Nature, purpose and sources of finance (01)

Question 1

What is a financial objective?

Answer 1

A financial objective is a specific target or goal measured in monetary terms, relating
to financial performance, resources or structure of a business.

Question 2

What are the key benefits of setting financial objectives?

Answer 2

-Provide a focus for the business
-Measures success or failure for the business
-Reduces risk of business failure
-Helps to coordinate the various business functions/departments
-Provides a target to help make investment decisions
-Provides an indication to stakeholders, such as shareholders the priorities of the management

Question 3

Note:
As the financial instruments in the money market include deposits and collateral loans, businesses typically rely
on the money market for short-term debts to cover operating expenses.

Question 4

What are the types of internal sources of finance?

Answer 4

-Retained earnings
-Sale (and leaseback) of assets
-Reductions in working capital

Internal sources of finance do not increase the liabilities of the business, and there
is no risk that the original owners would lose control as no shares are sold. However,
depending only on internal sources of finance for expansion can slow down business
growth, as the speed of development is limited by profits earned or the value of
assets sold. Hence, rapidly expanding companies often depend on external sources
when they raise funds.

Question 5

What are internal sources of finance?

Answer 5

Internal sources refer to funds raised from assets owned by the business or profits
that are ploughed back.

Question 6

What are external sources of finance?

Answer 6

External sources are funds raised from outside the business. They can be further
classified in terms of short to medium-term and long-term finance.

Question 7

What are some short to medium-term external sources of finance?

Answer 7

-Bank overdraft
-Debt factoring
-Hire purchase
-Leasing

Question 8

What are some long-term external sources of finance?

Answer 8

-Equity
-Long-term bank loan
-Bonds

Question 9

What are the advantages of debt finance?

Answer 9

 As no shares are sold, the ownership of the company does not change or is not
‘diluted’ by the issue of additional shares.
 Debts have to be repaid eventually, hence liabilities will not increase
permanently.
 Lenders such as banks, financial institutions and bondholders have no voting
rights at annual general meetings.
 Interest expense is tax-deductible.

Question 10

What are the advantages of equity finance?

Answer 10

 Equity is a permanent capital and never has to be repaid.
 Companies can opt not to declare and pay dividends every year, unlike interests.

Question 11

What are some other external sources of finance?

Answer 11

-Grants
-Venture capital
-Crowd funding

Question 12

What are some factors affecting sources of finance?

Answer 12

-Cost
-Risk-bearing by fund providers
-Flexibility
-Legal structure
-Desire to retain control

Question 13

SUMMARY

Answer 13

1. One common financial objective is to maximise wealth for shareholders. This
   can be achieved by raising funds at the lowest possible costs, and utilising funds
   to maximise returns at minimum risks.
2. Beyond the regular funds required to pay for raw materials and daily operating
   expenses, businesses typically require huge financing as start-up capital, as well
   as for growth and expansion.
3. Financial institutions and markets consist of capital and money markets.
4. Sources of finance can be classified into internal and external, as well as short-
   and long-term sources of finance.
5. No single source of finance is suitable for all business needs. It is essential to
   make a careful choice on the appropriateness of the source of finance, and
   consider both advantages and disadvantages of the different sources.
6. Many factors influence choice of sources of finance, including cost, risk-bearing
   by fund providers, flexibility, legal structure and desire to retain control.