3.2 Sources of Finance

Personal funds refer to money invested by the owner(s) of a business from their own savings, assets or personal funds. 

Personal Funds

• Money invested by the business owner(s) from their own savings

• Often the only source of finance available for sole traders and new companies with little experience

• Owners may also need to invest personal funds during difficult economic times to keep the business operating

Advantages

• No interest or repayment obligations.

• Maintains full ownership and control.

• Shows commitment which can help secure external financing if needed

Disadvantages

• Limited funds available from personal savings

• Sole traders and partners risk losing all personal funds invested if business fails

• Represent a high risk so sole traders less likely to access external financing

• Rarely sufficient to meet funding needs of most small businesses

• Entrepreneurs risk losing their entire life savings invested in a failed business venture

Works Best When...

• The business is a new sole trader or partnership just starting up as it is often the only source of finance available 

• During difficult economic times when owners need to invest funds to keep the business running

Overall, personal funds provide an easy internal source of startup capital but amounts are limited and come with significant risks, especially for high risk business structures like sole traders.

Retained profits are earnings left over after covering all costs, expenses, dividends and taxes for the trading year. 

Retained Profits

• Profits left over after costs, expenses, taxes and dividends are paid

• Primary source of internal finance for established businesses

• Shown as part of equity on the balance sheet

Works Best When...

• Business is established and able to generate consistent profits to save over time 

• Funds are needed for long-term investments like new buildings that require large amounts saved up 

Advantages

• Interest free source of finance as it comes from business savings 

• Considered permanent capital as it does not need to be repaid if investments fail 

• Flexible use within the business for any purpose 

Disadvantages

• Not available for startups with no accumulated profits yet 

• May be insufficient for large capital expenditures 

• Shareholders prefer dividends so entrepreneurs reluctant to use 

In summary, retained profits are the primary internal source of finance for established businesses but have limitations for new ventures due to lack of accumulated earnings.

Sale of Assets

• Selling unnecessary fixed assets like equipment, vehicles, buildings, intellectual property

• Raises large amounts of capital that can be reinvested in new projects or update technology

Advantages

• Frees up capital tied in non-productive assets.

• No interest costs as funds are obtained through asset sale rather than a loan

• Entrepreneur retains full control over use of funds 

• Large sums can be raised from selling major assets like buildings or fleet of vehicles

Disadvantages

• Opportunity cost of losing future production or revenue from sold assets 

• Funds raised are usually insufficient and takes time to find buyers 

• Selling certain assets can reduce productive capacity if still needed 

• Low resale prices for obsolete assets and time consuming to find buyers 

• Only option for established businesses, not startups 

Works best when

• A business wants to update its technology and replace old equipment. For example, selling older vehicles to help finance purchasing new delivery trucks.

• Excess or unused assets can be sold without impacting production capacities. For example, selling a redundant unused building.

• Obsolete assets with low resale value can find buyers, such as selling outdated computers or machinery no longer used in operations.

In summary, sale of assets provides an interest-free source of internal capital but comes with opportunity costs and has limitations for raising significant funds. It works best when obsolete assets can be sold without impacting operations.

Share Capital

• 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. 

Works Best When...

• Expanding or scaling a business.

• Financing long-term growth projects.

Advantages

• No interest payments or repayment required to shareholders so reduces business expenses 

• Considered permanent long term capital as shares don't need repaying 

• Publicly held companies can raise more funds through share issues 

Disadvantages

• Founders may lose control if most shares are sold 

• Share issues can also dilute ownership and control

• Shareholders may expect dividend payments 

• Complex and time-consuming process of incorporation 

• Issues shares publicly are only available to shares on the stock market

In summary, share capital provides large permanent capital through stock offerings but comes with costs of dividend payments and potential loss of founder control. It is best for companies seeking major funding

Business Angels

• Wealthy individuals who invest personal money into high-growth potential startups and SMEs

• Provide early-stage funding that other sources like banks don't offer 

Works Best When...

• The business has a innovative concept or product in the early stages of development with high-growth potential that can appeal to risk-tolerant investors seeking large returns

• Businesses seeking mentorship and connections alongside funding.

• The founders have an established track record and can demonstrate sector expertise to give confidence to business angel investors

• Investors are able to take an active role in advising and governance of the business to help improve its chances of success

Advantages

• Valuable expertise and experience offered to support businesses 

• No interest payments and dividends required initially 

• Fills gap for businesses unable to access conventional loans 

Disadvantages

• Loss of firm control/ownership as angels take equity stake 

• Very high-risk investments so funding availability limited and angel investors may lose their money

• Competition for funding from many entrepreneurs so difficult to get

• Business angels may want significant influence.

In summary, business angels and venture capital provide risk capital especially for startups but come with high risks, loss of control, and limited availability due to selectivity of investors. The support offered can help offset some disadvantages though.

Loan capital refers to medium- to long-term borrowing that businesses obtain from financial institutions like banks. Common types include bank loans, mortgages, debentures, and corporate bonds.

Advantages

• Can get large amounts of money.

• Maintains ownership control.

• Allows repayment over time through installments, making large funds affordable 

• Large businesses can negotiate lower interest rates due to scale

Disadvantages

• Interest payments increase business costs.

• Collateral often required which risks asset seizure if default

• Variable interest rates can impact liquidity if they rise 

Works Best When...

• Large capital is needed without relinquishing ownership 

• Sufficient collateral is available to secure favorable loan terms 

• Cash flows can support regular interest and principal payments 

• Borrower has established credit history and reputation 

In summary, loan capital provides immediate funds through installments but incurs interest costs. It works best for buying assets when ownership retention is important and credit/collateral qualifications can be met.

What is an Overdraft?

• Short-term banking service that allows customers to withdraw funds above their account balance 

Advantages

• Relatively easy to obtain, important source for small businesses 

• Helps manage short-term cash flow issues.

• Flexible and quick access to funds.

Disadvantages

• Interest charged is usually higher than ordinary loans

• Only small amounts lent, unsuitable for large purchases

• Banks can demand quick repayment 

• Generally a high-cost short-term source 

Works Best When...

• Covering temporary cash flow shortages.

• Managing day-to-day operational costs.

• Certainty of repaying the overdraft within a short time period

In summary, overdrafts conveniently provide emergency funds but come at a high interest cost and short repayment timeframes, so are best suited to resolving very short-term liquidity problems

What is Microfinance?

• Providing small loans ("microcredit") and other basic financial services to low-income individuals/small businesses who have limited access to traditional sources of financing

• Focuses on small business loans without collateral 

• Often given to a small group of borrowers in a community who will support each other in case anyone has difficulty paying the loan

• Less than $100 - several thousand dollars

Targeted towards...

• Targeting micro-entrepreneurs in developing/low-income countries 

• Those living in poverty or on very low incomes, below $2 a day, represent a major portion of microfinance clients globally as they lack collateral or credit histories for bank loans.

• Microfinance helps fill the gap for bottom of the pyramid individuals and activities too small to interest commercial banks. Access to even small loans can help the poor engage in income-generating activities

• Women entrepreneurs in particular have benefitted from microfinance which aims to empower them financially. Around half of microloans are given to women

• People in rural areas or developing countries have limited traditional banking access. Microfinance providers step in to offer financial services to low-income clients and the working poor in these contexts

Advantages

• Helps entrepreneurs, especially women, gain access to finance 

• Allows people to become self-sufficient and financially independent 

• Provides poverty relief and community benefits 

• Individuals may not qualify for traditional bank loans

Potential Limitations

• Interest rates are often high 

• Limited loan amounts

• May increase debt burden for struggling entrepreneurs

• Profitability challenges in retaining skilled staff

In summary, microfinance provides financial access to empower entrepreneurs in developing areas, though high costs and limited scale constrain its impact. It targets an underserved population through flexible small loans.

What is Crowdfunding?

• Raising small amounts of money from a large number of people (the "crowd") to fund a business project or venture 

• Typically done online via crowdfunding platforms 

Types of Crowdfunding

• Equity crowdfunding: Investors receive shares in the company 

• Rewards-based: Investors receive non-financial rewards 

• Donation-based: Donors receive no financial returns 

• Peer-to-peer lending: Investors provide loans and earn interest

Advantages

• Access to a wide pool of investors.

• Provides marketing exposure.

• No repayment or interest obligations if equity-based.

• Limits risks from individual investments being small amounts 

• Avoids complex bank loans process 

• Raises funds from many small investments 

• Investors have no ownership control 

• Very cheap to do crowdfunding

Disadvantages

• Equity crowdfunding dilutes ownership.

• May require meeting funding targets to access funds.

• Legal and regulatory costs 

• Potential delays from due diligence 

• Risk of idea theft if too much disclosed (intellectual property theft)

• Potential for fraud from loose regulations 

• Platform commission fees 

Examples

• Kickstarter is a major platform 

• Student project example 

When Appropriate:

• Launching new products or startups.

• Projects with strong public appeal.

In summary, crowdfunding allows businesses to raise funds from many small individual investments online, but regulatory costs and fraud risks must be managed

Obtaining the use of equipment or vehicles and paying a rental or leasing charge over a fixed period. This avoids the need for the business to raise long-term capital to buy the asset. Ownership remains with the leasing company.

What is Leasing?

• Renting/hiring a fixed asset over time instead of purchasing it outright

Leasing works best when...

• A business needs an asset for a short term rather than permanent acquisition

• Acquiring expensive equipment or vehicles.

• Technology may quickly become obsolete.

Advantages

• Business can use asset without fully financing upfront

• Does not own asset so no maintenance/repairs

• Can always lease latest model and return when done

Disadvantages 

• Business never owns asset and does not gain if value of assets increases

• Can be more expensive than purchase over long-term

Types of Leasing

• Operating lease: Renting asset for short period, no ownership 

• Finance lease: Long-term rental with ownership option

• Sale and Leaseback: Business sells assets and leases them back for cash injections

Examples:

• Cars

• Aircrafts

• Office Equipment (printers)

• Office buildings / Retail Space

• Medical and laboratory devices

In summary, common reasons why businesses lease rather than buy include managing cash flow, having predictable operating expenses, gaining access to new technologies, and maintaining flexibility as business needs evolve over time. Leasing is especially attractive for assets that are costly or have a high risk of depreciation.