Sources of Finance — Internal and External (HSC SSCE Business Studies): Revision Notes

Sources of Finance — Internal and External

Why businesses need finance

Businesses require funds throughout their entire life cycle to pursue various activities and achieve their objectives. These activities can range from the initial establishment phase — whether starting from scratch or purchasing an existing operation — to later expansion and growth initiatives.

Common activities requiring finance include:

• Expanding product ranges
• Introducing new products to the market
• Opening additional outlets or branches
• Upgrading systems and technology
• Employing additional staff members
• Constructing warehouses or other facilities

During the establishment phase, owners and shareholders typically provide the initial funding. However, as the business enters the growth stage, management must consider various options regarding where to obtain funds and how to use them effectively.

Internal sources of finance

Internal finance refers to funds generated from inside the business. The most common example is retaining profits to finance expansion rather than distributing them to owners or shareholders.

Retained profits

The most common source of internal finance is retained earnings or retained profits. This occurs when a business does not distribute all its profits to shareholders but instead keeps some (or all) within the company as a cheap and accessible source of finance for future activities.

Key features of retained profits:

• Most businesses in Australia retain some profits for future use
• No interest payments required (unlike borrowing)
• No dilution of ownership (unlike issuing new shares)
• Immediately accessible when needed
• Lower costs compared to external financing

Advantages and disadvantages of internal funding

Advantages:

• No interest costs or repayment obligations
• Maintains full ownership control
• Flexible and immediately available
• No application processes or approval requirements
• Appears to be working for most Australian SMEs (growing 4 times faster than national economy)

Disadvantages:

• Can inhibit growth potential — businesses with access to additional external capital could potentially grow even faster
• Limited by the amount of profit generated
• May not be sufficient for major expansion or capital-intensive projects
• Relies on business profitability

External sources of finance

External finance refers to funds provided by sources outside the business, including:

• Banks and financial institutions
• Other investors and creditors
• Government agencies
• Suppliers
• Financial intermediaries

Finance provided from external sources through creditors or lenders is known as debt finance. External sources can be categorised into two main types: debt and equity.

Understanding debt finance

Using debt means the business relies on outside sources rather than owners to finance operations and growth. When managed effectively, increased funds should generate higher earnings and profits.

Types of external debt are classified as either short-term or long-term borrowing based on the repayment period.

Debt: short-term borrowing

Short-term borrowing generally refers to funds that will be repaid within 12 months. Financial institutions provide this type of borrowing through overdrafts, commercial bills and bank loans.

Primary uses:

• Finance temporary shortages in cash flow
• Provide working capital
• Address seasonal fluctuations in revenue

Overdrafts

An overdraft occurs when a bank allows a business or individual to overdraw their account up to an agreed limit and for a specified time, to help overcome a temporary cash shortfall.

How overdrafts work:

• Bank sets an agreed maximum limit
• Business can overdraw up to this limit when needed
• Interest charged only on the daily outstanding balance
• Interest rates are usually variable
• Banks typically require security
• Technically repayable on demand (though this is uncommon)

Advantages of overdrafts:

• More flexible than short-term bank loans
• Functions as a line of credit — only use what you need, when you need it
• Provides immediate coverage for temporary fund shortfalls
• Acts as a financial safety net
• No regular repayment schedule — pay back when able
• Lower interest rates than other forms of borrowing
• Minimal costs to establish

Exam tip: Be prepared to explain why overdrafts are particularly suitable for businesses experiencing seasonal variations in sales or temporary cash flow problems.

Commercial bills

Commercial bills are primarily short-term loans issued by financial institutions for larger amounts (usually over $100,000) for periods generally between 30 to 180 days.

How commercial bills work:

• Borrower receives the full sum immediately
• Promises to repay the money with interest at a future date
• Full amount borrowed doesn't need to be repaid until the end of the term
• Usually secured against the business's assets
• Can be "rolled over" until the borrower has funds to repay in full

Key features:

• Flexible regarding both interest payments and repayment period
• Suitable for larger borrowing requirements
• Typically used by established businesses with substantial assets
• Fixed term provides certainty for financial planning

Factoring

Factoring is a short-term source of borrowing that enables a business to raise funds immediately by selling accounts receivable at a discount to a firm that specialises in collecting accounts receivable (a finance or factoring company).

How factoring works:

1. Business makes credit sales and issues invoices to customers
2. Business sells these invoices to a factoring company at a discount
3. Business receives up to 90% of the receivables amount within 48 hours
4. Factoring company collects payment from customers
5. Once collected, factoring company pays business the balance minus fees and interest

Advantages of factoring:

• Immediate access to funds improves cash flow
• Improves gearing ratios
• Eliminates collection costs and administration
• No need to wait 60-90 days for customer payments
• Enables business to keep pace with growth
• Particularly valuable for industries with long payment cycles

Disadvantages of factoring:

• More expensive than overdrafts and commercial bills
• Full amount of receivables not received (sold at discount)
• Commission must be paid on the debt
• Greater risk due to potential unpaid debts
• Administrative errors by factoring company can cause issues

Industries using factoring: Construction, manufacturing, agriculture and mining, transport and storage, wholesale trade, and labour hire commonly use factoring due to extended payment cycles.

Exam tip: While factoring was historically seen as a "last resort," it's now recognised as a legitimate financing method. However, you should note it's more expensive than traditional sources and involves greater risk.

Debt: long-term borrowing

Long-term borrowing relates to funds borrowed for periods longer than 12 months. This type of borrowing is usually used to purchase major assets such as buildings and equipment, with the assets often serving as security on the loan.

Mortgages

A mortgage is a loan secured by the property of the borrower (business). The property mortgaged cannot be sold or used as security for further borrowing until the mortgage is repaid.

Key features of mortgages:

• Used to finance property purchases (premises, factories, offices)
• Secured by the property being purchased
• Repaid with interest over an agreed period of time
• Usually involve regular repayments (monthly or quarterly)
• Property serves as collateral for the lender

Typical uses:

• Purchasing new business premises
• Acquiring factory or warehouse space
• Buying office buildings
• Expanding physical facilities

Debentures

Debentures are promises issued by a company to repay a loan for a fixed rate of interest and for a fixed period of time. Companies provide them as a way to raise funds from investors, as opposed to financial institutions.

How debentures work:

1. Company needs to raise funds
2. Investor lends money to the company
3. Company issues a debenture with a promise to make regular interest payments
4. Interest paid for a defined term at a fixed rate
5. Company repays the loan (principal) at a particular date in the future (maturity date)
6. Company may buy back the debenture at maturity

Key features:

• Usually secured over the company's assets
• Carry a fixed rate of interest (unaffected by company profitability)
• Require a prospectus detailing:
  • Company information
  • How funds will be used
  • Terms of the investment
  • Return offered and associated risks
• Finance companies raise much of their funds through public debenture issues

Unsecured notes

An unsecured note is a loan from investors for a set period of time. Unlike debentures, unsecured notes are not secured against the business's assets.

Key features:

• Present the most risk to investors (the lenders)
• Therefore attract a higher rate of interest than secured notes
• Companies sell unsecured notes to generate money for various initiatives such as:
  • Share repurchases (buybacks)
  • Business acquisitions
  • Major projects

Leasing

Leasing is usually a long-term source of borrowing for businesses. It involves the payment of money for the use of equipment that is owned by another party.

Assets suitable for leasing:

• Business vehicles and cars
• Plant and machinery
• Equipment and tools
• Computers and software
• Furniture and fittings

How leasing works:

• Lessor owns and leases the equipment
• Lessee uses the equipment and makes payments
• Costs and benefits of the asset transfer from lessor to lessee
• Lease arranged for an agreed period of time

Advantages of leasing:

• Assists cash flow — payments spread over several years instead of one large upfront payment
• Establishment costs may be lower than other financing methods
• May improve ability to borrow funds for other purposes
• Provides long-term financing without reducing ownership control
• Permits 100% financing of assets
• Fixed repayments for a period make cash flow monitoring easier
• Lease payments are a tax deduction
• Payment usually includes maintenance, insurance and finance costs

Disadvantages of leasing:

• Interest charges may be higher than other forms of borrowing
• Don't own the asset at the end of the lease (unless purchase option exercised)

Equity finance

In the Preliminary course, you learned that equity finance refers to funds contributed by business owners (such as initial capital or reinvesting net profit). Equity as an external source of funds refers to the finance raised by a company through inviting new owners.

This is achieved by issuing shares to the public through the Australian Securities Exchange (ASX) and is used as an alternative to debt funding.

External equity includes:

• Ordinary shares (new issue, rights issue, placements, share purchase plan)
• Private equity
• Crowd-sourced equity funding (CSEF)

Ordinary shares

Ordinary shares are the most commonly traded shares in Australia. When individuals purchase ordinary shares, they become part-owners of a publicly listed company.

Rights of ordinary shareholders:

• Voting rights according to the number of shares held
• Entitlement to dividends (profit distributions)
• Right to attend annual general meetings
• Access to company information

Share value determination: The value of shares is determined by a company's current or future performance, creating potential for capital gains (or losses).

Types of ordinary share issues

New issue (Initial Public Offering - IPO)

A new issue (or IPO - Initial Public Offering, also called a "float") refers to a security that has been issued and sold for the first time on a public market (e.g., the Australian Securities Exchange).

How IPOs work:

1. Private company decides to list on stock exchange
2. Company prepares a prospectus containing all relevant information for investors
3. Prospectus lodged with ASIC (Australian Securities and Investments Commission)
4. Shares offered to public at a set price
5. Company begins trading on the ASX
6. Investors hope shares will rise over time

Purpose of IPOs:

• Raise money to help grow the business
• Provide liquidity for existing shareholders
• Increase company profile and credibility
• Enable future capital raising

Rights issue

A rights issue is an invitation to existing shareholders to purchase additional new shares in the same company at a discount to the market price on a set future date.

How rights issues work:

• Existing shareholders receive rights (a type of option)
• Rights can be traded on the market like ordinary shares
• Shareholders can purchase new shares in proportion to current holdings
• Offered at a discount to market price
• Shareholders have the right but not the obligation to purchase
• Can choose to exercise rights, sell rights, or let them lapse

Purpose of rights issues:

• Raise additional capital
• Pay down debt
• Used especially when unable to borrow more money
• Maintain existing shareholder ownership proportions

Placements

A placement involves creating new shares in return for capital and issuing them to selected investors at a discount to the current market price.

Key features:

• Additional shares offered at discount to current trading price
• Issued to institutional investors or specific investors who can invest large sums
• Typically issued without a full disclosure document
• Participation limited to institutional investors or those qualifying under s708 of the Corporations Act 2001
• Discount intended to persuade specific investors to invest

Share purchase plans

Share purchase plans refer to offers to existing shareholders in a listed company to purchase newly issued shares in that company without brokerage fees, usually at a discount to the current market price.

Key features:

• No prospectus required
• Maximum of $30,000 in new shares per shareholder
• Offered at a discount to market price
• No brokerage fees
• Only available to existing shareholders
• Simple application process

Purpose:

• Raise capital from existing shareholder base
• Reward loyal shareholders with discounted shares
• Avoid dilution that can occur with placements

Private equity

Private equity is money invested in a (private) company not listed on the Australian Securities Exchange (ASX).

Key features:

• Investment in unlisted private companies
• Aim: raise capital to finance future expansion/investment
• Similar purpose to public equity but for private companies
• Often involves institutional investors or high-net-worth individuals
• May involve venture capital firms or private equity funds

Advantages for businesses:

• Access to capital without public listing requirements
• Retain more control compared to public listing
• Less regulatory compliance than listed companies
• Investors may provide expertise and networks

Crowd-sourced equity funding (CSEF)

In 2017, the Australian government amended the Corporations Act 2001 to allow companies to access crowd-sourced equity funding (CSEF).

How CSEF works:

• Large number of individuals make small financial investments (up to $10,000)
• In exchange, receive an equity stake in the company
• Fundraising conducted through online platforms
• Companies can raise up to $5 million per year

Purpose of government amendments:

• Make it easier and less expensive for small businesses to raise equity
• Remedy the shortage of finance options for SMEs and start-ups
• Democratise investment opportunities

Exam insight: CSEF represents an innovative alternative to traditional equity raising, particularly suitable for small businesses and startups that may struggle to access conventional funding sources.