Companies in stages of start-up phase and existing ones that are planning to grow both needs to find ways of financing their operations. Most businesses are started with an individual or individuals providing a small amount of equity capital from their private funds/savings and then may be a bank assisting them with some short term working capital. Once the business is established, then unless the owners are able to provide more funds, further funding for expansion will have to be sought from outsiders (Pandey, 2006).
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Businesses are faced with and ever increasing myriad of products and services available from financial institution and private investors. These products and services have become more and more sophisticated with an equal increase in the quantity, hence making the right decision on a method of finance an uphill task for finance managers. These financial institutions be it banks, micro-finance institutions or credit institutions have great product and services, but they need wise selection so that they suit the company’s short-term, medium-term as well as long-term financial needs.
The core genesis of finances for almost all organizations and companies is usually categorized into quick-fix finances, medium-term and then lengthy term sources. Finance which is repayable within one year is usually regarded as short term. But sometimes short term finance like overdraft repayable within 6 months may be rolled-over and thus go beyond one year. Financing a business for more than a year but less than five years period is known as medium-term financing. This type of money can be sourced for the main aim of expanding the company. It may also be needed for the acquisition of assets and expensive raw materials. Long term sources of finance provide the funds that may be used by an organization for a period usually exceeding 5 years. Sources of funds can also be internal or external.
Analysis of sources of funds
As stated projects exist in short-term, medium term and long-term projects, and so do the sources of funds. Examples of short-term funds include short-term bank loans, overdrafts, trade credit (invoice discounting and factoring) and bills of switch over. Short-term funds in most cases are used by companies to finance their short-term projects such as financing debtors and work in progress, maintaining stock.
An Overdraft financing facilities are availed to businesses when they make payments from their business current account in higher amounts more than the obtainable financial balance. They are commonly used by small and medium sized companies that may not qualify for a loan making it a flexible form of short-term funding. Advantages of using this type of financing includes the fact that interest is only paid on the amount withdrawn, arrangements for securing an overdraft is relatively easy and the flexibility of overdrafts. While disadvantages for this type of financing is the amount borrowed is payable on demand and the interest charged is high as compared to that of loans (Pandey, 2006).
Trade credit which encompass factoring and invoice discounting are methods of acquiring funds through the selling of debts (debtors and invoices respectively) to lenders in order to get quick funding worth a percentage of the amount owed. Invoice discounting is usually with recourse to the supplier if the customers fail to pay and collection of debts from customers is also by the supplier of the goods. In view of this charges are usually lower than factoring.
Advantages of trade credit include savings to the company in the form of reduced bad debt losses, salary costs, telephone and postages for administering debtors, the cash paid by the lender can help a company pay its suppliers and generally aid more profitable trading and growth, interest is calculated on the daily outstanding balance of the funds advanced, and the client’s invoices are the lender’s security; they usually do not impose financial ratio covenants as commercial banks. Disadvantages of trade credit are the cost/service charge is usually high especially if there are very many small value invoices or a lot of customer accounts or where the risk of default is high and the Factoring services may not be available to companies with very many small value transactions.
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Bills of exchange are legal documents that commit to the payment of a given sum of money at a specific time in the future. It involves three parties the supplier, the consumer and the lender. Advantages of bills of exchange are that all parties benefit from the transaction if the amount stated will finally be paid; i.e. the customer gets the goods he needs to buy, the seller records a sale while the lender has recourse to the seller. Another advantage is that the low interest rates and risks of default make this type of funding favourable to many companies.
Medium sources of capital include hire purchase and lease financing schemes. Hire purchase is an increasingly important source of finance for capital goods – plant & machinery, motor vehicles, tractors, and agricultural equipment. In this method, the Hire Purchase (HP) Company purchases the equipment that the borrowing firm needs from the seller. Once purchased the equipment belongs to the HP Company, who will then allow the hirer to use the equipment in return for regular payments (covering interest and principal). On the other hand the HP Company remains the legal owner of the equipment and hence can repossess it if the hirer defaults/fails to remit the regular payments. Hence the hirer will only get good title to the asset when he pays the final instalment (Besley 2005).
Advantages of HP are that the initial outlay is usually low, easy to arrange as it is done at the point of sale, source of finance cannot be withdrawn an the hirer gets to use the asset just after paying the first instalment. Disadvantages include the high charges on the instalments, and the title remains a property of the hirer and can be repossessed if the instalment payment is not is not honoured in full.
On the other hand, lease finance is a contract between the lesser (owner) and the lessee for a specified period. Usually the owner conveys rights to the use of the asset in return to regular payments. Disadvantages of this method of raising capital is that the method is risky if the owner does not agree to renew the lease after a period expires, in addition rental charges are high and the lessee may end up paying more tan the cost of the asset. Advantages of this type of financing is that the initial outlay is low, risks of obsolesces are low, the lessee has the right to cancel the lease, and lastly rentals are an allowable for taxation purposes.
Long term sources of funds include Ordinary Share Capital, Preference Share capital, retained earnings, debentures and sale and lease-back. Ordinary share capital involves the selling of the company’s shares to the public who become shareholders and hence can take management over the corporation through voting rights. Advantage of this to the company is that it has gives no responsibility to the company of clearing off the dividends, when the equity finances can be used lastingly to put into long-term investments with the high amount of capital made available to the firm. On the other side, disadvantages of OSC include the loss of control of the company by the entrepreneur(s), the high cost involved in the issuing of shares, the tax expenses charged on dividends payable and the long period it may take the Capital Markets Authority to approve the rights issue.
On the other hand preference share capital is contributed by preference shareholders due to the large amount of shares they contribute they in-turn get fixed amounts of dividend each year whether the company makes profit or not. The main advantage of this is that the payment of dividends is also optional and the preference shareholders don’t have voting rights. The disadvantage of this financing is the high cost of the issue and the dividends which are not tax deductible.
Retained earnings represent the profits which are not distributed, making this the cheapest way of raising funds in a company. This is because there is no cost involved in acquiring this fund, reducing shareholders tax liability which doesn’t affect control of the company. The only disadvantage is that retained earnings can only mean a reduction in dividends.
A debenture is the most secure type of bond and is usually secured by either a fixed or a floating charge against the firm’s assets. The advantage of this is that control of the company is not affected i.e. debenture holders have no voting power in the company. In addition, interest payment is a deductible expense for tax purposes and therefore reduces the overall cost of debt. Disadvantages include the interest on debt which is a fixed charge and must be paid whether the company makes a profit or not and the maturity date on debentures is also fixed. In addition having a fixed charge on a firm’s assets may limit its future flexibility in using its assets as it wishes e.g. the firm may not be able to sell a building without the consent of the lenders.
Management of sources of funds
Basically management of sources of funds falls under the Financing Decision and Investment decision roles of the finance manager. The investment decision will involve the finance manager making decisions on which assets to acquire, how much resources will be needed to be invested to produce a certain return. The financing decision will involve the making of decision on how much capital the company requires in order to be able to fund certain operations and projects, it is vital to consider the best mix of funding i.e. whether to use internal or external sources or long-term or short-term financing. In addition, in order to raise funds, knowledge is needed of financial markets and the way in which they operate (Besley, 2005).
While weighing the return versus the cost that will be incurred it is important to that interest is tax-deductible therefore increasing costs, in addition, effective interest rate is usually lower than nominal rate for example if it is assumed that the tax payable on business profits is at 25%, then for every pound the business pays it will get a tax saving of 25cts. This makes the effective rate of interest on a loan less than the nominal rate of interest and only effective to the level of tax rates. In addition, debt can increase return on equity by controlling profits. On the other side, sources such as equity have costs which include dividends that are not tax deductible making dept increase the returns on equity.
Risks are always high when the level of dept debt goes high. This also applies to the risks on financial distress. Repayment of debt is a fixed obligation and has to be honoured. It should also be remembered that above the interest being repaid, a debt would require the repayment of the Capital borrowed. Contrary, equity does not involve a fixed obligation as the owners are given the profits which depend on the availability.
It is important for a company to select a source of finance that matches with the requirements of the company. An overdraft facility is well flexible and provides credit when it is needed and payment is only up to the amount used. Flexibility of debt finance is subject to the finance need being matched to the most appropriate type of finance. Some finance products are also more flexible than others. Equity finance is a form of a flexible source of finance. Flexibility of a source of finance will largely depend on the company’s cash-flow, tax requirements and the length of the finance in relation to the project being financed.
It is essential that the finance management do accurate matching of the projects to the right types of financing. Management cannot possibly use long-term financing using a bank overdraft which is meant to counter short-term financial needs. Therefore, as a rule the method of finance should match the life of the asset being financed, for example, a finance scheme of ten years should match an asset with a useful life of the same number of years or slightly less (Grinblatt, 1997).
Companies, be they small medium or large have financial needs which include financing day-to-day operations and financing long-term growth. These factors are considered according to the company’s business plan which prioritises which projects are to be financed, what period of financing is the best for the project, and the methods for raising this cash. In addition the company will have to come up with the best strategy to combine the different types of financing in order to achieve the highest returns.
A good business plan intending to acquire an asset, start a project or expand a business relies heavily on a good financial mix. This includes proper matching of the activity being financed to the best type of finance. To get at this, aspects such as cost risk, flexibility, the financial position of the company, the effect on control and others have to be bared in mind. This because the requirements and choices for businesses are as varied as the businesses and one type of plan may not necessarily work for all companies.
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Further, the company’s finance management team must know the trade-off between the risk and the return attached to a mode of financing. In order to come up with the best method of financing projects, it is paramount that the department considers: the cost of the finance as compared to the returns, the risk involved in that type of financing, determine whether the method of financing will involve giving up of control of the company, the flexibility of the method of financing, the amount of retained earnings available in the company’s savings, and the business environment which the company operates in.
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- Besley, S & Brigham, EF (2005), Essentials of Managerial Finance, 13th Ed. Prentice Hall, New Jersey.
- Brealey, RA & Myers, C (2003), Principles of Corporate Finance. Columbus: McGraw- Hill.
- Grinblatt, M & Titman, S (1997), Financial Markets and Corporate Strategy, McGraw- Hill, Irwin.
- Pandey, I (2006), Financial Management, Vikas Publishing House, New Delhi India.
- Peter, F (1954), Application of Management, Row Printing Press, New York.