Advantages and Disadvantages of Different Sources of Finance

Finance is essential for a business’s operation, development and expansion. Finance is the core limiting factor for most businesses and therefore it is crucial for businesses to manage their financial resources properly. Finance is available to a business from a variety of sources both internal and external. It is also crucial for businesses to choose the most appropriate source of finance for its several needs as different sources have its own benefits and costs.

1. Personal Savings

This is the amount of personal money an owner, partner or shareholder of a business has at his disposal to do whatever he wants.When a business seeks to borrow the personal money of a shareholder, partner or owner for a business’s financial needs the source of finance is known as personal savings.
  • The owner would not want collateral to lend money to the business.
  • There is no paperwork required.
  • 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.
  • Personal savings is not an option where very large amounts of funds are required.
  • Since it is an informal agreement, if the owner demands the money back in a short notice it might cause cash flow problems for the business.

2. Retained Profits

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.

  • They need not be paid back since it is the organisation’s own savings.
  • There are no interest payments to be made on the usage of retained profits.
  • 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.
  • The plans of what is to be done with the money need not be revealed to outsiders because they are not involved and therefore privacy can be maintained.
  • There maybe opportunity costs involved.
  • Retained profits are not available for starting up businesses or for those businesses that have been making losses for a long period.

3. Working Capital

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

  • Since it is an internal source of finance there are no costs involved.
  • No repayment is needed.
  • External parties cannot influence business decisions.
  • Will not increase debt capital of the firm so gearing ratio is maintained.
  • Opportunity costs are involved.
  • Is not suitable for long term investments.
  • Working capital cannot raise large amounts of funds.
  • Total risk is undertaken by the company.
  • Using working capital as a source of finance will affect the current ratio of the business

4. Sale of Fixed Assets

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 assets to raise finance. Selling fixed assets reduces the production capacity of a business affecting a business’s return.
  • 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.
  • If the asset is sold then the business would lose opportunities to generate income from it.
  • If the business wants to buy a similar asset later on it may cost more than it was sold for.
  • 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.

5. Ordinary Share Issue

Ordinary shares also known as equity shares are a unit of investment in a company. Ordinary shareholders have the privilege of receiving a part of company profits via dividends which is based on the value of shares held by the shareholder and the profit made for the year by the company. They also have the right to vote at general meetings of the company. Companies can issue ordinary shares in order to raise finance for long-term financial needs.
  • The amount need not be paid back — it is a permanent source of capital.
  • Able to raise large amounts of finance.
  • 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
  • Issuing shares is time consuming.
  • It incurs issuing costs.
  • There are legal and regulatory issues to comply with when issuing shares.
  • Possible chances of takeover where an investor buys more than 50% of the total issued shares value.
  • Groups of equity shareholders holding majority of shares can manipulate the control and management of the company.
  • May result in over-capitalization where dividend per share falls.
  • Once issued the shares may not be bought back and therefore the capital structure cannot be changed.

6. Preference Share Issue

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.
  • Have no voting rights and thus the management can retain control over the affairs of the company.
  • Preference shareholders need not be paid if the company makes a loss.
  • Even if the company makes large profits preference share holders need to be paid only a fixed rate of interest.
  • Has other benefits similar to ordinary share issue such as — no repayment required, large amounts of capital can be raised, permanent source of capital and no collateral required.
  • Redeemable preference shares can be redeemed.
  • Even if the company makes a very small profit it will have to pay the fixed rate of dividend to its preference shareholders.
  • Preference shares are usually cumulative and thus twice the amount must be paid the following year if dividends are not paid on the year they need to be paid.
  • Taxable income is not reduced by preference dividends unlike debentures where interest paid reduces taxable income.
  • Have other drawbacks similar to ordinary share issues such as the cost, time consumption and legal requirements.

7. Debentures

Debentures are issued in order to raise debt capital. Debenture holders are not owners but long-term creditors of the company. Debenture holders receive a fixed rate of interest annually whether the company makes a profit or loss. Debentures are issued only for a time period and thus the company must pay the amount back to the debenture holders at the end of the agreed period. Debentures can be secured,unsecured, fixed or floating.
  • Debenture holders do not have rights to vote at the company’s general meetings.
  • Tax benefits — debenture interests are treated as expenses and charged against profits in the profit and loss account.
  • Debentures can be redeemed when the company has surplus funds.
  • Debenture interests have to be paid regardless the company makes a profit or loss.
  • The money borrowed has to be paid back on an agreed date.

8. Bank Overdraft

Bank overdraft is a short term credit facility provided by banks for its current account holders. This facility allows businesses to withdraw more money than their bank account balances hold. Interest has to be paid on the amount overdrawn. Bank overdraft is the ideal source of finance for short-term cash flow problems.
  • No security is needed for a bank overdraft.
  • Ideal for short-term cash-flow deficits.
  • Easy and quick to arrange.
  • Interest is only paid when overdrawn and on the exact amount needed.
  • Since overdraft is a short term debt it is not included in calculating the firm’s gearing ratio.
  • There is a limit to the amount that can be overdrawn.
  • Interest has to be paid on an overdraft that is calculated on a daily basis and sometimes the bank charges an overdraft facility fee too.
  • Overdrafts are meant to cover only short-term financing and are not a permanent or long-term source of finance
  • Interest is calculated on a variable rate and therefore it is difficult to calculate the cost of borrowings.
  • Overdrafts can be recalled by the bank at any time if not stated in the agreement.

9. Loans

Loans are amounts of money borrowed from banks or other financial institutions for large and long-term business projects such as the development or expansion of the business. However loans can be substituted by other alternative sources of finance which are more suitable.
  • Large amounts can be borrowed.
  • Suitable for long-term investments.
  • The lender has no say on how the money is spent.
  • 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.
  • Collateral is needed.
  • The amount borrowed has to be repaid at the agreed date.
  • Interest is charged.
  • Loans will affect a company’s gearing ratio.

10. Hire Purchase

Hire purchase allows a business to use an asset without paying the full amount to purchase the asset. The hire purchase firm buys the asset on behalf of the business and gives the business the sole usage of the asset. The business on its part must pay monthly payments to the hire purchase firm amounting to the total value of the asset and charges of the hire purchase firm. At the end of the payment period the business has the option of purchasing the asset for a nominal value.
  • The business gains use of the asset before paying the asset’s value in full.
  • The payment is made in affordable installments.
  • Hire purchase installments are taxable expenditures.
  • At the end of the payments ownership of the asset is transferred to the company.
  • Payments can be made from the asset’s usage and return of the asset.
  • 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.
  • If the asset is required to be replaced due to breakdown or because it is out-dated in which case the payment may still have to be made and the asset replaced.

11. Lease

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.
  • 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 cash flow.
  • In an operating lease, payments are made only for the usage duration of the asset.
  • Lease is inflation friendly where the agreed rate is paid even after five years when other costs increase due to inflation.
  • It is easier to obtain a lease than a commercial loan.
  • 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.
  • In a finance lease the lessee ends up paying more than the value of the asset.
  • Lease cannot be terminated whenever at lessee’s will.

12. Grants

Grants are funding given to businesses for programs or services that benefit the community or public at large. Grants can be given by the government or private firms.
  • Grants do not have to be paid back.
  • There are no costs involved in obtaining a grant.
  • Grants are given on certain restrictions and laws imposed by the government.
  • Not all organisations are eligible for grants.
  • Grants are given freely and therefore are very competitive because lots of firms try for the same source of fund.

13. Venture Capital

Venture capital is the capital that is contributed at the initial stages of an uncertain business. The chance of failure of the business is great while there is also a possibility of providing higher than average return for the investor. The investor expects to have some influence over the business.
  • Venture capitalists invest large sums of money in the business.
  • They may also bring a lot of experience and expertise along with the money.
  • Since they become owners by investing in the business they have equal interests in the business’s success.
  • Venture capitalists are only periodical investors wanting to exit the business at some stage.
  • The profits will be shared with the investor.
  • Acquiring venture capitals is a lengthy and complex process where a business plan and financial projections must be submitted to the potential venture capitalist.
  • As an owner of the business the venture capitalist may want to influence the strategic decisions and take control of the business.

14. Factoring

This is where the factoring company pays a proportion of the sales invoice of the business within a short time-frame to the business. The 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.
  • A large proportion of money is received within a short time-frame.
  • The sales ledger of the business can be outsourced to the factor.
  • The money collections from debtors are undertaken by the factoring company.
  • Helps a business to have a smooth cash flow operation.
  • Non-recourse factoring protects the client company from bad debts.
  • The business has to pay interests and fees for the factor for its services.
  • The cost will be a reduction on the company’s profit margin.
  • Lack of privacy since the sales ledger is maintained by the factor.
  • Costumers would not like factoring companies collecting debts from them.

15. Invoice Discounting

In invoice discounting the client company send out a copy of the invoice to the invoice discounting firm. The client then receives a portion of the invoice value. In contrast to factoring, the client company collects the money from its debtors. Once the payment is received it is deposited in a bank account controlled by the invoice discounter. The invoice discounter will then pay the remainder of the invoice less any charges to the client.

  • The client company receives the money in a short period.
  • There is some amount of privacy since the sales ledger is maintained by the client company and only some invoices are submitted for immediate cash.
  • Less costly than factoring since the sales ledger is maintained by the client company.
  • Unlike factoring customers are not aware of invoice discounting since the debt collection is undertaken by the client firm.
  • Debt should be collected by the client company itself and thus resources and time are wasted in debt collection.
  • Sales ledger has to be maintained by the client company itself.

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