the right to
vote at general meetings of the company. Preference shares are also an
ownership capital source of finance. There are several types of preference
shares. Some of them are Cumulative preference share, Redeemable
preference share, Participating preference share and Convertible
preference share.
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○ Debentures
○ Bank overdraft
○ Loan
○ Hire-purchase
○ Lease
○ Grant
○ Venture capital
○ Factoring
○ Invoice discounting
2.2.2.1 Debentures
Floating debentures – do not have fixed rate of interest and are not
tied to any specific asset.
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Registered debentures – are not easily transferable and legal
procedures have to be followed in case of a transfer.
2.2.2.3 Loan
2.2.2.5 Lease
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In a lease the leasing company buys the asset on behalf of the
business and the asset is then provided for the business to its use. Unlike
a hire purchase the ownership of the asset remains with the leasing
company. The business pays a rent throughout the leasing period. The
leasing firm is known as the lessor and the customer as lessee. Leasing is
of two types, namely Finance lease and Operating lease.
Operating Lease – this lease does not run for the full life of the asset
and the lessee is not liable for the full value of the asset. The residual risk
is taken up by the lessor.
2.2.2.6 Grant
2.2.2.8 Factoring
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remainder of the money is paid to the business when the factoring
company receives the money from the business’s debtor. The remainder
of the money will be paid only after deducting the factoring company’s
service charges. Some factoring companies even offer to maintain the
sales ledger of the business. Factoring is of two types: Recourse factoring
and Non-recourse factoring.
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3.0 The financial costs of the different sources of
finance
Personal savings – have low costs since they are provided by an owner,
partner or shareholder. The owner may charge a rate of interest for the
loan provided.
Retained profits – have opportunity cost, that is the money could have
been used elsewhere for some other purpose. Otherwise there aren’t any
other costs for this source of finance.
Working capital – they do not have any costs other than opportunity
cost.
Sale of assets – by selling fixed assets it uses then the firm’s production
capacity will diminish. If it sells unused or abandoned fixed assets then
only the potential production capacity reduces. Sometimes firms will have
to stop offering certain products or services in order to sell its asset and
raise finance. The asset may cost much more than what it sold for if it
wants to replace it.
Bank overdraft – interest is a little higher than for bank loans and
interest is calculated on a daily basis.
Loans – Interest is usually fixed for short term loans, and long-term loans
usually have a variable rate of interest. Interest rates are lower than for
bank overdrafts.
Lease – the ownership of the asset remains with the leasing company
even after the business pays more than 90% of the asset’s value but
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however some leasing firms provide the option of purchase of the asset a
nominal value.
Venture capital – the venture capitalist will have some influence over
the business and the business will have to share profits with the investor.
The investor will want the capital back at a later date.
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4.0 Advantages and Disadvantages of the different
sources of finance
Advantages
✔ The owner would not want collateral to lend money to the business.
✔ The money need not necessarily be paid back to the owner on time.
✔ Can be interest free or carry a lower rate of interest since the owner
provides the loan.
Disadvantages
Advantages
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✔ The company’s debt capital does not increase and thus gearing
ratio is maintained.
✔ There are no costs raising the finance such as issuing costs for
ordinary shares.
Disadvantages
Advantages
✔ No repayment is needed.
Disadvantages
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✗ Using working capital as a source of finance will affect the current
ratio of the business
Advantages
✔ Funds are again raised by the business itself and therefore need not
be paid back.
✔ No interest payments are required.
✔ Large amounts of finance can be raised depending on the fixed
asset sold.
✔ Would be the ideal source of finance if it was for an asset
replacement.
Disadvantages
✗ If the asset is sold and the money is spent without return then the
business is broke.
✗ The asset may be able to generate more income than the purpose it
was sold for.
Advantages
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✔ If the company follows a rational dividend policy it can create huge
reserves for its development program.
✔ The dividends need to be paid only if the company makes a profit.
✔ No collateral is required for issuing shares.
✔ It will help reduce gearing ratio
Disadvantages
✗ There are legal and regulatory issues to comply with when issuing
shares.
✗ Once issued the shares may not be bought back and therefore the
capital structure cannot be changed.
Advantages
✔ Have no voting rights and thus the management can retain control
over the affairs of the company.
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✔ Even if the company makes large profits preference shareholders
need to be paid only a fixed rate of interest.
Disadvantages
✗ Even if the company makes a very small profit it will have to pay
the fixed rate of dividend to its preference shareholders.
4.7 Debentures
Advantages
Disadvantages
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✗ Debenture interests have to be paid regardless the company makes
a profit or loss.
Advantages
Disadvantages
✗ Overdrafts are meant to cover only short-term financing and are not
a permanent or long-term source of finance
4.9 Loans
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Advantages
✔ Need not be paid back for a fixed time period and banks do not
withdraw at a short notice.
✔ Interest rates are lower than for bank overdrafts and are set in
advance.
Disadvantages
✗ Collateral is needed.
✗ Interest is charged.
Advantages
✔ The business gains use of the asset before paying the asset’s value
in full.
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✔ Payments can be made from the asset’s usage and return of the
asset.
Disadvantages
✗ Ownership remains with the lender until the last payment is made.
✗ The asset will cost the company more than the original value.
✗ If payments are not made on time the lender has the right to
repossess the asset.
4.11 Lease
Advantages
✔ The amount in full need not be paid in order to start using the asset.
✔ The total cost and the lease period is pre-determined and thus helps
with budgeting cashflow.
✔ Lease is inflation friendly where the agreed rate is paid even after
five years when other costs increase due to inflation.
Disadvantages
✗ The ownership of the asset remains with the lessor even after
payments but however in a finance lease the option is provided to
buy the asset at a nominal value.
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✗ In a finance lease the lessee ends up paying more than the value of
the asset.
4.12 Grants
Advantages
Disadvantages
✗ Grants are given freely and therefore are very competitive because
lots of firms try for the same source of fund.
Advantages
✔ They may also bring a lot of experience and expertise along with
the money.
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✔ Since they become owners by investing in the business they have
equal interests in the business’s success.
Disadvantages
4.14 Factoring
Advantages
Disadvantages
✗ The business has to pay interests and fees for the factor for its
services.
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✗ Lack of privacy since the sales ledger is maintained by the factor.
Advantages
Disadvantages
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5.0 Choosing an appropriate source of finance
There are many sources of finance available to a business. Finance
is needed for several purposes and different purposes need sources of
finance which are most suitable to them. When choosing an appropriate
source of finance some factors have to be considered.
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This refers to the amount of time the business can spend on
collecting funds. If the business has plenty of time before its financial
needs need to be met then it can spend time searching for cheap
alternatives of sources of finance. On the other hand if the business wants
the money as soon as possible then it would have to make some cost
sacrifices and accept a source of finance that may even cost higher. The
urgency of funds needs to be identified also because certain sources of
finance need more time to be raised than other sources of finance.
For example issuing shares is a very long and complex process where
there are legal requirements and then the potential shareholders have to
be informed (advertising) and after all these the money is collected
through the process of application and allotment which takes more time.
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The gearing ratio plays an important role in the availability of the
sources of finance since the gearing ratio shows the ratio of debt capital
to the total capital of a business. If a business is high geared then
commercial lenders will be unwilling to give loans because the business is
already operating on more loans than equity capital. A high geared
company will have to pay more of its profits as interests on loans and
other debt capital. That being the case potential lenders fears the
business’ ability to be able to cope with more interest payments and debt
settlement.
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6.0 The impact of several sources of finance on the
financial statements
Financial statements keep record of a business’s trading year
(Trading, profit and loss account) and show the financial position of a
business as at a date (Balance sheet). Obtaining finance from different
sources bring about a change in the financial statements. This portion of
the report investigates how each source of finance is recorded and affects
the financial statements.
Personal savings –
Sale of assets –
Sale of assets will reduce the value of fixed assets on the balance
sheet. The profit or loss made on the sale of asset will be recorded in the
profit and loss account for the year. The depreciation of the asset along
with its original price will be removed from the balance sheet.
Debentures –
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Bank overdraft –
Loan –
Venture capital –
This does not appear in the balance sheet. However the money
received from factoring and invoice discounting can show higher balances
of cash. The interest charges and fee is recorded in the profit and loss
account.
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7.0 The information needs of different decision makers
Different decision makers will want different information about the
company regarding their interests in the business. A long-term lender will
always want to know the gearing ratio of a company while the short-term
lender will want to know about the liquidity ratio of the business. The
information for different parties is all taken from financial reports,
cashflow and financial statements such as the balance sheet and profit
and loss account. The manager needs accounting information to take
managerial decisions since all functions of an organisation are tied to the
financial strength of a business. Using the financial statements, the
financial stability and profitability of an organisation can be analysed and
interpreted. Using this information the interested parties make decisions
regarding the business.
Ratio analysis
The ratio shows the relationship between two relevant items in the
financial statement. The relationship is shown as a ratio or as a
percentage. Different ratios calculable on a business’s financial
statements are:
• Liquidity ratios –
○ Current ratio
• Profitability ratios –
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○ Gross profit margin ratio
○ Debt/Asset ratio
○ Dividend yield
○ Price-Earnings ratio
○ Interest yield
○ Redemption yield
The above ratios being calculated the performance of the business can be
assessed and necessary decisions can be taken by relevant parties. Due
to limited time the ratios have not been explored in detail.
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8.0 Financial planning
Importance of financial planning
A financial plan not only help the business to understand what it wants to
do but also helps the business understand how to achieve it.
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9.0 Singer (Sri Lanka) PLC
Singer is a public limited company that was established in 1877.
Today Singer is a large, diversified company unlike any other in Sri Lanka.
It is a member of the worldwide franchise Singer. Beginning with sewing
machines, Singer’s product portfolio consists of a range of household,
industrial and financial categories.
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9.1 Identifying sources of finance in Singer (Sri Lanka)
PLC’s balance sheet.
• Fixed or Non-current assets that can be sold are potential sources of
finance that is categorised as sales of assets
○ Property, Plant and Equipment = LKR 1,419,011,146
• Working capital is current assets minus current liabilities
○ Working capital (7,855,964,730 – 6,302,249,382) = LKR
1,553,715,348
• Retained earnings are the accumulated earnings of a company
○ = LKR 373,951,178
• Share capital
○ = LKR 629,048,050
• Loans and borrowings
○ = LKR 1,383,661,616
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10.0 Conclusion
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