The success of any business venture can be attributed to the strength of its financial muscle. Businesses of all types and sizes certainly require funds in order for them to survive and be able to substantively grow and expand. For a business to thrive, it has to effectively compete in the market and even reach out to new untapped market.
In this paper, various sources of finance for a business are discussed extensively, elaborating on their nature and implications. The appropriate sources for finances are also explained with regards to different scenarios such as short/medium-term and long-term investments requiring massive capital inputs. In addition, an assessment and comparison of the costs of the different sources of finance is made. The importance of financial planning in a business is addressed tackling the information needs of the different decision makers and the impact a financial statement has on the finance for a business.
The Major Sources of Finance Available to a Business
There exist a vast number of sources for financing a business whether for the long-term or even for a short-term. These sources of finance are each unique in terms of their nature, the accompanied implications and prerequisites. They can be elaborated as follows:
This refers to a situation where a mutual agreement is reached between a business and a lending institution to offer an extension of credit even when the minimal account balance is exceeded. This enables the business to continue making withdrawals form their accounts while the lending financial institution usually charges a certain rate of interest on the overdraft amount.
The advantage of an overdraft is that it makes it possible for a business to overdraw from their bank accounts to fund their activities. It provides an efficient source of funds, as bank overdrafts can be arranged expediently, and they offer a considerable level of flexibility as far as the amount to be withdrawn is concerned.
Demerits of this source of funding is that bank overdrafts assume priority over all the other expenses that the business has to settle at the end of every month, or financial year, e.g. electricity and water bills, rent, wages etc. In addition, the rate of interest charged on overdrafts makes it a costly method of funding a business
This is a form of a loan that involves a written documentation detailing the issuance of the loan by a lender and the business making the borrowing. The documentation usually contains, in known and certain terms, the guidelines that are to be followed in repayment of the amount borrowed. This method of raising funds bears stark resemblance to government bonds, as they do not require to be secured by collateral. They are also different from incorporation, which involves stock issuance, in that the lender does not share in the ownership of the business. Some debentures may be offered with a floating rate of interest, which means that the rate can be adjusted by the lender as per the prevailing dictates of the market.
These are very similar to bank overdrafts, only that the incur higher interest rates.
Financial institutions, such as, banks readily grant business loans to companies that are venturing into other new markets, or growing in their capacity to provide a wider cope of goods and services. Loans usually attract a fixed interest rate and require a collateral to act as security against the amount borrowed.
Venture Capital Investment
Financial institutions known as venture capital firms usually offer this service. They offer loans to new businesses in their early-stages of growth, or to already existing ones businesses, which have demonstrated a high growth potential, seeking to expand.
The main advantage of venture capital investments is that they provide funds under circumstances that merit higher risks than banks would do. The only demerit is that these firms would almost always demand either a very high interest rate or a stake in the ownership of the business.
A number of countries provide a provision for issuance of grants to certain categories of businesses, which must be legitimate firms, showing a willingness to venture into markets that are in low-income and impoverished areas. These grants are usually to subsidize the cost of providing services or the manufacturing of the products in the said areas. They are offered as part of a government’s effort to stimulate economic growth in areas that have a high rate of unemployment.
However, grants are not easy to asses due to the high levels of bureaucracy that is associated with them. They also dictate that firms seeking for the grants should meet strict criteria and be willing to do business in unfavorable market niches.
This refers to a situation where a certain percentage of ownership of the business is sold to investors. These investors benefit by laying stake to a proportion, of the profits made by the firm. Entrepreneur owners seeking to finance their business using this method can choose to sell just an interest in their entire firm, or just in a new product range.
However, these investors may demand to have a stake in the decision making process after investing in your firm.
Sale of shares
This is another popular means of raising funds for a business. It entails the sale of units of ownership interest in a business to the public, so as to raise capital for a new business or an already existing business that seeks to expand.
Individuals or firms who have bought shares in a business are referred to as shareholders and these are not entitled to have any control, or influence whatsoever, in the operations of the firm.
In addition, there also do not stand to equally share profits or losses. Any profits made are distributed to each shareholder in the form of dividends at the end of each financial year. There are different types of shares that possess several implications to a business and these are as discussed below:
Also referred to as equity, these are only issued to the existing investors or proprietors of a firm. Ordinary shares a predetermined face value, which is largely influenced by the existing market dynamics. The disadvantage of this type of shares to the shareholders is that, unlike preference shares, ordinary shares do not warrant mandatory issuance of dividends at the end of every fiscal year. However, these are issued only if they are available. The advantage of this type of shares is that they give voting rights, equivalent to the number of shares held, to the shareholders.
Ordinary shares are advantageous to a business that seeks to raise capital as they are unsecured, implying that no collateral required.
Deferred ordinary shares
These are a type of ordinary shares that have terms and conditions attached to them. In this, only after a set target for profits is reached will the shares will be considered for the payment of dividends. Ordinary shareholders also enjoy privileged voting rights. Capital raised through this type of shares can be through shareholders either paying cash for the issuance of shares or ploughing back of the profits they get from the business in exchange for the shares.
The second alternative provides a much simpler and cost-effective means of obtaining financing for the expansion of a business. However, this method has a bottleneck in that it may not provide sufficient funds.
This is when a certain number of new shares are offered only to existing shareholders. This is a fairly easier way of raising funds for a business by encouraging the shareholders to generate new share capital through the remission of cash in exchange for shares. These are issued in a ratio that is directly proportional to their percentage of ownership in the business. The demerit for this method is that the firm offering a rights issue has to set a price that is as low as possible to attract the shareholders while avoiding a decrease in the earnings per share.
This type of shares come with a fixed percentage dividend that assumes priority of payment over the other types of shares that a listed company has. However, they can only be paid if the company made enough profits to warrant their payment. Unlike the case with debts, the payments of dividends are tax exempted.
These shares entitle the holders to preferential treatment in the payment of dividends, which is done at a fixed rate. In addition, they also have an attached rate of dividend, which is fixed, that must be paid before any dividends are paid to the other categories of shareholders.
For this type of shares to be attractive to the prospective investors, their payable amount of dividends should be higher. Preference shares tend to be less attractive to prospective investors because they are not securable against the company’s assets. This class of shares also has fixed levels of income and so even in the event that the business performance increases, the shareholders cannot benefit more.
Loan stock – this can be compared to debt capital that is acquired and paid over a long period. It attracts a certain fixed rate of interest, which is calculated particularly quarterly or half-yearly. The holders of loan stock in a company can be viewed as its long term creditors,
Loan stock is similar to ordinary shares in that they both have a predetermined face or nominal value. It is from this value that the amount of money payable to the holders, by the company, is determined by working out the amount of interest accrued on the loan stock.
Retained earnings – these are profits or dividends withheld by a business for the purposes of generating capital for growth and expansion of the business.
Leasing – is another cost-effective method of acquiring capital goods for the running of a business. This is a contract between a lessor, who is the owner of the capital assets, and the lessee. The later pays for use of the asset as stipulated in the terms of the lease, and this is only for a stipulated period of time after which the lease expires.
There are several benefits associated with use of leasing as a method of acquiring financing in business. To begin with, lease contracts offer security to the firm’s finances, in that the leased assets are still owned by the leasing company. They also do not require large initial capital outlays, as would the purchase of the assets. A business can obtain very expensive assets on lease and still maintain a steady flow of cash for running its day-to-day activities. Payment for lease rentals are recognized as deductable from tax as they are considered as part of the operating costs of the business. However, if the assets are leased over a long period, it becomes very expensive to the business. The cost of maintenance of the assets is also borne by the lessee, which implies a major financial burden on their part especially considering that they do not own the assets.
This is a form of making payments in installments and shares some many similarities with leasing. The only difference is that ownership of the assets is transferred to the business on payment of the final installment of the credit, but with a lease, the lessee never becomes the owner of the assets. It is however offers assets at a much higher price as compared to buying in cash.
Is an excellent method for expanding a business on an especially low budget. Conditions include that the franchisor pay for the cost architect’s work, establishment, legal, marketing, and other support services. In return, they charge the franchisee an initial franchise fee to compensate for the initial set-up costs.
The advantage here is that the franchisee gets ownership of a business for an agreed period. There is also the benefit of receiving the support of a large, well established, organization’s experience, and marketing effort. It also helps the franchisee get around common pitfalls that many new entrepreneurs have to go through.
Comparison of the costs of different sources of finance
The different sources of finance for a business come with varied levels of cost. When analyzing the cost of these sources, two factors are considered. These are namely the tangible and opportunity costs. Tangible costs of sources of finance include the dividends to be paid and even the rate of interest charged on the amount borrowed, as is the case with shares and loans respectively (Anon., 2009).
In comparing these sources, reference should be made to their nature and attached implications. According to their nature, financial sources can be divided into long-term and short-term source. Long-term sources include bank loans, equity shares, debentures, franchising and venture capital investments. Short-term sources include leasing, hire purchase and working capital stock control.
This includes means of acquiring funding such as bank loans. In this case, a company borrows money form a bank under the agreement of paying back the principal together with interest accrued, at a given rate, after a given period. This is very common with many start-up companies and it is also employed by existing ones to obtain long-term financing. The costs associated with this method include the high rates of interests that are charged by most banks, especially on large amounts borrowed over long periods. Again, borrowing is injurious to a company’s credit rating as the more the loans the less attractive the company is to a potential investor.
Lending is also another widely common means of businesses raising capital, which is payable for a short-term period, is through obtaining trade credit. This is a commonplace practice in business where items are purchased but the payment is made later. The supplier or lender usually allows the borrower or purchaser to obtain goods without paying cash. At the end of every month, the supplier then posts an invoice or statement that states the amount of money owed. The purchaser is then allowed to settle the amount over a certain period. The demerit here is that the
Most long-term sources offer reasonable and slightly lower financial costs as compared to the short/medium-term finance sources. This is attributable to the level of urgency that is attached to short-term sources. Long-term sources may also require security in the form of collaterals, and offer a fixed or floating interest rate of payment.
Issuances of shares, especially preference shares, represent means of raising huge amounts of capital. It is an appropriate financial source for long-term business projects, which require massive funding. A good example is during the expansion of the business to other markets, since this involves the acquisition of assets like warehouses, office-space, vehicles, plants, and machineries.
The benefits of issuance of preference shares by a business include the following:
- They are affordable, as they do not bring about a financial burden to the firm. Dividends on the shares are only paid when the firm has made sufficient profits to warrant their issue.
- Preference shares carry a fixed dividend value hence provide to the firm a source of fixed returns. As compared to ordinary or equity shares, the dividends payable for preference shares are usually lower.
- Preference shareholders are not entitled to voting rights, so their issuance does in no way lead to the dilution of the ownership of the business.
However, preference shares come with added costs which can be elaborated as follows:
A company has to pay higher rates of dividends on these shares than the interest payable on debentures. This makes them an expensive source of finance. Issuance of preference shares also adversely affects the credit-worthiness of a company which in turn discourages prospective investors from putting their money into the company in the future.
Compared to bonds and debentures, preference shares tend to be a slightly expensive source of finance. This is because the interest payable to both bonds and debentures is deducted from a company’s taxable income. However, the total amount paid, in the form of dividends to preference shareholders, is not usually deductable from the taxable income of a company.
This is also another viable source of long-term finance, usually for between 10 to as long as 30 years. These are provided by either a building society, or a financial institution, for the purpose of acquisition of a property. The security against which they are issued is the property. A business could make use of Commercial mortgages to acquire or expand their existing business premises.
Some mortgage firms do provide commercial mortgages for shorter periods of even less than 5 years. Commercial mortgages come with some extra costs, which include the following:
- The business that acquires a property using a mortgage is responsible for the insurance, maintenance, and security of the said property.
- In the event that the business goes under, the mortgage firm is allowed to repossess the property and this greatly reduces the net-worth of the affected business.
- To acquire a property using this method entails the making of regular deposits in the settlement of the mortgage agreement. This affects the cash flow in a business and this adverse effect is worsened in the case of a variable rate type of mortgages, as these are subject to adjustments in the interest rates.
Appropriate choices of finance for business projects
Settling on the most appropriate source of finance depends on the nature of the business activity. For instance, in the day-to-day operations of a business, one has to consider a reliable means of acquiring capital. Some of the easiest ways to obtain such capital is through leasing. This can be compared to renting and the most common capital goods leased include vehicles, furniture, production plants and machinery, computers and office equipment.
The two methods of leasing namely finance and operating leases. The benefit to the lessee is that it makes it possible for them to easily acquire very costly assets without actually purchasing them. It is a cheaper source of money, as opposed to getting a bank loan, since the cost of paying interest on loans may be higher than the cost of a financial lease (Anon, 1997).
A bank loan would be an appropriate option since this requires medium-term lending, Banks and other financial institutions provide medium term lending in the form of loans or overdrafts. This ensures that the amount required is obtained immediately and then repaid with a considerable degree of flexibility. These vehicle loans are usually payable over a period of spanning from three to ten years. Another common way of acquiring a vehicle for a business is through hire purchase. This has the advantage of availing the vehicle immediately, even before the final installment is made. However, the quoted price for hire purchase is usually a bit higher than that of buying the vehicle in cash. Ownership of the vehicle also remains in the hands of the dealer until the final payment is made.
To obtain capital for long-term, one can make use of finance leases, which are essentially commercial agreements governing the acquisition of assets. In this case, the motor vehicle dealer, the lessor, will supply a vehicle provided that a bank or any other financial institution agrees to provide financing to the lease agreement. Therefore, the bank will indirectly purchase the vehicle from the dealer and lease it out to the lessee, who then undertakes to pay for the amount over a period of time. On the other hand, the lessee obtains the vehicle from the dealer, and starts to make regular payments to the bank as agreed upon in the terms governing the lease.
Factory expansion, purchase of land or buildings
For this kind of business activities, which require massive investment, it is logical to consider the most cost-effective sources of finance. These are those offering a higher margin of capital over a long period. A good example is issuance of equity shares. This easily attracts a large number of investors seeking to lay stake in the business thereby generating huge amount of long-term funding. The main disadvantage is that there is a dilution of the ownership of the company as these shareholders would require voting rights (Madura, 2008, p. 500).
Another means of funding the expansion of a factory is through acquisition of government grants. Venture capital firms are also a good source of capital for expansion. They provide loans to already existing companies seeking to expand their operations. Unlike banks, these firms offer lending even in high-risk circumstances like expansion to overseas countries or the introduction of a new range of products. Their disadvantage is that they demand either a very high interest rate or a significant stake in the ownership of the business.
The importance of financial planning
Sound financial planning is a prerequisite for the success of any business venture. A financial plan can be equated too a budget for determining how to spend capital and make savings of the income earned in the near future. It specifically makes allocations for future income on the several types of expenses, e.g. salaries, wages, rent and bills. Another way of looking at it is comparing it to an investment plan, that is used to make provisions for the income, or savings acquired, to the various business ventures that are expected to generate income in the near future.
The significance of financial planning is that it creates awareness of what the current assets or resources a business posses. It also defines clearly the various financial goals that the firm aims to achieve in the future and then goes ahead to detail how to achieve them both effectively and efficiently. It provides a directives that govern how finances are to be spent by clearly stipulating what amount are to be allocated to the various expenses that a business has (Liraz, 2010).
Planning makes it easier to cope with the uncertainties of the market as provisions are made to address such issues as bad debts, miscellaneous expenses and other eventualities. Without prior planning these would spell doom for a business. These financial plans also lay down proper guidelines for the creation of wealth. They help in determining which investment decisions are appropriate, allocate sufficient resources and assets to facilitate optimal returns on investments, and also lay down strategies for the future.
In addition, a financial plan acts as a source of much needed motivation that drives the firm to outdo itself in meeting the set targets. It provides a sense of security to potential investors as they can see how their capital will be utilized to generate returns.
This is because a financial plan greatly affects the kind and level of funding that is necessary for establishing, maintaining, or even expanding a business venture
It is key in determining what inputs, capital assets and raw materials that should be acquired. It also defines the products to be produced, their marketing and distribution strategies. A financial plan also bears a profound effect on both the resources a business has, both human and physical, as it describes the type and quantity of each required resource for the actualization of the targeted profit margins.
In the process of financial planning, credible information is crucial if a sound plan is to be arrived at. This information acts to direct the whole process and it include the following:
- The basic common financial statements like a statement of retained earnings, balance sheet, statement of cash flows and an income statement.
- A break-even analysis, which states the levels of sales a new business has to make so as to start making profits.
- Pricing policies or formulas, these are important in the calculating the most profitable selling prices for both the products and services a business would provide.
- Cash flow statement (budget) serves to specify how cash is to be spend in the business.
- Ratio analysis, which acts essential as a means of drawing comparison between a business and other similar ones in the market.
- A pro forma statement of income, which aids in the determination of the anticipated future income for a business.
- Information on the types and possible sources of financing that are available to fund the business operations.
When all these pieces of information are factored during the drafting of a financial plan, a greater success rate of the business venture is assured.
Financial statement has a substantial impact on the finance of a business. This is because it determines the amount of financing the business can obtain, from prospective investors, to facilitate running of its operations. It also dictates how the funds will be allocated for use during the day-to-day running of the business. The financial statement also describes both the short-term and long-term plans that the business has.
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Madura, J. (2008). International Financial Management. OH, Cengage Learning. Web.