Unit 5.2 — Sources of finance
Learning outcomes (from the 9587 syllabus). This note is complete when every bullet below is covered.
Learning outcomes
- Financial institutions and markets: money and capital markets
- Legal structure and sources of finance: relationship between legal structure and sources of finance
- Types of sources of finance: short-term vs long-term; debt vs equity (optimal mix); internal vs external
- Factors affecting sources of funds: cost, risk borne by fund providers, flexibility, degree to retain control, gearing position
Running example: Swift Logistics needs $500,000 for new vans and a new depot — where should it get the money?
Big picture
In plain English: when a business needs money, it can get it from inside (its own profits) or outside (borrowing or selling shares), for the short term or long term. The choice is about cost, risk and control.
Analogy: sources of finance are like ways to fund a big purchase — use your savings (internal), borrow from a bank (debt), or take a partner who shares ownership (equity). Each has a price.
Core content
1. Financial institutions and markets
- Money market — the market for short-term borrowing and lending (under one year), e.g. interbank loans, short-term deposits.
- Capital market — the market for long-term funds, e.g. the stock market (shares) and bond market.
Swift uses the money market for a short-term overdraft to cover wages this month, and the capital market if it later issues shares or bonds to fund a long-term expansion.
2. Legal structure and sources of finance
The business’s legal structure limits which sources it can use:
- Sole traders and partnerships — mainly personal savings and bank loans (lenders may be cautious because of unlimited liability).
- Private/public limited companies — can sell shares (equity) and issue debentures (debt), so they have more choices.
As a Pte Ltd, Swift can raise equity by selling shares to new investors — an option Mdm Tan’s sole-trader bakery did not have.
3. Types of sources of finance
By time:
| Short-term (under 1 year) | Long-term (over 1 year) | |
|---|---|---|
| Examples | Overdraft, trade credit, debt factoring | Bank loan, mortgage, shares, debentures, retained earnings |
By ownership:
- Debt — borrowed money that must be repaid with interest (loans, overdrafts, debentures).
- Equity — owners’ money that does not have to be repaid (shares, retained earnings), but shareholders expect dividends.
- Optimal mix: too much debt → high interest cost and risk; too much equity → ownership diluted. The optimal mix balances cost, risk and control.
By source:
- Internal — from inside the business: retained earnings (profits kept back), sale of assets, working capital.
- External — from outside: loans, overdrafts, shares, venture capital, crowdfunding.
4. Factors affecting the choice of source
| Factor | What it means |
|---|---|
| Cost | Interest (debt) vs dividends (equity) — pick the cheaper |
| Risk borne by fund providers | Lenders want security and repayment; risky businesses pay higher interest |
| Flexibility | Can the source be increased/repaid when needed? |
| Degree to retain control | Issuing shares dilutes owners’ control; debt does not |
| Gearing position | If the business already has high debt (gearing), taking more debt is risky |
Swift chooses a bank loan (debt) for the vans because it wants to keep control (no new shareholders) and interest is tax-deductible. But because Swift already has some debt (moderate gearing), it limits further borrowing and funds part of the depot from retained earnings (internal) to avoid over-gearing.
Analysis & evaluation points (AO3/AO4)
- Debt vs equity is a classic trade-off: debt keeps control but adds fixed interest; equity shares control but has no repayment obligation.
- Internal finance is cheapest and safest but limited by past profits.
- Short-term vs long-term must match the use — financing a long-term asset with a short-term overdraft is risky (mismatch).
- Gearing risk: high debt raises returns in good times but magnifies losses in bad times.
Language bank: however · on balance · it depends on · trade-off ·
Worked examples (PEEL)
PEEL = Point → Explain → Example → Link. Use this structure for every written answer.
Worked example 1 — “Explain” (6 marks)
Question: Explain one advantage and one disadvantage of debt finance.
- P (Point): Debt finance lets owners keep full control.
- E (Explain): Lenders do not become owners, so the original owners keep all decision-making power, unlike selling shares.
- E (Example): Swift’s bank loan for vans means Mr Lim keeps full ownership and control.
- L (Link): This preserves the owner’s independence.
- P (Point): However, debt must be repaid with interest.
- E (Explain): Interest is a fixed cost that must be paid even when profits are low, raising financial risk.
- E (Example): Swift must pay the loan instalment every month even in a quiet season.
- L (Link): So too much debt can threaten survival.
Worked example 2 — “Evaluate” (10 marks)
Question: Evaluate whether a business should use retained earnings rather than a bank loan to fund expansion.
- P (Point): Retained earnings have no interest cost and no loss of control.
- E (Explain): Using its own profits avoids interest payments and keeps ownership unchanged.
- E (Example): Swift funding part of its depot from retained profits pays no interest and keeps Mr Lim in control.
- L (Link): This is cheap and safe.
- Evaluate (AO4): However, retained earnings are limited by past profits and may be insufficient or too slow for a large expansion, causing missed opportunities. On balance, retained earnings are ideal for smaller, gradual expansion, while a bank loan suits larger, urgent investment — provided gearing stays manageable.
Application bank (Singapore quick reference)
| Idea | Singapore example |
|---|---|
| Equity | Companies raising share capital on the SGX |
| Debt | SME bank loans, business term loans |
| Government support | EnterpriseSG loans and grants for SMEs |
| Alternative finance | Crowdfunding platforms used by start-ups |
Exam technique
- How it appears: a case study describes a funding need and asks you to recommend a source.
- Model skeleton for “recommend a source”: state the need (amount, short/long term) → apply the five factors → compare 2–3 sources → recommend one and justify.
- Common pitfalls: recommending shares for a sole trader (not possible); ignoring gearing; matching short-term needs with long-term sources (or vice versa).
Self-test checklist
Essay practice: “Evaluate the view that debt finance is always better than equity finance.” (25 marks)