3.5.3 - Choosing sources of finance

Retained profit and share capital

Internal finance comes from within the business, while external finance is obtained from outside providers.

Retained profit is profit kept in the business rather than distributed to owners. It can support investment without a new loan repayment or a new shareholder. However, an accounting profit does not guarantee the equivalent cash is immediately available: customers may not yet have paid, or money may already be tied up in inventory or assets. Managers should check cash availability before committing retained profits.

Retaining profit also has an opportunity cost. Shareholders forgo a possible dividend, and the funds cannot simultaneously finance another project. A new or loss-making firm may have little retained profit. It is therefore an attractive source only when sufficient resources exist and the investment is justified.

Share capital is external finance raised by issuing shares. The buyers become owners rather than ordinary lenders; there is no scheduled repayment of the original share capital as there is with a loan. That can suit long-term projects with uncertain early receipts. Dividends are not the same as contractual interest payments.

Issuing new ordinary shares can dilute existing shareholders' ownership and voting influence. A company must consider investor demand, issue costs and control. Trading already-issued shares between investors does not itself put fresh money into the business.

Ownership after a new issue

An owner holds 20,000 of 100,000 ordinary shares. The company issues 25,000 more and the owner buys none.

1. Original ownership:

1. New share count:

1. Revised ownership:

The holding stays 20,000 but its proportion falls.

A second owner retains 40,000 shares when a different company increases its share count from 160,000 to 200,000.

1. Original ownership:

1. Revised ownership:

1. The reduction is 5 percentage points, rather than the loss of 5% of the original shares. No holding was sold in this example.

Illustrative case: a design company retains available profit to buy equipment while preserving its owners' control. Another design company issues shares for a larger expansion that its retained funds cannot cover. The second choice brings resources but can change priorities if new owners expect faster returns.

Overdrafts and debt factoring

Short-term finance can bridge a timing gap between cash payments and receipts.

An overdraft is permission to draw a bank account below zero up to an agreed limit. A retailer could use an overdraft to fund stock ahead of seasonal sales, then reduce the balance as customers pay. Its flexibility is useful when the precise borrowing need changes. Interest normally relates to the amount borrowed, but fees, rates and limits depend on the agreement.

An overdraft can be costly, and the provider may change its terms or require repayment according to the contract. A business must not assume it can continue indefinitely or exceed its agreed limit. Financing a long-lived asset entirely through a facility vulnerable to withdrawal may create an avoidable funding risk.

Debt factoring converts receivables into earlier cash through a specialist provider. Advance percentages, fees, later settlement and non-payment risk depend on the particular contract.

Advance and later settlement

A factoring contract provides an advance of 85% on a £20,000 invoice and charges 1.5% of its value after collection.

1. Advance:

1. Fee:

1. Later settlement after the customer pays:

Total receipts are £19,700, while the advance makes most cash available earlier.

Different contractual terms

A second agreement advances 70% of a £45,000 invoice and charges a 4% fee on invoice value after collection.

1. Advance:

1. Fee:

1. Remaining settlement:

Total receipts are £43,200. The lower advance and greater fee make the timing and cost less attractive on these terms; they are not universal industry rates.

Factoring can shorten the gap between selling on credit and receiving cash, and the provider may manage collection. In return, the fee reduces the amount retained from sales. The arrangement may also affect customer relationships if collection is handled in a way customers dislike. Whether the factor takes the risk of a customer not paying depends on whether the arrangement is with or without recourse; do not assume every factoring agreement removes bad-debt risk.

A business needs eligible credit sales for factoring, while an overdraft depends on bank approval and an appropriate limit. Neither source repairs a persistently unprofitable model by itself. They can manage timing, but continuing losses eventually consume the funds.