RISE School of Accountancy (Islamabad & Rawalpindi) Business (PRC-03) Notes

Chapter 4: Sources of Business Finance

Financial Management
Financial management is the art and science of managing a company’s funds so that it can meet its goals and
objectives.
 Knowledge of accounting and finance plays a critical part in understanding the concept of financial
management.
 A company’s financial statements such as Balance Sheet, Income Statement, and Cash Flow Statements
are a key source of information for financial management, which are mostly prepared by professional
accountants.
 Financial managers focus on financial planning and cash flow management.
An important aspect of financial management is the choice of financing methods for a company’s assets.
Companies use a variety of sources of finance and the aim should be to achieve an efficient capital structure that
provides:
 A suitable balance between short-term and long-term funding
 Availability of adequate cash for day to day expenses
 A suitable balance between equity (funds raised through the sale of ownership in the business) and from
debt (borrowed funds) in the long-term capital structure.

Role of a Financial Manager

The key activities of the financial manager, to achieve their primary goal, are:
 Financial planning: Preparing the financial plan for project’s revenues, expenditures and financing
needs over a given period.
 Investment (spending funds): Investing the organisation’s funds in projects and securities that provide
high returns in relation to their risks.
 Financing (raising funds): Obtaining timely funding for the organisation’s operations and investments
and seeking the best balance between debt and equity.

Sources of Finance
Balance Sheet
As at 31 December 20XX
Assets Liabilities and Shareholders’ Equity
Current assets (short-term): which are convertible into cash within Current liabilities (short-term): obligations due within one year
one year
Non-current assets (long-term); which are of a more permanent Non-current liabilities (long-term): obligations due within one
nature year
Total liabilities

Shareholders’ equity (permanent): including capital and retained

earnings

Total assets Total liabilities and Shareholders’ equity

M. Bilal Kamran Page 1

RISE School of Accountancy (Islamabad & Rawalpindi) Business (PRC-03) Notes

Debt Capital (financing): Debt capital refers to fund or assets generated by borrowing from a lender. A
business owner takes on debt to get capital. This can be done privately through bank loans, or it can be done
publicly through a debt issue. These debt issues are known as corporate bonds, which allow a wide number of
investors to become lenders (or creditors) to the organisation. The drawback of borrowing money is the interest

M. Bilal Kamran Page 2

RISE School of Accountancy (Islamabad & Rawalpindi) Business (PRC-03) Notes

that must be paid to the lender, where a failure to pay interest or repay the principal can result in default or
bankruptcy. But, the interest paid on debt is typically tax-deductible and costs less than other sources of capital.

Equity Capital (financing): Business owner do not take on debt in equity capital. Investors purchase partial
ownership in the business (equity) and the owner does not have to repay. An organisation can also raise capital
by selling its ownership in the form of shares to interested investors, existing or new, which is known as equity
funding. The benefit of this type of capital is that investors do not require interest payments like bondholders
do. The drawback is that further profits are divided among all shareholders (including new ones) in the form of
dividends. Furthermore, shareholders have voting rights on important matters of the organisation, which means
that the company’s management control is weak or forfeited, due to increase in shareholders. Another way of
equity financing is through retaining earnings in the business by not fully distributing the profits to shareholders
as dividends.

Sources of finance can also be classified based on time-duration or maturity. This results in two types of
financing:
 Short-term Financing
 Long-term Financing

1. Short-Term Financing
Short term finance refers to financing needs for a small period normally less than a year. In businesses, it is also
known as working capital financing. Short-term financing is shown as a current liability on the balance sheet. It
is used to finance current assets and support operations.
Financing may be secured or unsecured, which is on the basis of the firm’s creditworthiness and the lender’s
previous experience with the firm.

a. Trade Credit: Accounts Payable: Accounts Payable are amounts due to vendors or suppliers for goods or
services received but have not yet been paid. Generally, an unsecured mode of financing.
 An organisation should try to negotiate favourable credit terms from its suppliers.
 Trade credit from suppliers has no cost, and is therefore an attractive method of short-term finance.
 It’s not a good strategy for any organisation to increase the amount of its trade payables by taking excess
credit and making late payments.
b. Bank Loans: Short-term bank loans might be arranged for a specific purpose, for example to finance the
purchase of specific items.
 Several different types of business loans are generally available. The specific type of loan that a
organisation obtains may depend on its reasons for funding need or the length of time the funds are
required.
c. Committed lines of credit: A committed credit line is a legal agreement between a financial institution and a
borrower setting out the conditions of a credit line. Once signed, the agreement requires the financial institution
to lend money to the borrower, provided that the borrower does not break the conditions.
 This allows the organisation to borrow up to a specified amount of money within a specified period of
time.
 A line of credit is especially useful when an organisation expects that it will need funding in the future,
but does not know exactly when it will need funds or how much it will need.

M. Bilal Kamran Page 3

RISE School of Accountancy (Islamabad & Rawalpindi) Business (PRC-03) Notes

d. Operating leases: A lease is a contractual agreement whereby one party that is the owner of an asset grants
the other party the right to use the asset in return for a periodic payment.
 In simpler terms, leasing is renting an asset of the organisation for a specified period.
 In some cases, operating leases might be an alternative to obtaining short-term finance.
 Operating leases are similar to rental agreements for the use of non-current assets, although they might
have a longer term. (Rental agreements are usually very short term).
e. Factoring / Discounting of Receivables: In discounting, a firm sells its accounts receivable outright to a
factor, which is a financial institution (often a commercial bank or commercial finance company) that buys
accounts receivable at a discount.
 Discounting is more expensive than a bank loan, however, because the factor buys the receivables at a
discount from their actual value, but provide quick access to funds.
 For businesses with steady flow of orders but a lack of funds to make payroll or other immediate
payments, discounting is a popular way to obtain financing by selling its invoices to a third-party.

2. Long-Term Financing: The funds which are paid back after a period of one year are referred to as long term
finance. Certain long term finance options directly form a part of the permanent capital of the organisation,
where an obligation does not even arise. The primary purpose of obtaining long-term funds is to finance capital
projects and carry out operations on an expansionary scale e.g. modernization, expansion, diversification and
development of business operations.

Types of Long-term Financing options

Long-term financing sources include both debt (borrowing) and equity (ownership). Equity financing comes
either from selling new ownership interests or from retaining earnings. Financial managers try to select the mix
of long-term debt and equity that results in the best balance between cost and risk.
i. Debt Financing
The term ‘debt finance’ is used to describe a type of finance where the borrower:
 Receives funds, either for a specific period of time or possibly in perpetuity.
 Acknowledges an obligation to pay interest on the debt for as long as the debt remains outstanding; and
 Agrees to repay the amount borrowed when the debt matures (reaches the end of the borrowing period).

a. Term Loans: which is used to finance the purchase of fixed assets such as machinery. The maturity on a
term loan may typically be between 3 and 10 years. Such loans are considered long-term loans and can be
secured or unsecured.

b. Bonds: Bonds are long-term debt instruments involving two parties- the borrower (issuer) and the lender
(buyer or investor). The borrower can be the government, a local body or a corporation. They generally provide
fixed interest payments at periodic intervals and are redeemable at a predetermined date in future.
 The issuer of a bond must pay the buyer a fixed amount of money called interest, stated as the coupon
rate on a regular schedule.
 The issuer must also pay the bondholder the amount borrowed called the principal, or par value at the
bond’s maturity date (due date). A bond certificate is issued as proof of the obligation.
 Bonds are normally issued against collateral and are therefore a highly secured form of long term
finance.

M. Bilal Kamran Page 4

RISE School of Accountancy (Islamabad & Rawalpindi) Business (PRC-03) Notes

c. Finance Lease: A finance lease is another way of providing finance, where effectively a leasing company
(the lessor or owner) buys the asset for the user (usually called the hirer or lessee) and rents it to them for an
agreed period.
 Simply, the finance lease is the type of lease wherein the lessor transfers all the risks and rewards
(control) associated with the asset to the lessee before the lease agreement expires.
 The ownership could be transferred at the expiry of the lease agreement with mutually agreed terms.
 Finance Lease is more widespread in the acquisition of assets
 It is very important while making the leasing decision to compare the cost of leasing the asset with the
cost of owning the same.

ii. Equity Financing

Equity refers to the owners’ investment in the business. In corporations, the preferred and common stockholders
are the owners. A company obtains equity financing by selling new ownership shares (external financing) or by
retaining earnings (internal financing).
a. Retained Earnings: The Retained Earnings represent that portion of the equity earnings (left after deducting
the tax and preference dividends), which is sacrificed by the equity shareholders and is ploughed back into the
company to reinvest these in the core business operations, such as paying off the debt obligations or purchasing
capital assets.
 The board of directors of each company decides how much of the company’s earnings should be
retained (reinvested in the company) versus distributed as dividends to owners.
 Dividends are payments to stockholders from a corporation’s profits. Dividends can be paid in cash or in
stock.
 When companies retain profits in the business, the increase in retained profits adds to equity reserves.
The retained capital, in principle, is reinvested in the business and contributes towards further growth in
profits.
b. Issuing Shares for cash: Companies can raise equity capital externally by issuing new shares for cash, but
the opportunity to do so is much more restricted for private companies than for public companies.
 The main difference between a private vs public company is that the shares of a public company are
traded on a stock exchange, while a private company’s shares are not. Accordingly, the worth of
ownership is measured by the share price (for public companies) or value of stocks (for private
companies).
 Private companies cannot offer their shares for sale to the general investing public, and shares in private
companies cannot be traded on a stock market. They can sell shares privately to investors but it is
usually difficult to find investors who are willing to put cash into equity investments in private
companies.
 The existing owners of a company might not have enough personal capital to buy more shares in their
company. Existing shareholders are therefore a limited source of new capital.
 Public companies may offer their shares to the general public. Many public companies arrange for their
shares to be traded on a stock market. The stock market can be used both as a market for issuing new
shares for cash, and also a secondary market where investors can buy or sell existing shares of the
company.
There are three main methods of issuing new shares for cash:

M. Bilal Kamran Page 5

RISE School of Accountancy (Islamabad & Rawalpindi) Business (PRC-03) Notes

 Issuing new shares for purchase by the general investing public: this is called an initial public offer or an
IPO
 Issuing new shares to a relatively small number of selected investors: this is called a placing or private
placement of shares.
 Issuing new shares to existing shareholders in a rights issue.
There are mainly two types of shares that a company may issue to raise equity. These are known as Common
Stock and Preferred Stock.
Preferred Stock (Preference Shares): Another form of issuing new shares as form of equity is preferred stock.
While both preferred shares and common shares give shareholders ownership in a company, they come with
different shareholder rights. Preference shares, also known as preferred shares, have the advantage of a higher
priority claim to the assets of a corporation in case of insolvency and receive a fixed dividend distribution.
These shares often do not have voting rights and can be converted into common shares.
The basic features of preference shares are as follows:
 Most preference shares are issued with a fixed rate of annual dividend.
 Preference dividends are paid out of after-tax profits.
 Preference shareholders will be entitled to receive dividends out of profits before any remaining profit
can be distributed to ordinary shareholders as equity dividends.
 If the company goes into liquidation, preference shareholders rank ahead of equity shareholders, but
after providers of debt finance, in the right to payment out of the proceeds from sale of the company’s
assets.
 Preference shares are fairly uncommon with a few exceptions.
For the issuing firm, preferred stock is more expensive than debt because its dividends are not tax-deductible,
and its claims are secondary to those of debtholders but less expensive than common stock.

Comparison of Short-term Finance and Long-term Finance

Short and Long-term Finance Short-term Finance Long-term Finance
Duration (maturity) Typically repayable within one Have a longer time span, varying from
year or less. 1 to 30 years.
Requirements Obtained to fund temporary Obtained to fund the growth, purchase
shortfalls in working capital, of property, plant and equipment, or
repayment of current liabilities capital projects on a large scale.
etc.
Collaterals Do not create a charge on the Collateral is generally a primary
assets of the company. requirement for obtaining long term
finance.
Terms of loan Interest rates are unstable and Interest rates are generally stable and
vulnerable to inflationary forces. the terms of the loan offer flexibility,
Terms of loans are not very such as prepayment options, re-
flexible. negotiation of interest rates upon
improvement in credit rating etc.
Volume of funds Used to raise funds in limited A large volume of funds can be
amounts since they are repayable obtained. However the same is
in the near future. restricted by the nature of securities
provided, the credit rating of
borrower, etc.
Examples Overdraft, Credit Cards, Line of Leasing, Term Loans, Public Deposits,
Credit. Bonds.

M. Bilal Kamran Page 6

RISE School of Accountancy (Islamabad & Rawalpindi) Business (PRC-03) Notes

Short-term Financing Long-term Financing

Approval Process / Chances Simple and fast process with Complex and slow process with slightly
higher chances of approval – less to harder chances of approval – more to
verify verify
Repayment Schedule Lower flexibility Higher flexibility

Financing Cost Higher interest rate Lower interest rate

Selection Criteria Short-term financing is preferable Long-term financing preferable if

if the borrower is in a liquidity borrower is stable and need funds for
crunch and needs funds quickly to strategic goals at best interest rate due
bridge timing gaps in cash flows. to better credit position.

Debt versus Equity Financing

As per the ‘pecking-order theory’, a company should prefer to finance itself in the following order:
i. First internally through retained earnings, which signals to market that the company is performing strong.
ii. Second through debt, which signals to market that management is confident that the company can meet its
obligations.
iii. Finally, and as a last resort, through the issuing of new equity, which is normally a negative signal that the
company is overvalued and it seeks money prior to its share price falling.
However, the ultimate financing decision should always be based on optimal capital structure and value
maximization for shareholders.
Differences between Debt and Equity Financing
Areas Debt Financing Equity Financing
Have a say in Creditors typically have none, unless the Ordinary shareholders have voting
Management borrower defaults on payments. rights.
Creditors may be able to place restraints
on management in the event of default.
Financial covenants can also be added
in debt agreements such as
maintaining minimum current and
quick ratios.
Have a right to Debt holders rank ahead of equity Equity owners have a residual claim on
income holders. Payment of interest and income (dividends are paid only after
and assets principal is a contractual obligation of paying interest and any scheduled
the company. principal) and no obligation to pay
dividends.
Maturity (date when Debt has a stated maturity and Equity has no maturity date; the
debt needs to be paid requires repayment of principal by a company is not required to repay it.
back) specified date.

Tax Treatment Interest is a tax-deductible expense. Dividends are not tax-deductible and
are paid from after-tax income.

Conventional and Islamic Banking

1. Conventional Banking: Conventional banks operate on traditional financial principles. They follow standard
practices of lending, borrowing, and saving within a capitalist framework.

M. Bilal Kamran Page 7

RISE School of Accountancy (Islamabad & Rawalpindi) Business (PRC-03) Notes

Key Features
i. Interest-Based System: Conventional banks lend money to customers at an interest rate, and they also pay
interest to depositors. This interest is the primary source of income for banks.
ii. Profit Maximisation: The main objective of conventional banking is to generate profit by charging higher
interest rates on loans than those paid to depositors.
iii. Risk and Return: Conventional banks are allowed to engage in speculative trading and investment
activities, which may involve a higher level of financial risk.
iv. Regulation: Conventional banks are generally regulated by central banks or government bodies. Regulations
usually focus on financial stability and ensuring liquidity, but they do not specifically address ethical
considerations.
v. Financial Products: Conventional banks offer a wide range of financial products such as personal loans,
mortgages, credit cards, savings accounts, and investment products.

2. Islamic Banking: Islamic banking, based on the principles of Sharia (Islamic law), operates under guidelines
that emphasise ethics, justice, fairness and the prohibition of exploitative practices, such as charging interest
(Riba).
Key Features
i. Prohibition of Interest (Riba): Islamic banking prohibits both paying and receiving interest. Instead, banks
earn profit through trade, or risk-sharing arrangements, where both parties share risks and rewards.
ii. Profit and Loss Sharing: Transactions may be structured on a profit-and-loss sharing basis, such as
Mudarabah (capital from one party, expertise from another) and Musharakah (joint venture where both
contribute capital and share profits/losses).
iii. Asset-Backed Financing: All transactions must be linked to tangible assets or services, so as to ensure that
financing supports real economic activity and avoids speculation.
iv. Ethical Investments: Islamic banks avoid investing in sectors prohibited by Sharia, such as alcohol,
gambling, adult entertainment, conventional financial services involving interest etc. Investments must align
with socially responsible and ethical principles.
v. Sharia Compliance: Islamic banks are overseen by Sharia boards or committees, which ensure that all
financial products and operations comply with Islamic principles.
vi. Types of Contracts
a) Murabaha: A cost-plus-sale, where the bank buys an asset and sells it to the customer at a profit.
b) Ijara: A lease agreement where the bank purchases an asset and leases it to the client.
c) Mudarabah: Profit-sharing where one party provides capital, and the other provides expertise and effort.
d) Musharakah: A joint venture with shared capital and profit/loss distribution.

Difference between Conventional and Islamic Banking

Conventional Banking Islamic Banking

Interest Interest is charged on loans and paid on Interest (Riba) is prohibited.

deposits.

Profit Banks earn profit by lending money at Profit is generated through partnerships, asset-
Generation interest rates. backed transactions, etc.

Ethical Primarily focused on profit maximisation, Must adhere to ethical guidelines under Sharia
Standards with limited ethical restrictions. law (avoids unethical investments)

M. Bilal Kamran Page 8

RISE School of Accountancy (Islamabad & Rawalpindi) Business (PRC-03) Notes

Regulation Regulated by central banks and government Regulated by central banks along with Sharia
authorities supervisory boards/committees.

Investment Free to invest in any industry Avoids investment in Haram industries (e.g.,
alcohol, gambling).

Contract Standard interest-based loans, mortgages, Murabaha, Mudarabah, Musharakah, Ijara, etc.
Types and credit facilities.

M. Bilal Kamran Page 9