1. Types of sources of finance and their advantages or disadvantages
There are various types of sources of finance, and these sources of finance are used differently depending on the purpose or situation of the company. Companies should evaluate the source of capital and make appropriate choices. Choosing an appropriate financial source is the most important key task for all companies. To select the right financial resources, it is necessary to analyze the types of financial resources closely. And close analysis is possible only when a finance manager in the company knows various funding sources. Financial sources can be classified into internal and external sources depending on where a company gains funds.
Internal sources of finance
The internal source of finance refers to funds from within a company. Representative examples include owners’ capital, retained earnings, and selling assets.
- Owned capital refers to the owner’s capital. Since owned capital is an individual’s property, interest fees are not incurred. The advantage is that formal document work is not required, and it is free from collateral or duration needed in other types. The disadvantage is that the owner’s capital alone may not meet the required capital.
- Retained earnings are the profits left in the company, excluding outflows from the funds earned due to corporate activities. Retained earnings may require financial backup among corporate departments or may be used for corporate expansion or development. This source is one of the most valuable types because it does not cost money. As an advantage, retained earnings are savings of the organization itself, so there is no obligation to repay them, and interest also does not need to be paid. Also, there is no cost of financing. On the other hand, as a disadvantage, opportunity costs may be incurred, and retained earnings cannot be used for start-up companies or companies losing money for a long time.
- Selling assets refers to raising capital by selling machinery, equipment, and real estate owned by a company. In other words, companies raise funds by selling things they no longer use or need. The advantages of asset sales may be fast financing, and it is economical because it raises money with unused equipment. However, while financing may be fast, the disadvantage is that if no buyer needs the assets to be sold, they may not be able to sell or receive a reasonable price.
External sources of finance
The external source of finance refers to funds drawn from outside the company. External types include government subsidies, bank loans, stock issuance, etc.
- Loans refer to borrowing funds from banks or other financial institutions for corporate expansion or long-term projects. Loans are usually repaid with interest over a fixed period. The advantages of loans are that they can borrow a large amount of money and are suitable for long-term investments. In addition, they are less burdensome because they are repaid in installments for a fixed period. On the other hand, as disadvantages, collateral is required, the borrowed amount must be refunded on the agreed date, and interest is incurred.
- Bank overdraft is a system that allows checking account holders to withdraw more money than their account balances. Interest must be paid on excess withdrawal amounts, and overdrafts usually require high-interest rates, so they must be used carefully. The advantages of overdraft are that collateral is not needed, and it is suitable for resolving short-term cash shortages, and the process can proceed easily and quickly. On the other hand, as disadvantages, the amount that can be withdrawn is limited, and interest is generated daily, which may be a burden. Moreover, it is not suitable for long-term financing.
- Venture capital refers to investors or companies that invest money in venture companies with highly innovative technology and potential for development. If an invested company succeeds, it can recover its investment funds and make high profits, which also carries a risk. The advantage of venture capital is that an investment company can receive a lot of money, and investors bring their expertise or expect high returns on the investment. Hence, the company and investors cooperate for success. However, the downside is that if the company’s business fails, investors can suffer enormous losses. If successful, the company’s profits can be shared with investors so that net profit can be reduced.
- New business partners refer to distributing part of the business instead of receiving funds. As an advantage, you may grow further with advice or help from a partner about your business. The disadvantage is that the stake in the project must be donated in return for financing, and conflicts can arise if it has a different vision from the partner.
- Issuance of common stocks: A company issues and sells ordinary shares to raise capital. Shareholders who purchase ordinary shares can receive some of the company’s profits based on the value of their shares and the profits earned by the company. In addition, they have the right to vote on business changes. The advantages of stock issuance are that it can raise many funds and issue stocks without collateral. In addition, dividends only need to be paid if the company yields profits. On the other hand, as a disadvantage, stock issuance takes a lot of time, and issuance costs are also incurred. In addition, shareholders with a majority of the company’s shares can collude and exert influence on the company’s management. Finally, the capital structure cannot be changed after issuing the stock.
- A lease is a way for a company to rent assets necessary for business activities. The company has to pay rent to the leasing company every month. The advantages of the source of finance are that it is not necessary to pay all the amount of assets required for the business. In addition, the leasing period and cost are fixed, which helps the company to budget. Finally, if it is a temporarily necessary asset, it can prevent the company from spending because it is borrowed and used only during that period. On the other hand, the disadvantage of rental assets is that they are not owned by the borrowed company, so caution should be taken against the risk of damage. In addition, in the case of financial leases, the lessee may pay more than the asset’s value.
- Hire purchase is a conditional installment sales method. In other words, this source of finance is a method in which a company uses the asset without paying the full amount when purchasing the asset, and pays the amount in installments that have not been paid with monthly rent. The advantage of this type is that the company can use the asset before spending all the amount for the asset. In addition, it is less burdensome because it is a method of paying in installments. The drawback is that additional charges such as rent are incurred every month, which eventually costs more than the total value of the asset. Moreover, failure to pay the installment on time may result in a seizure from the borrower.
- Grants are a method of receiving a set amount of aid from the government or private organization. The government or private organization provides subsidies to a company to support the development and expansion of programs or facilities for the local community to which the company belongs. The advantages of this resource are no obligations to repay, and no costs are incurred in this process. On the other hand, as a disadvantage, subsidies can only be received if they meet the subsidy-related regulations.
2. Appropriate sources of finance for the business project
As explained above, the capital necessary for business operation can be raised with various alternatives. However, choosing the right source of finance for each business plan is the most important task for all businessmen. Comparing and evaluating multiple sources helps build a business capital structure by finding suitable for your business. Capital and liabilities exist in any industry. Funds that come from equity and debt determine the capital structure of the business. Companies must choose the method through appropriate decision-making because the ratio of equity and debt varies depending on raising funds. Building a capital structure that optimizes the value of a company begins with determining the financial source.
When planning a new project, companies face the choice of funding sources accordingly. In this case, the most important thing to be considered is whether financing is possible with internal resources. And if funding from outside, which form should it be, whether a form of debt or capital. If funding for a new project is possible from within the company, you should check how much cash you have and ensure it is not insufficient to proceed with the project. If such extra money exists within the company, there are no sources of finance as clear and effective as this. For this reason, the more retained earnings the company has, the easier it is to plan a new project. It is because retained earnings are extra funds existing in the company. However, if it is difficult to raise funds from the inside of a company, an external financing method must be selected. When considering external financing, debt or equity must be determined. There are several things to consider in this process.
The equity or debt decision
The first is the cost. Internal difficulty raising funds means there are not enough extra funds, so external financing should be carried out in consideration of charges. Debt financing usually seems more attractive because it costs less than stock financing, but it should not overlook that interest is incurred.
In addition, company security in external capital raising is also important. For example, if investors demand intangible assets such as R&D knowledge, not tangible assets, as collateral for loans, it could be a risk to the entire company unless security is guaranteed.
Business risk is also one of the things to be considered. If the company’s profit fluctuates greatly, it may not cover the interest on external sources of funds, so it is necessary to analyze the change in the company’s profits and borrow enough to cover interest under any circumstances.
In addition to the above, there are many things to consider. Before determining an external financial source, the company will be able to grow with desirable fund management only by considering the company’s future circumstances based on these various factors.
Equity Finance
Equity finance refers to a method of financing related to stocks. It is also known as risky capital from an investor’s point of view in that profits are not guaranteed. Equity finance includes funding by issuing market prices of stocks, convertible bonds, and bonds with warrants. Shareholders can claim their shares in the company’s profits and assets. Investors have high expectations for profits as much as the risk is high. The advantage of equity financing is that there is no debt to repay. Due to these advantages, it is a very good way for start-up companies. It is because there is no loan to repay, so the burden is low. In addition, one of the advantages is that through equity financing, you can form partnerships with experienced people to learn or obtain useful information. On the other hand, the disadvantage of equity financing is that conflicts with equity shareholders may arise. Sharing ownership of a company with multiple people often leads to conflicts when the way the business is operated and the vision each person aims are different.
Debt Finance
Debt financing refers to paying back money borrowed within a specific period by adding interest. Types of debt financing include bank loans, bond capital, overdraft, mortgage loans, and asset leases. The advantage of debt finance is that unlike equity finance, which shares a company’s shares with investors, debt finance can completely control its business. In addition, borrowers are only obligated to repay, and unlike equity financing, there is no need to share business information with investors. On the other hand, as a disadvantage of debt financing, it can only be borrowed if it meets various conditions when borrowing money. The approach is relatively difficult. Banks are very conservative in terms of loan targets. In particular, debt financing may be difficult for start-up companies because profitability is not guaranteed. Moreover, failure to repay on time can affect credit ratings. A fall in credit ratings could adversely affect future loans.
Hybrid Finance
Hybrid finance is a finance that has some characteristics of both debt finance and equity finance. In other words, mixed finance can be seen as an appropriate combination of the advantages of equity finance and debt finance. Types of hybrid finance include Preference capital, convertible debentures, warrants, etc.
3. The costs of capital
The costs of capital are expenses that companies must bear about capital raising and use. From an investor’s point of view, it is also defined as the required rate of return expected for the invested funds. Capital costs are factors that greatly influence companies’ investment decisions. Depending on the source of capital, it is divided into cost of equity and cost of debt. Debt capital refers to funds such as loans or bonds raised from outside the company, and equity capital refers to those raised from shareholders through a paid-in capital increase. The amount of interest paid for the debt after the company has raised loans from outside the company is called the cost of debt. The cost of equity capital refers to the rate of return of the stock when the shareholder holds the stock. The cost of capital is sometimes used as a concept of opportunity costs. For example, it includes the highest return that a company can get from an investment plan that is not chosen. The company should consider capital costs in making investment decisions. In other words, when the company invests, it can be seen that the investment decision was correctly made only when it receives a higher return than the capital cost to be paid and the expected return of the abandoned investment plan. Thus, companies determine their target return or discount rate based on capital cost data when making investment decisions.
The cost of equity
In finance, the cost of equity capital refers to the rate of return a company pays to shareholders as compensation for the risk of capital investment. Companies must draw money from other individuals or companies for growth. Investors investing in companies invest in anticipation of future rewards for their investments. Since there are risks to investment, compensation for future investments should also correspond to risks.
The cost of debt
The cost debt simply refers to the amount of interest paid by the company’s debtor on the debt held by the company. From the creditor’s point of view, it can be seen as the required rate of return of creditors who provide funds to companies. It has the effect of saving corporate tax because interest payments and discounts on liabilities are treated as deductions from corporate tax calculation. For this reason, the cost of debt is lower than the interest rate.
The Cost of Preferred Stock
The cost of preferred stock refers to the expected return based on the market price of the stock and the annual dividend amount to encourage investors to invest in the company’s preferred stock. Companies issue preferred stocks to finance new projects. Corporate management tries to select the best option by analyzing preferred stock costs to measure whether this investment is efficient in financing through preferred stocks.
The cost of retained earnings
Companies do not distribute all the money earned from corporate activities through dividends between shareholders. Some profits are held within the company for new projects or business expansion. It is called retained earnings. However, if dividends were distributed, including remaining retained earnings, future profits from retained earnings are the cost of retained earnings. For example, assuming that shareholders received dividends, including the company’s retained earnings, and the return on retained earnings alone from investment was 20%, the cost of retained earnings is 20%.
The weighted average cost of capital (WACC) refers to a weighted average of the costs of each capital constituting the capital of a company according to the capital composition ratio. This value serves as the basis for a company’s investment decision. WACC represents the rate of return that stakeholders such as investors in the company or shareholders with shares can receive. In other words, the weighted average cost of capital of the company can represent the required rate of return of all capital stakeholders of the company. The company’s management uses weighted average capital costs to determine expansion plans such as mergers.
4. The importance of financial planning
Financial planning is to estimate capital according to a company’s plan and make the most appropriate decisions. In other words, it is to plan monetary policies related to corporate financing and investment. The company determines their capital requirements and the appropriate capital structure by making financial plans. The company’s financial planning is an essential process for the success of its projects because it is the process of determining how the company can perform economically according to the period of planned projects. The method of making financial plans includes the business environment, goals, resources needed for the project, and estimated budgets, and also includes predicting all possible risks. When the company performs a task, not all processes will flow as planned, but by making such a plan, it is possible to prepare for a quick and appropriate response. Financial planning plays an important role in maintaining a balance between inflow and outflow of funds so that corporate stability can be maintained. If the ratio of outflow and inflow is much different from the financial plan, it can be disrupted. In addition, it helps corporate capital investors invest in companies that effectively carry out financial planning. It is difficult for investors to trust companies that fail to implement their financial plans properly. Moreover, it will be difficult for companies that have not made financial plans even to find investors. It is based on the company’s long-term operation, and planning programs related to business expansion, and uncertainties related to changes in business market trends can be reduced by establishing financial plans. Finally, one of the reasons why financial planning is important is that it helps to effectively cope with or reduce factors that hinder the company’s operation.
5. Explain the information needs of different decision-makers in a business
Decision-makers refer to people within a company who make important decisions such as acquisition, expansion, or investment. Decision-makers within the company play an important role in making efficient decisions for the company’s continuous operation and growth. Corporate decision-makers make significant decisions to set the company’s target direction and allow ordinary employees to focus on carrying out the decided project. Decision-makers help the company select business partners needed to generate successful profits, establish sales strategies to successfully lead to sales of their products or services, determine marketing strategies to increase the value of corporate brands, and also develop policies to improve employees’ work environment. In other words, it can be seen that all company decisions are finally made by the findings of the decision-makers. However, this does not mean that all decision-makers are high-ranking officials of the company. Each company has a variety of decision-makers depending on the type of industry or the company’s role. Representative types of corporate decision-makers include brand-centric decision-makers, multifocal decision-makers, and aggregators.
Brand-centric decision-makers focus on making decisions to improve the company’s brand value. Consider how the decisions they make will affect the brand value of the company. When making their decisions, they consider information such as the impact of the decision on customers and how it will be accepted by customers.
Multifocal decision-makers consider the consequences in many ways and focus on various goals of the company when making decisions. In addition, they focus on generating corporate profits and collecting multiple factors that affect the brand as information for effective decision-making. Moreover, they try new strategies for the its development by using a trial-and-error approach.
Aggregators make decisions to promote corporate financial growth and development. In particular, the decisions they make are focused on establishing strategies that enable companies to create new acquisitions. Their decision types require data on the financial situation of a company because they focus more on financial performance than on the company’s culture. They share opinions with its financial analysts and investors to help companies make the right business decisions.
6. The impact of finance on financial statement
Financial statements are reports showing a company’s financial position and management performance. Companies provide the results of economic activities to various company stakeholders, such as shareholders and creditors, in the form of a report. Reports produced in this process are financial statements. The main contents listed in the financial statements include the company’s financial position, management results, and cash flow. Financial statements are used internally to determine the performance of a company. However, listed companies are obligated to disclose these financial statements to the general public every year. The types of financial statements vary depending on the purpose of the report.
The statement of financial position is a report showing the financial status of a company as of the last day of a specific accounting period. It is also called a balance sheet because liabilities, capital, and assets are listed to show the financial status of a company.
The statement of comprehensive income is a report showing the management results of a company during a specified accounting period. Management results include corporate profits and expenditures.
The state of changes in equity is a report showing differences in corporate capital during the accounting period. Factors that makeup capital include capital stocks, retained earnings, and accumulated other comprehensive incomes.
The statement of cash flows is a report showing a company’s cash inflow or outflow during the accounting period.
The four main types of financial statements described above are important for checking a company’s financial position and predicting future profitability. In addition, there is also a report that presents additional information that helps to understand the contents of these four types of reports. The report is called footnotes or disclosure.
Woody Train is trying to buy a store to expand its business. Toy store A and toy store B are being considered store sites. The table below shows the estimated cash flow of each store.
| Year | Toy store A | Toy store B |
| ￡ | ￡ | |
| 0 | -375,000 | -425,000 |
| 1 | 200,000 | 200,000 |
| 2 | 110,000 | 150,000 |
| 3 | 220,000 | 300,000 |
| 4 | 130,000 | 250,000 |
Annual rate: 12%
Net Present Value (NPV): This is one of the measures representing the value of a business and refers to the value obtained by converting the flow of net benefits every year until the end of the business, including initial investment funds, into present value. If the net current value is greater than zero, it can be considered that the business plan is worth adopting. The method of calculating the net present value is to convert the benefits and costs into the current value according to the discount rate and then subtract the present value of the cost from the present value of the benefit.
The Payback Period refers to the period to recover the invested funds from cash flows generated by business activities. Through the payback period, investors can obtain information on investment risk and indirectly grasp the liquidity of funds, which affects investment decisions.
The payback period for store A is about 2.34 years.
The payback period for store B is 2.4 years.
As a result, when comparing stores A and B through financial analysis, the fund recovery period is almost the same. However, the net present value of Store B is almost twice as high, so it is recommended to acquire Store B.
When looking at the financial statements of Hamleys Group Limited in 2019, the strategic report briefly explained the company’s major activities, key risks in its corporate activities, unexpected hazards such as coronavirus, and the company’s losses compared to last year. Following is the directors’ report and the directors’ statement of responsibility, which includes a list of directors and information disclosure. The directors’ statement of responsibility explains some of the directors’ duties for financial statements. Then, the next page includes reports from auditors on Hamleys Group’s financial statements. They check and judge whether financial statements during the accounting period are made by laws and International Financial Reporting Standards (IFRS). Before showing the company’s financial status with representative types of financial statements such as balance sheets or cash flow sheets, additional factors related to the company’s finances, such as basic information or goals and responsibilities of the board of directors, were explained.
Firstly, the statement of comprehensive income, one of the types of financial statements, was presented. It is a table created to show the company’s achievement has been achieved. This table contains the following points: operating profit and loss, fiscal income, fiscal expenditure, net profit, and other income, etc.
The second table presented is the balance sheet. The balance sheet shows a company’s financial position during the accounting period. This report specifies the current financial status of a company by showing its liabilities, assets, and equity.
The next statement presented is the statement of changes in equity. It is a table showing how corporate capital has changed over the year. Hamleys group’s financial statement is given to compare the economic fluctuations in 2018 and 2019. The statement of changes in equity shows the first balance of the accounting period. The balance at the end of the period changed according to capital, capital surplus, capital adjustment, retained earnings, and accumulated other comprehensive income.
The last table presented is a statement of cash flow. It is a table that shows the inflow and outflow of cash from a company, allowing the company to see its cash flow.
The following pages include additional information to understand the previous four reports better. The notes include the criteria for preparing financial statements, explanations of depreciation methods, and details of loans.
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