Lesson No.

Topic: Sources and Uses of Funds

I. Objectives: At the end of the lessons, the learners shall be able to:

1. Determine the financial requirements of a business.

2. Enumerate and classify the common sources of financing.

II. Key Concepts

Debt and Equity Financing

Sources of financing are divided into two major categories: debt financing and equity financing.

Debt Financing
· Borrowing money from lenders and not giving up ownership.
· Can be in the form of borrowing from the banks or other lending institutions or issuance of debt securities
like commercial papers and bonds.
· For some companies, it can also be in the form of advances from stockholders to expedite the process of
raising funds.

Equity Financing
· The method of raising capital by selling company stock to investors (stockholders) in exchange of
ownership interests in the company.
· The safest source of financing for a company because it does not require a mandatory payment of
dividends.
If you own enough shares of a company, you can end up controlling its operating and financing
decisions. Controlling stockholders defines the direction of a company because they can choose who will
manage the company.
· Also provides the company financial flexibility.
This means that if a company is 100% financed by equity, it will be attractive to creditors.
Therefore, when this company is in need of financing, it can have more options as regards financing. It
can easily raise funds through debt financing or equity financing or a combination of both.

Table 1: Comparison of Advantages and Disadvantages of Debt Financing vs. Equity Financing

DEBT FINANCING EQUITY FINANCING

Advantages Disadvantages Advantages Disadvantages
Cost It is limited to interest It does not require a It has the highest cost.
payments. fixed dividend
payment.

Control Lender has no control It may limit cash

over the operations dividend declaration by
and investment management.
decisions.

Maturity There is a specified There is no maturity

maturity date or date. It is perpetual.
periodic amortization
payments.

Risk There is a risk of not Among the sources of

meeting the obligation financing, it is the
(default risk) riskiest.

Tax Interest expense is tax Dividends are not tax

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 deductible (it can deductible.
minimize tax expense.

Pecking Order Hypothesis (in corporate finance)

· Was developed based on repeated observations of how companies fund their financing requirements.
· According to this hypothesis, this is how companies fund their requirements:

1. Internally Generated Funds. These are the funds that come from operating cash flows.
2. Debt. When internally generated funds have been exhausted, debt financing is the next
alternative.
3. Equity. The last in the priority list of financing. This is not surprising given that it is more
difficult to issue new shares of stocks.
Financial Requirements

The financial needs of a business can be categorized as follows:

Fixed Capital Requirement

In order to start business, funds are required to purchase fixed assets such as land, building, plant,
machinery, furniture and fixtures. This is termed as fixed capital requirements of the enterprise. The funds
required in fixed assets remain invested in the business for a long period of time.

Working Capital Requirement

No matter how small or large a business is, it needs funds for its day-to-day operations. This fund is known
as the working capital. This is used for holding current assets such as stock of material, bills receivables and for
meeting current expenses like salaries, wages, taxes, and rent.

Sources and Uses of Short – Term Funds

Short – term Funds

· Normally used to finance the day – to – day operations of the company.
· Are used for working requirements such as accounts receivable and inventories.
· Can be used for bridge financing where a company has some maturing obligations and does not have
enough cash to pay such maturing obligations. There are some occasions when the management of a
company decides to borrow short – term loan to address this problem.
· Sources of short – term financing may be unsecured or secured. They appear as current liabilities in the
balance sheet as accounts payable, accrued expenses and notes payable.
· Generally include trade credits, accruals, commercial papers, bank loans, banker’s acceptances, receiving
financing, and inventory financing.

Spontaneous Sources of Short – Term Funds

· Refers to those sources that automatically arise from normal operations of a business firm. The two
major sources under this category are trade credits and accruals. As a firm’s sale volume increases,
so does its purchases and expenses, and consequently, its accounts payable and accrued expenses.
These two items of liabilities are “interest free” for they do not have explicit costs (although they
have implicit costs).

Deliberate Sources of Short – Term Funds

· Refers to sources that can be made use by the deliberate act, on the part of the borrower, of
negotiating for the availment of the particular source. With the exception of trade credits and
accruals, the rest of the given sources of short – term financing are deliberate.

Factors to be considered in Choosing Sources of Short – Term Financing

1. Cost (interest)
- Informal lending sources like 5/6 may be the most expensive.
2. Availability of short – term funds
- Informal lending sources like 5/6 is the most available because there are no formal
requirements to avail of the facility.
3. Risk
- Whatever the source of funds is, if the company defaults, the lenders may foreclose some
of the company’s properties or even the entire business itself to settle the loan.
4. Flexibility

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 - This pertains to the ability of the company to access funds.
- This financial flexibility can be influenced by:
a) Nature of the Company’s Business
b) Leverage ratio
c) Stability of Operating cash flows
5. Restrictions(Debt Covenants)
- Some lenders like banks may require a minimum deposit balance with their branch for
as long as the loans remain outstanding.
- The bank’s approval may also be secured before cash dividends can be declared.

Short – term loans provide the following advantages to the firm:

1. Short – term loans are easier to obtain.
One of the factors that affect the level of the risk on loans is the term or length of the payment
period. Short – term loans are not as risky as long – term loans. If a firm has a good relationship with
banks and financing companies, securing a short – term loan is usually easy. The firm may even be given
an unsecured loan.
2. Financial institutions charge less interest on short –term loans.
Firms do not spend much on debt servicing (interest charges) of short – term loans. Because of
the relatively low risk, the return required by banks and financing companies is lower compared to what
they would require on riskier loans. It is worth stating that in the financial markets, the rule of thumb is
“The higher the risk, the higher the return.”
3. There is flexibility in terms of options.
There are many types of short – term loans offered by different financial institutions. Depending
on the need of the firm, there are several options available. At times, even corporate credit cards provide
credit limits whose caps are high enough to allow the purchase of new equipment.

Disadvantages of short – term Loans

1. A firm that has easy access to short – term loans may become more relaxed in the way they manage their
working capital.
2. Firms with slow – moving inventories may end up with an even tighter financial position.
As short – term loans mature and money is still tied up to inventories, the firm’s short – term
liquidity will be compromised; as a result, it may not be able to settle its long – term obligations.
3. Short – term loans may not be strategically aligned with the firm’s long – term objectives.
The firm will have to use long – term sources of funds such as long – term loans for projects that
require larger funds and with a duration that is estimated to last for more than a year. The role of the
finance manager is to properly evaluate each project proposal or program to make sure that there is
proper matching of which sources of funds to use.

Suppliers of Short – term Funds

Other than short – term loans, there are other sources which serve as providers of short – term funds for
the firm. (Medina, 2011)

Trade Credits
- The credit extended by one trader to another for purchasing goods or services is known as trade
credit.
- Trade credit facilitates the purchase of supplies on credit.
- The terms of trade credit vary from one industry to another and are specified on the invoice.
- Small and new firms are usually more dependent on trade credit, as they find it relatively difficult
to obtain funds from other sources.
- A trade credit is unsecured.
If a firm purchases machineries and equipment, it does not qualify as trade credit because
the loan is secured by the machineries and equipment which serve as collateral. Furthermore, the
purchase of high peso value equipment is on installment, or several payments in equal increments
over a specified period of time.
- Trade creditors, depending on the amount of the supplies or inventories purchased, may require
a firm to submit a promissory note. The loan is still unsecured but the promissory note serves as
the written promise by the firm to pay the supplier the amount owed within the specified term
stated on the letter. Promissory notes are often used as evidence when cases involving
uncollected debt are taken to court for litigation.
Commercial Banks

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 - Considered as the “department stores of finance” because they cater to a variety of savers and
borrowers. As such, commercial banks also offer a wide array of products and services to suit the
diverse needs of their clients.
- Offer short –term loans to firms to finance business activities.
- Also offer intermediate or medium – term loans and long – term loans to individual and business
clients. An intermediate loan is a loan that will mature in 1 – 10 years. On the other hand, a long
– term is a loan that will mature in 10 years or more.
Finance Companies
- Are firms whose line of business is to provide short – term and intermediate loans to both
consumers and other businesses.
- Loans granted by finance companies may either be secured or unsecured. There are finance
companies that only cater to the needs of small businesses or small to medium enterprises
(SMES).
- There are also finance companies whose main core of business is the purchase of installment
receivables from retailers of automobiles, household appliances, machineries and equipment, and
other durable goods sold on the installment payment plan. After the purchase is complete, the
debtors are then notified that they are dealing with a different company for the repayment of the
installment loan.
Factoring
- A financing method in which a business owner sells accounts receivable at a discount to a third-
party funding source to raise capital. Here the risk of credit, risk of credit worthiness of the
debtor and as number of incidental and consequential risks are involved. These risks are taken by
the factor which purchase these credit receivables without recourse and collects them when due.
- A financial service wherein a factor purchases accounts receivables. The factors become the
owner of the receivables and are now responsible for collecting those from customers. The
factors also assume the risk of incurring credit losses such as bad debts. There is no recourse of
action against the seller of those receivables even in cases of default. On the other hand, the
factors do not take responsibility for disputes concerning and/or defective goods.
- For the borrowing firm, factoring becomes immensely helpful as the receivables become
collateral for a loan - - something that the firm may not even have such as a parcel of land or
equipment that may be used as collateral.
- Is more expensive than a regular loan or other financing schemes, but this works best for new
businesses that have yet to establish a relationship with banks and other financial institutions.
Company Accruals
- An accrual is an expense that has been incurred by the firm but has not been paid.
- Provide a source of short – term financing for firms because money could be used to either
support operations or pay other financial obligations. There are two major types of accruals:
accrued wages and salaries and accrued taxes.
Commercial Paper
- Firms issued commercial papers either directly to investors or through dealers in exchange for a
minimal commission.
- An unsecured promissory note issued by a firm to raise funds to meet short-term debt
obligations. Maturities on commercial paper rarely range any longer than 270 days.
- Businesses issue commercial papers to finance their short – term working capital needs. Firms, on
the other hand, issue commercial papers at a discount which serves as interest. The rates are
applied higher on commercial papers with longer terms to maturity.

Uses of Short – term Funds

The best way to understand why firms resort to short – term financing is to look into its operations. Firms
need to access short – term funds for the following reasons.
1. To support seasonal increase in demand for its products and/or services.
An increase in demand will require the firm to purchase more inventories and supplies.
Additional manpower will require more funds devoted to salaries.
2. Payment of short – term obligations.
Firms need to satisfy their financial obligations. At times, they have to resort to short – term
loans in order to repay other obligations such as money owed to suppliers and tax liabilities.
3. Funding for short – term projects and/or programs.
Short – terms plans and programs are identified during the annual planning of any term. Even at
that point, the finance manager should already have an idea of whether there would be sufficient funds or
not. If funds are projected to be inadequate, then early on, other sources of funds should already be
identified. Otherwise, projects and/or programs have to be parked until funding becomes available.
4. Allowance for receivables.

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 It may take some time before a firm is able to collect money that is owed to them by customers.
Before sales are actually converted into cash, the firm has to supply funding to cover maturing obligations
and to replenish inventory.
5. Funding for unforeseen events.
There could be a host of unforeseen events that may affect the firm’s operations. Such events
may be economic such as a sharp increase in the prices of inputs and prime commodities, a natural
calamity such as a storm causing damage to a portion of a firm’s building, or anything that may arise as a
result of the firm’s operations like a defective product that negativity affected a customer.

Sources and Uses of Long – Term Funds

Long – term Funds

· Are used for long – term investments or sometimes called capital investments. This includes expansion,
buying new equipment, or buying a piece of land which will be the site for future expansion.
· Can be used to finance permanent working capital requirements.
· Long – term investments have to be financed by long – term sources of funds to minimize default risk or
the risk that you may not be able to pay maturing obligations. The returns on the long – term investments
may not be realized immediately, and therefore require more patient sources of financing.

Sources of Long – term Funds

The Sources of Long Term Funds re those sources from where the funds are raised for a longer period of
time, usually more than a year. Long term financing is required for modernization, expansion, diversification and
development of business operations.
Equity Investors
- are people who invest money into a company in exchange for a share of ownership in the
company. Typically, equity investors have no guarantee of a return on their investment, and may
lose their money should the company go out of business. In the event that the company is
liquidated, the equity investor may be entitled to a share of the assets.
- Can be issued common stocks, which is the most patient source of capital. As far as the company
is concerned, this is the safest source of financing. Unfortunately, it is not always available when
the company needs it. They have to identify a correct timing or opportunity for them to issue
more shares.
There are two primary ways to finance a growing business -- with debt financing or equity
financing or a hybrid combination of the two. If a company has sufficient current and expected
cash flow, as often occurs with stable or mature companies, then debt is typically the better
alternative. For companies with limited current or anticipated cash flow, as with start-ups and
rapidly growing firms, equity often provides the better solution. Equity is stock or shares in a
corporation.
With equity financing via common stock, you reduce your ownership percentage in your
company through the sale of common stock to one or more individuals or entities in exchange for
a specified amount of money. These company stock purchasers could be active participants in the
business as would occur if you brought in a business "partner" or a hands-on angel investor.
Alternatively, the purchasers could be passive investors. Regardless of their level of activity,
common stock buyers take on the company risk because they believe the potential upside far
outweighs the downside.

Retained Earnings
- This refers to the amount of net earnings not paid out as dividends. This is usually being reserved
by the company for its growth and development.
A company generally does not distribute all its earnings among the shareholders as
dividends. A portion of the net earnings may be retained in the business for use in the future.
This is known as retained earnings. It is a source of internal financing or “ploughing back of
profits”. The profit available for ploughing back in an organization depends on many factors like
net profits, dividend policy and age of the organization.

Debentures
- Are debt instruments used by large companies to borrow money, at a fixed rate of interest. This is
not secured by physical assets or collateral. Debentures are backed only by the general
creditworthiness and reputation of the issuer. Both the government and private companies issue
debenture bonds to secure capital funding.

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 Debentures usually offer more flexibility than a term loan as there is more variety with
respect to the maturity, security, interest rate, repayment and special features. Debentures are
the promissory notes issued to the debenture holders, often called as creditors of the firm, for a
fixed period of time and at a fixed rate of interest.
The company is legally obliged to pay interest and principal at specified times, the failure
of which could even lead to bankruptcy. When the debentures are issued to the investing public, a
trustee is appointed, which is generally the bank or a financial institution or the insurance
company. These are appointed to safeguard the interest of the debenture holders and ensure
that issuer firm fulfills its contractual obligations.

Preference Shares
- This is also a form of fund sourcing from the general public. Preference shareholders are being
paid first if there are dividend declarations but they do not have voting rights. Investors who
prefer steady income without undertaking higher risks prefer these shares.
- Are a long-term source of finance for a company. They are neither completely similar to equity
nor equivalent to debt. The law treats them as shares but they have elements of both equity
shares and debt. For this reason, they are also called ‘hybrid financing instruments’.
- More commonly referred to as preferred stock, are shares of a company’s stock with dividends
that are paid out to shareholders before common stock dividends are issued. If the company
enters bankruptcy, preferred stock holders are entitled to be paid from company assets before
common stockholders. Most preference shares have a fixed dividend, while common stocks
generally do not. Preferred stock shareholders also typically do not hold any voting rights,
but common shareholders usually do.

Loan from Banks and Financing Institutions

- This is a source of funding by borrowing money from banks or financing institutions and is expected
to be paid back with interest. These institutions include commercial banks, investment banks,
credit unions, savings and loans associations and insurance companies.

The 5Cs of Credit

Financial institutions or intermediaries need a way to evaluate the credit worthiness of potential clients –
individuals and firms who apply for credit. Credit worthiness is associated with the debtor honoring his or her
financial obligations. This also means that the chance of default is low. There are 5 characteristics of a borrower
that financial institutions use to evaluate their credit worthiness:
1. Character – This refers to an applicant’s reputation.
In credit the application, the loan applicant is required to write down the names and contact
information of references. The references are contacted by the credit investigator for a background check
on the applicant.

2. Capacity – This measure’s one’s capacity to pay.

In credit applications, the applicant is asked to list down the sources of income, expenses, and
debt. The purpose of this is to measure if one has the capacity to pay as reflected by the sources of funds
and existing obligations.

3. Capital (Equity) – From the perspectives of the lender, this minimizes the risk of default. This is common
when a borrower is applying for a car loan or mortgage on a house. In the Philippines, an applicant is
required to put a 20% down payment of equity contribution.

4. Collateral – This is the property that is used to secure the loan. Long – term loans for larger amounts are
typically required to have collateral. This also minimizes the default risk. In the case of vehicle loans and
home mortgages, the vehicle or the house itself serves as the collateral.

5. Conditions of the Loan – Factors such as the amount of principal, interest rate, and the terms of
payments, all have an influence on the lender’s decision to a[prove or disapprove the loan application.

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For further readings:
https://www.toppr.com/guides/business-studies/sources-of-business-finance/classification-of-sources-of-funds/

https://corporatefinanceinstitute.com/resources/knowledge/finance/sources-of-funding/

http://www.fao.org/3/w4343e/w4343e08.htm