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Financing a business: internal and external financing options

In Accounting, Finance on April 29, 2013 at 1:32 pm

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Capital is the lifeblood of any business. As well as supporting long term investment, working capital is used to invest in the current assets used in a company’s day-to-day operations.

Businesses have multiple ways of raising finance which may be suitable depending on the characteristics of the firm, the nature of the intended investment and the economic environment. To simply the advantages and disadvantages of these options, HBR has compiled the following table (click to enlarge).

Financing options table

Note: This table shows the general characteristics of financing options. However, most change according to factors such as business reputation, credit ratings, market conditions and service used.


Internal sources of finance

Retained profits:
Companies can increase funds by retaining profits and not distributing them as dividends. The shareholders deprived of capital will expect retained profits to be invested to achieve a competitive rate of return. Most big businesses retain 50% of profits to fund expansion.

Tighter credit control:
The remaining internal financing options increase businesses’ cash assets by decreasing working capital items. For example, chasing trade receivables owed by credit customers releases funds which can be re-invested in the business.

Reduce inventories:
Purchase and storage costs use revenue that could otherwise be used to expand the business. However, when reducing inventories enterprises should be careful to retain the capacity to meet future demand.

Delay paying trade payables:
This cheap form of finance extends the period before a business has to make good on their credit payments, releasing the funds in the interim. This can come at a reputational cost, which damages the possibility of buying on credit in the future.

External sources of finance

Ordinary shares:
Under this arrangement, companies raise capital by selling stock in their business. This entitles the purchaser to a voice in the decisions made by the firm. While ordinary shares do not have a fixed rate of dividend (a share of company profits) from profits after current liabilities and other investors are services, not paying them can diminish share value. A business will avoid this if they hope to issue shares in the future.

Preference shares:
Preferential shareholders receive dividends before individuals with ordinary shares. Their lower risk and lower levels of return mean that preference shares have a less volatile market price. These have lost popularity since, while they are alike borrowings in many other aspects, dividend payments are not tax deductible.

Rights issue:
In order to raise finance without diluting control of the business, a rights issue offers new shares to existing shareholders. Shares issued this way generate goodwill and maintain the predictability of shareholder governance, but must also be discounted (sold at an average of 31% under market price).

Bank overdraft:
Businesses can access funds by maintaining a negative balance on its bank account. The advantages of using an overdraft include flexibility, competitive interest rates and can become a long term source of finance (dependent on the confidence inspired by the borrower). But, reliance on an overdraft can have devastating consequences, since it is repayable on demand.

Term loan:
Financial institutions provide negotiable loans in which the rate of interest, repayment dates and security for the capital offered must be agreed. Because they are commonplace, this option is easy to set up and has a degree of flexibility. At the same time, borrowed capital often comes with obligations and restrictions known as ‘loan covenants’.

Loan notes/stock:
This form of borrowing, exchanges capital from investors for a note representing the loan which can then be traded on the Stock Market. The value of a loan note fluctuates with the business’s performance.

Finance lease:
Under this arrangement, a business will select an asset which is then purchased by a finance company. The lease will then be paid in a series of rentals or instalments. This avoids the large cash outflows of an outright purchase. The risks and rewards associated with the purchased item are transferred to the lessee.

Operating lease:
This is similar to the finance lease, except the rewards and risks of the item stay with the owner. The asset becomes security, meaning that operating leases are usually given without detailed credit checks. The term of an operating lease is short compared to the useful life of the asset, and so the asset might be used by multiple lessees in its lifetime. Businesses can, therefore, avoid obsolesce risks by this means.

Sale and lease back:
Businesses can raise funds by leasing their unused assets to a financial institution.

Debt factoring:
Debt collection can be outsourced to specialist subcontractors. This can increase cash assets by providing savings in credit management and certainty in cash flows. Stakeholder opinion should be considered before opting for this financing option, as the use of outside agents could be viewed as an indication of financial difficulties.

Invoice discounting:
This is a loan based on the value of a business’s outstanding credit sales. This is used as a short term alternative to debt factoring. It is more widely used based on its low service charges and the autonomy it gives to the business to collect payment for its own credit sales. However, repayment of the advance not dependent on trade receivables being collected, so a business must have confidence they can raise finance within the term of the loan.


Financial management cheat sheet

In Accounting, Finance on April 25, 2013 at 5:49 pm



Return on capital employed
= (operating profit / share capital + reserves + non-current liabilities) x 100

Operating profit margin
= (operating profit / sales revenue) x 100

           Operating profit
= sales revenue – operational costs

Gross profit margin
= (gross profit / sales revenue) x 100

           Gross profit
= sales revenue – cost of sales

Return on ordinary shareholders’ funds
= (net profit after tax and preferential dividend / ordinary share capital and reserves) x 100


Average inventory turnover period*
= (average inventories held / cost of sales) x 365

Average settlement period for trade receivables*
= (average trade receivables / credit sales revenue) x 365

Average settlement period for trade payables*
= (average trade payables / credit purchases) x 365

Sales revenue to capital employed
= sales revenue / (share capital + reserves + non-current liabilities)

Sales revenue per employee
= sales revenue / number of employees


Current ratio
= current assets / current liabilities

Acid test
= current assets (excluding inventories) / current liabilities

Gearing ratio
= (long term liabilities / (share capital + reserves + long term liabilities)) x 100

Interest cover ratio
= operating profit / interest payable


Dividend pay-out ratio
= (dividends announced for year / earnings per year available for dividends) x 100

Dividend cover ratio
= (earnings per year available for dividends / dividends announced for year) x 100

Dividend yield
= ((dividend per year / (1 + ‘dividend tax credit’ rate of income tax) / market value per share) x 100

Earnings per year
= earnings available to ordinary shareholders / number of ordinary shares issued

Price/earnings ratio
= market value for share / earnings for share

Cost-volume-profit analysis

Break-even point
Total sales = total costs

Number of units sold at break-end point
= fixed cost / contribution per unit

Number of units sold to achieve target profit
= (fixed cost + target profit) / contribution per unit

Contribution margin ratio
= (contribution/sales revenue) x 100

                = sales revenue per unit – variable cost per unit

Margin of safety
= actual sakes – break-even sales

Investment decisions

Payback period
= length of time it takes for the initial investment to be repaid from resulting cash inflows

Accounting rate of return
= (average annual profit / average investment) x 100

Average annual profit
= (total project revenue – depreciation) / lifetime of project in years

= initial cost – disposal value

Average investment
= (initial investment + disposal value) / 2

Present value
= future cash flow x (1 / discount factor)

Internal rate of return
= the discount rate at which future cash flows have a net present value of zero

Managing working capital

Working capital
= current assets – current liabilities

                Current assets
                = inventories + trade receivables + cash

                Current liabilities
                = trade payables + bank overdrafts

Operating cash cycle
= average inventories turnover period* + average settlement period for trade receivables* – average settlement period for trade payables*

Average inventory turnover period*
= (average inventories held / cost of sales) x 365

Average settlement period for trade receivables*
= (average trade receivables / credit sales revenue) x 365

Average settlement period for trade payables*
= (average trade payables / credit purchases) x 365

Lead time for orders (in weeks)
= annual demand for component / number of weeks in a year

* To nearest day