Finances are required for starting a business and for expansion and development of the business. Appropriate access to sources of finance for a business largely depends upon the type of requirements of the business. Businesses require finance for long term as well as for short term purposes. Sources of finance are internal as well as external of the business. The short term requirements of the business are normally for the working capital requirements of the business, and long term requirements are for financing the fixed assets that generate revenue for the business.
Working capital is represented by current assets that are financed through current liabilities. Lawrence J. Gitman (2006, 628) states that “current assets represent the portion of investment that circulates from one form to another in the ordinary conduct of business…. Current liabilities represent the firm’s short term financing, because they include all debts of the firm that come due (must be paid) in one year or less. These debts usually include amounts owed to suppliers (accounts payable), employees and governments (accruals), and bank (notes payable) among others.” That means basically the sources of short term finances of the entity are its current liabilities.
Two major sources of short term sources of these current liabilities are accounts payable and accrual, and are also called spontaneous liabilities as financing of these liabilities arises from the regular course of business. As per Fried, Shapiro and others (2007, p.1970) “Accounts Payable represents amounts owed to vendors and suppliers for services that have rendered or products that have been delivered.” Accounts payable are the results of regular transaction of purchases of merchandise or services for which the purchaser enjoy credit period to discharge the liability. The payment period of accounts payable normally depend upon cash conversion cycle, which is the period involved in en-cashing its accounts receivable. Accruals represents the current liabilities of services enjoyed by the entity e.g., wages of the workers, taxes payable to authorities. Wages are paid at the end of a period, say weekly or monthly, and till then funds required for wages are utilized to finance the current assets. Taxes are collected on behalf of authorities on regular basis, say sales tax; but those are required to be deposited after a period, say monthly, quarterly, or half yearly. The fund so collect on account of taxes are also used by entities for short term purposes, and thus collected taxes become internal source to finance current assets till those taxes are deposited. It may be noted that both accounts payable and accrual are completely unsecured sources of short term financing.
Line of credit and short term debts from commercial banks are also the major sources to finance current assets Credits are also provided by the banks in the shape of letter of credits, lease financing, bills discounting and others. Generally small loans from banks are approved on the basis of credit scores. As per Timmons and Spinelli, (2004, p 534).
“A Line of Credit is a formal and informal agreement between bank and a borrower concerning the maximum loan a bank will allow the borrower for one year period. Often the bank will charge a fee of a certain percent of the line of credit for a definite commitment to make the loan when requested.”
Another short term source of financing is Bill discounting. In the routine business a bill arises out of trade transaction. The seller of goods draws bill on the purchaser. The bill may be clean or documentary. A documentary bill is supported by a document or title of goods like bill of lading, air- way bill, and may be payable on demand or after a usance period. On acceptance of bill by the purchaser, the seller asks its bankers to discount the bill. When the bank discounts the bill it releases the funds to the seller after deducting charges.
Commercial paper is another short term financing source. Commercial paper can only be issued by those entities that have strong credit- worthiness. Normally commercial papers are issued for three months to six months period. They may also be issued for smaller period. The main attraction of commercial paper as short term financing source is that it offers an interest rate that is offered by treasury bills or certificate of deposit.
There are other short term sources as well like Floating lien (which is a loan from bank against a stable inventory); Trust receipts (generally financed by banks through manufacturers of expensive items like vehicles, industrial goods, and consumer durables), and Warehouse receipts (Inventory in warehouse can be used as collateral by placing the same under control of lender, say bank. Inventory is released only on approval of the lender)
Long term financing is required by the business to finance its fixed assets investments. There are four sources of long term financing, namely, long term debts, common stock, preferred stock, and retained earnings.
Common stock or equity financing represents the contribution of those investors who intend to undertake a stake in the ownership of the business. The equity holders have a residual claim to the income of the company. It is a permanent source without any repayment liability. It does not involve obligatory dividend payment. The most important feature of equities is that it forms the basis of further long term financing in the form of borrowings related to the creditworthiness of the entity. Raising equities finance is costlier because of cost of underwriting, brokerage and other issue expenses. It is believed that as a source of long term funding, equities are costlier but with less of risks. Further equities do not dilute control and put no restraint on managerial freedom.
Private equity and venture capital are also playing big role in long term or capital funding. As per a report submitted by EVCA (2001), “Private equity provides equity capital to enterprises not quoted on stock market. Private equity can be used to develop new products and technologies, to expand working capital, to make acquisitions, or to strengthen company’s balance sheet. Venture capital is a subset of private equity and refers to equity investments made for the launch, early development or expansion of a business.” This is an established fact the most long term assets are financed through equity contributions. The fundamental reason for the popularity of equity capital as compared to debt capital is that debts generate the risk of financial distress and bankruptcy.
Preference capital, on the other hand, is a hybrid form of financing. It carries fixed rate of interest, ranks higher than equity as claimant to income/ assets, does not have voting rights, and does not have a share in residual earnings/ assets. Preference dividend is cumulative. The weakness is that preference capital has fixed maturity. The benefit is that there is no legal obligation to pay preference dividend, and redemption can be delayed without significant legal hassels.It improves the net worth of the company and enhances its creditworthiness. In short it involves high cost of raising fund, does not dilute control, has negligible risk, and put no restraint on managerial freedom.
The easiest source of funding for an entity is its retained earnings. Retained earnings are always at disposal of company and do not have floating/ issue costs. There is no dilution of control. Its easy availability converts it into high cost source of financing when retained earnings are used for investments in unprofitable projects. One of the weaknesses of retained earning as a source of finance is that “retained earnings when used for long term needs reduces the current ratio of the company and thus adversely affect the liquidity of the company.”(R.Kannan, 2004).
Bonds (also called debentures) are issued by companies to raise long term debts. “A bond is a legal instrument that represents a formal promise to pay periodic interest on the principal and a specified principal amount at a specified date in the future. Bonds have different characteristics depending upon the character of issuing company, security, purpose of issue, payment of interest, and maturity of principal (term, callable, redeemable and convertible).” (Charles J. Woelful, 1993, p.39). Bond issue as a source of long term finance are advantageous because of lower cost due to lower risk and tax withholding of interest payments. There is no dilution of control as bonds do not carry voting rights. When a bond is sold for raising finance a trustee is appointed through a trust deed. It is a legal agreement between the issuing company and the trustee who is usually a financial institution/ bank/ insurance company/ firm of attorneys. The entity issuing bonds for long term financing has to be bound by restrictive covenants in the trust deed, legally enforceable contractual obligations in respect of interest payments and repayments of principal debt. It involves high risk and put some restraint on managerial freedom.
Comparing bonds with equities as source of long term financing, it is rightly said that “long term financing is a contingent on the ability of the firm to pay its creditors in the case of new bond issue and in the case of investors who buy stocks the concern is with the firm’s ability to generate future earning, which will be translated into dividends and capital appreciation. If a firm can demonstrate the ability to take advantage of growth opportunities, it has a better chance of selling its stock to investors.”(Angelico, Groppelli, and Nikbkhat, p.365).
References
Lawrence J. Gitman, Principles of Managerial Finance, Eleventh edition, published by Pearson Education, 2006, page 628.
Fried, Shapiro and others, Sport Finance, published by Human Kinetics, 2007, page 1970.
Timmons and Spinelli, New Venture Creation, published by McGraw Hill Professional, 2004, page 534.
European Venture Capital Association(EVCA), Private Equity Europe, 2001. Web.
R. Kannnan, Financial Analysis and Financial Tools, 2004, Web.
Charles J. Woelful, Financial Statement Analysis: The Investors Self Study Guide to Interpreting and Analyzing Financial Statements, 1993, page 39.
Angelico, Groppelli, and Nikbkhat, Finance, published by Barron’s Educational Series, 2000.