Learning Objectives

By the end of this lesson, learners should be able to:

• Explain the purpose of business financing.
• Distinguish between internal and external sources of finance.
• Distinguish between debt and equity financing.
• Explain short-term and long-term financing.
• Evaluate the characteristics of major financing instruments.
• Assess financing choices from an executive perspective.
• Identify the relationship between financing decisions, risk and organizational strategy.

1. Introduction to Business Finance

Organizations require finance to:

• Start operations.
• Fund working capital.
• Acquire assets.
• Expand operations.
• Invest in technology.
• Finance acquisitions.
• Refinance existing obligations.
• Maintain liquidity.

The financing decision addresses a fundamental executive question:

How should the organization obtain the funds required to achieve its strategic objectives?

Financing decisions are closely connected to investment decisions.

An organization may identify a project with an attractive NPV but still need to determine how the project should be financed.

2. Internal and External Finance

Sources of finance can initially be divided into two broad categories.

Internal Finance

Funds generated within the organization.

Examples include:

• Retained earnings.
• Operating cash flows.
• Disposal of surplus assets.
• Working-capital releases.

External Finance

Funds obtained from parties outside the organization.

Examples include:

• Bank loans.
• Bonds.
• Equity issuance.
• Private investment.
• Leasing arrangements.

3. Retained Earnings

Retained earnings represent profits retained within the organization rather than distributed to owners.

They can be used to:

• Finance expansion.
• Acquire assets.
• Fund projects.
• Strengthen liquidity.

Advantages

• No direct interest obligation.
• No new external ownership required.
• May reduce dependence on external financing.
• Can provide flexibility.

Limitations

Retained earnings are not free.

Using internally generated funds has an opportunity cost because those funds could otherwise:

• Be distributed to shareholders.
• Be invested elsewhere.
• Reduce debt.

Therefore, executives should not treat retained earnings as costless capital.

4. Equity Financing

Equity represents ownership capital.

Organizations can raise equity through mechanisms such as:

• Ordinary shares.
• Preference shares.
• Private equity.
• Venture capital.
• Strategic investors.

Equity investors generally participate in the organization’s residual economic performance.

Unlike conventional debt, equity does not normally require fixed contractual interest payments.

5. Ordinary Equity

Ordinary shareholders typically have:

• Ownership rights.
• Voting rights, subject to the company’s governance structure.
• Potential dividend income.
• Potential capital appreciation.
• Residual claims after creditors.

From the organization’s perspective, ordinary equity provides permanent capital but can involve:

• Ownership dilution.
• Governance implications.
• Higher expected investor returns than relatively safer debt instruments.

6. Preference Shares

Preference shares have characteristics that may combine elements of debt and equity.

Depending on their terms, preference shareholders may have:

• Priority over ordinary shareholders for dividends.
• Priority over ordinary shareholders in liquidation.
• Limited voting rights.
• Fixed or predetermined dividend characteristics.

The precise economic treatment depends on the instrument’s contractual terms and applicable accounting requirements.

7. Debt Financing

Debt financing involves obtaining funds that generally create a contractual obligation to repay principal and, depending on the instrument, interest or other financing charges.

Examples include:

• Bank loans.
• Bonds.
• Notes.
• Commercial paper.
• Revolving credit facilities.

Debt can provide substantial financing capacity but increases financial obligations.

8. Bank Loans

Bank loans are a common form of debt financing.

They may be:

• Short-term.
• Medium-term.
• Long-term.
• Secured.
• Unsecured.
• Fixed-rate.
• Floating-rate.

The financing agreement may contain covenants that restrict certain organizational actions.

Examples include requirements relating to:

• Leverage.
• Interest coverage.
• Asset disposals.
• Additional borrowing.

9. Bonds and Debt Securities

Large organizations may access capital markets by issuing debt securities.

A bond generally involves:

• Principal amount.
• Coupon or interest payments.
• Maturity date.
• Redemption terms.
• Covenants and other contractual provisions.

Investors receive contractual claims rather than ordinary ownership rights.

10. Commercial Paper

Commercial paper is generally a short-term debt instrument issued by eligible organizations to meet short-term financing needs.

It can be useful for organizations with:

• Strong credit quality.
• Predictable short-term cash flows.
• Access to institutional capital markets.

However, reliance on short-term funding can expose the organization to refinancing risk.

11. Leasing

Leasing allows an organization to obtain the use of an asset without necessarily purchasing it outright at the beginning of the arrangement.

Leasing can be relevant for:

• Equipment.
• Vehicles.
• Property.
• Technology.
• Specialized assets.

The economic and accounting consequences depend on the lease structure and applicable reporting standards.

Under IFRS 16, most leases from a lessee’s perspective result in recognition of a right-of-use asset and lease liability, subject to specified exemptions.

12. Short-Term versus Long-Term Finance

Short-Term Finance

Usually addresses financing requirements with relatively short maturities.

Examples:

• Overdrafts.
• Trade credit.
• Commercial paper.
• Short-term bank facilities.

Long-Term Finance

Generally supports longer-duration requirements.

Examples:

• Long-term loans.
• Bonds.
• Ordinary equity.
• Preference shares.

13. Matching Principle

A useful financing principle is to consider matching the maturity of financing with the economic life of the assets being financed.

For example:

• Short-term working-capital requirements may be supported by short-term financing.
• Long-lived assets may be supported by longer-term financing.

However, financing policy also depends on:

• Liquidity risk.
• Cost.
• Flexibility.
• Market conditions.
• Risk appetite.

14. Debt versus Equity

Characteristic	Debt	Equity
Ownership	Generally no	Yes
Mandatory contractual repayment	Usually	No
Interest/financing obligation	Usually	No fixed obligation for ordinary equity
Voting rights	Generally none	Usually present for ordinary shares
Financial leverage	Increases	Generally reduces relative leverage
Bankruptcy/financial distress exposure	Increases	Lower contractual pressure
Potential dilution	No	Yes

Neither source is universally superior.

The appropriate choice depends on organizational circumstances.

15. Financing Risk

Financing decisions influence the organization’s risk profile.

Heavy reliance on debt can increase:

• Interest obligations.
• Refinancing risk.
• Covenant pressure.
• Default risk.
• Financial distress risk.

Heavy reliance on equity can create different challenges, including:

• Ownership dilution.
• Higher investor return expectations.
• Potential governance complexity.

16. Financing Flexibility

Executives should consider not only the immediate cost of financing but also future flexibility.

A financing arrangement may restrict the organization through:

• Covenants.
• Security requirements.
• Maturity obligations.
• Dividend restrictions.
• Change-of-control provisions.

Therefore, the cheapest financing option today may not necessarily be the most advantageous financing structure over the organization’s strategic horizon.

17. Executive Financing Decision Framework

Senior executives should consider:

1. Purpose of financing
2. Amount required
3. Duration
4. Cost
5. Risk
6. Cash-flow capacity
7. Ownership implications
8. Financial flexibility
9. Covenants
10. Strategic objectives

Lesson Summary

Organizations can obtain finance from internal and external sources, including retained earnings, equity, debt, leasing and short-term financing arrangements.

The choice between debt and equity affects:

• Cost.
• Risk.
• Control.
• Flexibility.
• Liquidity.
• Financial leverage.

Executives should therefore evaluate financing sources as part of the organization’s broader strategic and risk-management framework.

Key Principle

The appropriate financing source is not necessarily the one with the lowest immediate cost; it is the one that provides an appropriate balance between cost, risk, control, flexibility and strategic requirements.

References

1. CFA Institute — Corporate Finance and Capital Structure
   CFA Institute
2. Brealey, R. A., Myers, S. C., Allen, F., & Edmans, A. — Principles of Corporate Finance. McGraw Hill.
3. Ross, S. A., Westerfield, R. W., Jaffe, J., & Jordan, B. D. — Corporate Finance. McGraw Hill.
4. IFRS Foundation — IFRS 16 Leases
   IFRS Foundation — IFRS 16 Leases