Theory 1 - Theories - Sources of finance - Finance - Business bank - Virtual Bank of Biz/ed

Finance - Sources of finance

Theory 1 - Internal or external - where's the money coming from?

Internal sources of finance are available to the firm, but these may be more limited in scope and for large projects, the firm may be forced to turn to banks or other institutions (external sources) to help them raise sufficient funding. The main internal and external sources are:

Internal sources

Internal sources are often preferable to a firm as they will usually be cheaper and perhaps easier to arrange at short notice. However, the potential for arranging large amounts of finance may be low. The main internal sources are:

  • Profit - the company of course has to be profitable for this to be a source, and it must be available in cash. Often this is not viable as they may have paid the profit in dividend to the shareholders, or perhaps already tied the money up for other reasons.
  • Reduce working capital - the firm may be able to raise some money for investment if they can reduce their stock level (through improved stock control) or perhaps improve their credit control and ensure that they collect their debts more promptly and delay payment to creditors for as long as is possible.
  • Sale of assets or perhaps sale and leaseback - this will depend on the value of the assets, but the firm may either be able to sell surplus assets (if they have any) or perhaps sell existing assets that they use to a specialist leasing company and then lease them back. This will give them access to some capital, though they are then burdened with annual leasing costs.

External sources

  • Loans - this is where the banks start to come into play. Banks will lend for either short-term or long-term purposes, but the nature of the loan will tend to differ. The main types are:
    • Overdrafts - this is a short-term facility where you can spend money, to an agreed limit, as you want. The bank will charge interest on any overdraft amount. They may only offer this as a short-term facility, but it can be very valuable for firms to fill short-term shortages of working capital or any possible brief cash flow problems.
    • Long-term loans - long-term loans usually refer to lending over five years. The bank lends you a sum of money for a set time at an agreed rate of interest. It is more expensive than an overdraft, but lasts longer. The bank may well want some sort of guarantee for this type of loan to ensure that they get it back. It could perhaps be secured against an asset of the business.
    • Debentures - a debenture is specialised form of loan. It is effectively a loan from people to the firm that will be repaid at a fixed date. Between the issue of the debenture and the maturity date, the firm will pay a set level of interest. They are a common way for businesses to raise money and are relatively low risk, though this will depend on the stability of the business.
  • Shareholders - limited companies or plcs can issue shares. These shares can be issued at a certain price though this price will depend on the profitability of the company and its prospects, so how successful the issue is will depend on how the markets view this.
  • Factoring debts - the firm may be able to sell their debts to a specialist debt-factoring company. This means that the firm sells their debts to the factoring company who pay them a proportion of the debts immediately. In this way the firm raises some immediate finance. The debt factoring company make their money by collecting the whole debt when it is due (having only paid the original firm a proportion of the debt).