Sources of Finance
There are various sources of finance for business to get cash for both its short term and long term requirements. Each source is applicable in a certain situation and has its advantages and disadvantages.
Ordinary Shares
This requires issuing of new shares to raise funds in order to boost the capital of the business. According to Mott (2008: p.50), ordinary shares carry ordinary risk and are at times referred to as risk capital or equity due to the risk an investor has to endure. The advantage with ordinary shares to the business is that they don’t carry a fixed rate of dividend and therefore, when a business makes no profits, it will not need to pay any dividends unlike when financing through preference shares or debt. In addition, the capital raised is permanently and will not be reclaimed by the shareholders unless the company is winding up, and even then, the ordinary shareholders will be the last to be repaid.
The disadvantage of ordinary shares to the business is that, they tend to be a bit expensive because ordinary dividend is not a deductible expense, and also the floatation cost of shares is high. In addition, due to the voting rights associated with ordinary shares, the business may be in danger of losing control especially when one shareholder amasses majority control through secondary market (Stoltz and Viljoen, 2007: p.115). Ordinary shares are mostly suitable for long term capital requirements although short term requirements such as working capital needs may be applicable.
Preference Shares
Preference shares carry a fixed rate of dividend such that, any profit realized must first be apportioned to the preference shareholders. Another disadvantage to the business is the high cost of capital due to no deductibility of preference dividends when computing taxable income. However one advantage with preference shares is that, unless stated redeemable, they form a permanent capital source for the business. In addition, preference shareholders do not have voting rights and therefore can not seize control of the company. Preference shares are suitable for long term capital requirements.
Bonds/Debentures
These are long term sources of finance that allow the business to borrow from the public, a certain amount of money, with a certain fixed rate of interest being paid for a specified period of time, the maturity of which, the business pays the whole amount at face value. Debentures are beneficial to the business because the cost of debt is relatively lower due to tax deductibility of interest. In addition, cost of raising debt and the rate of return are relatively lower than for equity (Stoltz and Viljoen, 2007: p.117). However, they are relatively risky to the business as they are mostly being secured by business assets or may be redeemable within a specific period of time. Debentures are suitable for long term capital requirements
Overdraft
An Overdraft is a bank facility that allows a business to overdraw cash from its bank account, provided the amount overdrawn will be repaid within a short time together with interest. This source of fund is beneficial to the business because it can be accessed within a very short time and is useful to finance short term obligations including boosting the working capital although its rate of interest is high. Overdraft is suitable for short term capital requirements such as boosting the working capital
Trade Credit
This is an internal source of finance that allows a business to defer payment of goods/supplies to a later date. The business orders goods but pays for them within a reasonable time after they are delivered. This short term borrowing helps the business to solve liquidity problems. However, paying for goods early enough after receiving them boosts the relationship between the business and the suppliers (Sources of Finance, n.d). Trade credit is suitable for short term capital requirements, generally solving working capital problems.
Bank Loan
This is a bank facility that is advanced to the business to be repaid within a specific period of time at constant installments and at a certain rate of interest. The benefit of bank loan is that, the rate of interest is lower than that of overdraft, installments help in cash flow management and the business can borrow large amounts. However the disadvantage is that the business has to offer assets as collateral which may be repossessed if terms of repayment are breached. Bank loan is suitable for short term capital requirements.
Mortgage
This is a long term source of finance that allows the business to own premises by paying a certain amount as down-payment and the remaining amount being paid over a certain period of time usually more than ten years. The business benefits as it does not need to have a large cash outlay to acquire premises. Mortgage is suitable for long term capital requirements.
Venture Capital
This is a source of finance that allows a business (unquoted firm) to source funds mostly for start up capital or expansion capital from venture capital firms. The investor is offered shares for the amount of capital invested and is paid dividends based on the profitability and growth of the business/investment. The advantage to the business is that, the business can easily raise large and committed amounts from the venture capital firm without having to float shares in the market. The disadvantage is that, since venture capital is a high risk venture to the investor, the business has to pay a high rate of return to cover the risk involved. This system is suitable for long term capital requirements.
Leasing
This involves acquiring an asset and making use of it while paying rental amounts for a certain contractual period of time. The benefit of this arrangement is that, the business will derive income from the use of the leased asset without having to pay huge amounts to acquire it. However, the disadvantage is that, the asset’s ownership remains with the leaser. Leasing is suitable for long term capital requirements, especially when the business does not have cash to purchase the asset.
Hire Purchase
This is a source of finance that requires a business to possess an asset, and make use of it with an option to buy it at a slightly higher value than the cash price of the asset. The benefit of this source of finance is that the business will acquire possession of the asset without having to pay a large amount for it. It is also beneficial when the business has liquidity problem, yet it needs to invest in a certain asset. The disadvantage of this system is that the business is bound to loose both amount paid and the asset if it fails to pay the remaining amount according to the terms of agreement. Hire purchase is suitable for long term capital requirements.
Gearing
Gearing is a measure of level of leverage or capital mix between equity and debt in a capital structure of a firm. The capital structure the firm adopts should be able to maximize the value of the firm. Generally, leverage is measured using debt/equity ratio commonly termed as gearing ratio. Gearing may be low or high depending on how the firm happens to fund its activities. In most cases, the optimal gearing should be around 30% to 50% (Stoltz and Viljoen, 2007: p.217).
A high gearing means that the firm uses more debt than equity to fund its activities. Gearing will be termed to be high if it is 50% and above (Mott, 2008: p.198). For example, if the firm’s capital structure comprises 60% debt and 40% equity, it will be said to be highly geared. On the other hand, a low gearing means that the firm makes use of less debt compared to equity in funding its obligations. For instance, a 40% debt and 60% equity capital structure will be termed as low gearing.
There are advantages associated with both low and high gear. A high gearing has the advantage of reduced cost of capital, considering that cost of debt is relatively lower than cost of equity due to the element of tax shield to the firm. Another advantage is that the increase in earnings/profits before interest and tax (EBIT) results to more that proportionate increase in return to shareholders’ funds. For instance, doubling the profits before tax results to more than double in earnings attributable to shareholders due to the tax shied in interest expense (Mott, 2008: p.198). The disadvantage of high gearing is that, during the times poor performance, the firm becomes vulnerable as it must keep on repaying debt.
Advantage of low gearing is that, the firm will be relieved from risks associated with debt defaulting and repayments, as well as having to forego dividends in favor of interest payments especially when business is low. In addition, low gearing is mostly viewed as aiding in the firm’s strength as equity acts as a cushion. The disadvantage is that, the firm will have to grapple with high cost of capital, as weighted cost of capital increases as the firm increases the use of equity. In addition, the value of shareholders will not be maximized as there will be a foregone opportunity to increase dividends by a higher proportion when profits increase.
Work Cited
Barthwal, R. R. Industrial Economics: An Introductory Text Book. Illustrated. New Delhi. New Age International. 2000. Web.
Kochhar, Rahul and Hitt, Michael. Linking Corporate Strategy to Capital Structure: Diversification Strategy, Type and Source of Financing. Strategic Management Journal, Vol. 19, No. 6. pp. 601-610. John Wiley & Sons. 1998.
Mott, Graham. Accounting for Non-Accountants: A Manual for Managers and Students. Seventh Edition. London. Kogan Page Publishers. 2008.
“Sources of Finance.” Sources of Finance. N.d. Web.
Stoltz, A. and Viljoen, M. Financial management. Illustrated. Cape Town. Pearson South Africa, 2007. Web.