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Sources of Finance



Sources of finance, internal versus external sources

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Internally generated: There is only one source of internally generated finance and that is retained profits. Profits are made when all the costs of production, including management overheads, and everything, are subtracted from all the sales revenue. Once profits are made tax has to be paid on them. After the tax is deducted the business can decide to two either of two things with them: (1) distribute them to the owners of the business, or (2) retain them for the future use of the business. It is these retained profits that provide the internal source of finance. Externally generated: The company can basically either (1) sell shares; or (2) borrow finance from banks and/or other financial institutions. There are other ways in which externally generated finance can be obtained, but these are the two principle methods, and the fundamental choice facing the owners of the business. Shares are as the sound - a "share" in the business. When an investor buys a share he/she pays over a sum of money that does not every have to be given back by the business in return for a share in the ownership of the company. The obvious advantage of share capital is that it is "non-redeemable" - in other words, as a source of finance it is permanent and never has to be returned. The disadvantage is that in issuing shares the original owners of the business have to accept that other people will own part of their company, and the loss of control that this entails. Of course, if the other partners also bring in other expertise, the loss of control may be a bonus, but partnership is a tricky thing, and it is possible to choose the wrong partner, with woeful consequences. Bank loans and loans from financial institutions are injections of capital, but this capital does have to be paid back, and at interest. The company does not lose control of the direction of the business, but must generate revenues and profits sufficient to pay off the loan and the interest. If the interest rate is variable, the company could expose itself to changes in interest rates, with increasing costs and a resultant profit squeeze or loss. This is the basic choice facing the directors or owners of any company that seeks further finance. However, there are a number of variations on these themes. (1) Director's loans: The directors of the company, who are its shareholders, may make a loan into the company. This is not strictly share capital and will have to be paid back, but the loan is made on the understanding that it will only be paid back as and when the company can afford to do so, so really it is part and parcel of the process of obtaining share capital. (2) Debentures: Dentures are a form of certificate that can be traded almost as if they were shares. However, they are not shares but actually a legal for of fixed finance, that is to say, a form of borrowing at a fixed or variable rate of interest from a finance house or possibly another company or wealthy individual. (3) Property and mortgages: Often a loan is sought from a bank for the specific purpose of purchasing a property, and the company pays the bank a mortgage. This is just a form of bank finance on which interest is charged, but the bank usually secures the loan against the property and this provides both them and the business with some degree of security in the case of business failure. (4) Hire purchase agreements: Companies can choose to buy equipment by means of hire purchase. This means that they do not have to find all the capital for the equipment in one go, but they pay for it as they use it. They are using expected future profits to pay for the capital equipment. The finance is created because creditors are willing to extend credit to the business in the faith that the business will make a profit, so it is a form of loan.
Contents of
Sources of Finance

1 The need for finance
2 Sources of finance, internal versus external sources
3 Short term finance
4 Issuing of Shares
5 Public limited company, plc
6 Franchise
7 Venture Capital

Related articles: (1) Cash Flow Management, (2) Sources of Finance