SOURCES OF FUNDS
If a business is to operate successfully and to expand, it will need an
appropriate level of assets, and an inflow of cash (funds) with which to
acquire the assets.
The source of such cash must be capital, liabilities, or both. The various
sources are listed here in ascending order of importance: short-term credit
(credit liabilities), long-term borrowings, capital introduce by owners/-shareholders,
and profits generated by the business.
Current liabilities are debts of the business that must be paid in a fairly
short time. Of course, the longer the business can take to pay these debts
the greater the use to which the cash can be put before it leaves the business.
On the other hand if the business's creditors do this, they are effectively
funding their operations with the cash owed to the business. Examples of current
liabilities are:
Trade creditors.
Bills payable, ie. acceptance by the business to pay the creditor on a due day
(eg, 90 days).
Taxation payable.
Dividends payable.
Accrued charges for services used but not yet charged.
Short-term loans repayable within one year.
Bank overdraft.
Strictly speaking, a bank overdraft is not a current liability, but a more
permanent form of financing, because the overdraft facility normally remains
available to a business over a number of years. However, bank overdraft is
shown as a current liability in the balance sheet, because it is repayable on
demand. Long-term borrowings are characterised by some, or all, of the following
conditions:
The amount of the loan is fixed.
The loan attracts a fixed interest rate per annum.
The loan is repayable more than 12 months after the balance sheet date.
The loan can be secured by a charge against the assets of the business eg, if
the loan cannot be repaid in cash, certain assets must be sold, and the proceeds
used firstly to pay off the secured loan before settling any other facilities.
Here are some examples of long-term borrowings:
Creditors for goods bought on hire purchase (where the business does not become
the owner of the goods until the last payment has been made).
Bank loans and other long-term loans, either secured or unsecured, against the
assets of the business.
Mortgage loans that are specifically secured against free hold property.
Debentures, which are bonds that acknowledge a sum on which a fixed rate of
interest (and usually a fixed redemption rate) are due until that sum is repaid.
Preference share capital. This is a form of financing that bridges the gap between
the long-term borrowings and the share capital of a company, because the preference
shareholders are (usually non-voting) members of the company. However, if there is
any capital repayment by a company, they are only entitled to a refund of the amount
that they have invested. Very often, redeemable preference shares are issued. This
means that the company will repay (redeem) the borrowed amount by a certain date.
Capital introduced by the owners/shareholders are finances intended to remain in the
business for as long as it exists. In the case of a private company, the capital is
called the ordinary or equity share capital. A private company will issue shares (eg.
one million ordinary shares at 1 each), and subscribers for those shares are called
ordinary shareholders or members. They are the real proprietors of the company. At
general meetings, they will vote on company policies. They receive dividends as proposed
by directors and voted by the general meetings. Ordinary shareholders shares in revenue
and capital profits after preferential rights have been satisfied, and are the last to
receive capital repayment (if any) if the company ceases to exist (is liquidated).
Profit is the most important source of funds for the growth of a business. To appreciate
how the concept of the profit relates to the idea that assets = capital + liabilities, the
implication of 'making profits' must be considered. Profit is an excess of income over
expenditure, in other words an increase in the cash owned by the company, and an increase
in cash is an increase in assets. Such profit belongs to the owners of the business, and
represents an increase in their capital. Therefore, having increased the assets employed
by the business, we can say that assets introduced + the increase in assets = the
liabilities + (the capital + the profit), therefore:
| Assets |
= |
capital |
+ |
liabilities |
Business Equation
Comparing the balance sheets for the beginning and the end of an accounting period enables
profit to be calculated using the following equation:
P = I + D - C
Where P = profit, I = the increase in net assets, D = the drawings made by the proprietors
during the period, and C = the additional capital introduced during the period. This is
only applicable to sole proprietors.
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