Source of finance

Table of Contents

Sources of finance. 2

• Borrowing from financial Institutions

1. Short Term
2. Long Term Loans

• Borrowing from Public

1. Deferred Ordinary Shares
2. New Shares Issue
3. Rights Issue
4. Preference Shares

• Borrowing from directors (Increasing Capital In house)

1. Loan Stock
2. Grants
3. Ventures
4. Franchising

• Importance of Financial Planning
• Financial decisions
• Conclusion
• References

Sources of finance

Enhancing capital to grow is a requirement for every business. In any shape form or size companies or business entities are always trying to generate capital to increase their finances so as to implement their ideas for generating profit.

Acquiring finance for a business may have numerous reasons which range from buying a new business venue, developing a new product or launch, research into other areas of business or just getting better equipped or the future.

Finance can be acquired from a lot of places. The type and modality of the finance acquired also governs it presence on the balance sheet as well as the pay-back terms and agreements. Basically a finance injected into a company can be divided into 3 types.

§  Borrowing from financial Institutions.

§  Borrowing from Public.

§  Borrowing from Directors.

§  Loan Stocks

§  Grants.

§  Ventures.

§  Franchising

§  Earnings of Previous Years.

All of these finances are considered as liabilities to the organization. [1]

Borrowing from financial Institutions

With regards to the borrowing from the banks there are 2 types of loans that can be taken which are short term and long term.

Short Term

A Short term liability is a one that ranges from 1 day to a total of 3 years. These short term loans are considered the most expensive modes of financing available. The total amount of short term loan taken by a company should not be more than the total amount earned the previous year. This may comprise of running finances, also known as overdraft, which may be feasible for the operating capital, the hire purchase agreement which may be feasible for the period of a single tender or a consignment that needs to be shipped. A bank loan is in most cases provided against the cash flow of the business. This also requires the borrowing company to look into its monthly earnings post current expenses, for one of the most significant aspect of a banked finance is that markup needs to be furbished on a quarterly or monthly basis. This interest should not be more than 20% of the net monthly earnings or else the profit would shrink and would be eaten up mostly by debt servicing.

Long Term Loans

Long Term loans are loans given to a business for a period of more than 3 years up to 10 years. The principal is paid after the end of the tenure and over a span of more than 5 years. This sort of capital is the most costly source of finance. Projects are financed over the period of 10 years.

Borrowing from Public

When borrowing from the banks we are actually relying on a single source or entity which in time may have a change of policy or heart and dismiss the whole idea of finance and hence may become impossible for the organization to fulfill its demands. Hence a better yet complicated method is to borrow it from the public. This source of borrowing is known as Ordinary Shares. The ordinary shares are of the face value and are not connected to the market value. Some of the methods are:

Ø  Deferred Ordinary Shares.

Ø  New Shares Issue.

Ø  Rights Issue.

Ø  Preference Shares. [1]

 Deferred Ordinary Shares

As the meaning of deferred goes it means delayed. Hence the owner of those shares although has the power of ownership yet the right to vote or the right to dividend or the right to sell may be deferred from them for a period no less than 6 months. These types of shares are basically provided to current share holders via pro-rata or if new are provided the circumstances differ.

New Shares Issue

Any company seeking to secure finance from the public for the first time has to issue new shares to the public. The method of issuing new shares is mostly followed by companies who are not listed on the stock exchange and want to grow at very large scale. Although this is not only for new public companies as there have been cases where while requiring finance the company already public issued fresh shares of the company and issued it for PO (Public Offering). They are also provided on the face value.

Rights Issue

This issue is provided only to the existing share holders where the company after performing the necessary schematics and calculations would invite the current share holders to get a new share for every number of shares they already have. This although is the safest of them all as the ownership and the cost of issue is limited to only the current share holders. Yet in hind sight improper planning and structure may lead to extreme dilution of EPS (Earnings per Share).

Preference Shares

These shares are like deferred shares but as in deferred share a timeline has to be appointed, this share has not time bound restrictions. Secondly they have a fixed percentage of profit which is to be paid if the company earns a profit. An organization offering preference shares has a lot of advantages as the dividend is not required to be paid in the year of the issue. They do not contain voting right hence the control of the organization remains intact. The issuance of these shares does not inhibit the borrowing power of the organization though other means as they are not secured against any asset in the business. Yet in hindsight they have a huge impact on the tax deduction. Just as interest payment on debt is not tax deductable from income the same is with the preference shares as fixed dividend is paid over time.

Borrowing from directors (Increasing Capital In house)

In case of an organization where the shares are not offered to the public the capital is increased in the same manner as it was initially started. The current directors are given more shares and against the share capital they invest in the company. This form of investment is highly secure and requires the least documentation. Although the decision to enhance the capital differs as some privately owned companies do not try to enhance their shares yet they increase the price of each share so as to maintain the earning per share.

Loan Stock

Loan Stock or term finance certificates are stock options given by an organization to selected group of investors who wish to attach their finances on a long term basis. A long term finance certificate is usually issued by the government for it to get finance to run a country. Yet TFC are also issued by large scale organizations so that they will have huge amount of finances for a longer period and will have to pay quiet less interest. The interest paid by the company in case of a loan stock is much less than the amount of interest it will have to pay in case of a loan taken from a financial institution over the same span of time. The TFCs are also secured against an asset of an organization which for that time cannot be sold or changed without the proper consent of the lenders. Although in case of a government organization is issuing a TFC it is backed by the government hence it at times does not require a lot of assets as collateral.

Grants

They are funds usually disbursed by the government to some individual or an entity to successfully complete the task which the grant makers consider very important. The grants given by the government often require a lot of scrutiny but on the other hand the grant most of the time is not meant to be paid back and hence no liability incurs on the receiver. Yet the desired results are required by the grant makers and also would want to receiver to of tax free status hence it is mostly distributed in non-profit organizations.

Ventures

Finance put into the organization by another person who also requires a stake and ownership of the said company. Joint Ventures of 2 or more organizations to launch a project which is going to be the joint ownership till the end are known as partnerships. But there are also organizations who for a selected time frame or five to seven till the completion of one of the selected project which the lending company or individual considers would help him in earning more and also see that his interest are at a high priority he would consider such an option. Usually for that time frame the lending organization also appoints a member in the board of directors so as to see whether the venture that has been created by the institutional financing can be successful. A venture capitalist would also give a time frame as to when they would want their finances to be redeemed along-with the applicable profits.

Franchising

A method utilized when there is less capital than required to expand the business. This way the capital in not increased but at a fee from the franchisee, the franchiser develops the area of operation and also provides the necessary expertise to run the site. Then after which the franchiser asks for a payment at regular intervals as a proceeds of sales. This process is highly appreciated as it curtails the cost of opening a branch along-with it also provides a stake of the owner in the business. The nature of the business also dictates the franchising of a product. Commodities or services rendered can be franchised yet some services that require a lot of control as adjudicated by the government cannot be franchised. The business model is good both for the franchisor and the franchisee as the franchiser would have generated business without the input of a lot of capital and the administrative hassles. Whereas the franchisee would attain a sound and marketed business with the teething phase of starting the business already in the past.

Importance of Financial Planning

Whilst running any business the basic idea is to earn money. In order to understand the total amount of money earned one also has to understand the total amount of money they spend and save. Hence to plan first as to what the person is going to use and spend is one of the most basic and important ideas of running a business.

The start of any year at hand is from the money that we currently have and the money that we will get during the year. Now we also set a baseline of the profit that we must achieve which becomes our target. Hence with the target in hand and the total amount of finance to be generated in the year and the total amount present at hand currently we start our budgeting for the year. This financial planning requires that we put aside the capital expenditures for the year first and then move towards the operating expenses. These operating expenses are very important as any disparity in the forecast may lead to dreadful results. We perform financial planning for the following reasons

Ø  [2]To efficiently manage income.

Ø  To increase cash flow and also monitors the spending and expenses.

Ø  To develop a strong capital base so as to have a stable and long term future.

Ø  To properly identify proper and good avenues of investment for sustained growth and development.

Ø  To Increase asset accumulation and minimizing liabilities hence increasing the capital and keep the company strong and efficiently run financially. [2]

Financial decisions

An example of the following budget is taken which if seen closely is a budget for a very small organization which is running on its own income. They do not require any finances of any kind yet in a few years time the sustained growth would take it to be a million dollar company when it would require a different type of attitude and a very different approach.

Operating	Budget	Actual Expense in 2010	Difference ($)	Difference (%)
Advertising	15,000.00	10,000.00	5,000.00	33.33%
Bad debts	1,800.00	1,500.00	300.00	16.67%
Cash discounts	2,800.00	2,500.00	300.00	10.71%
Delivery costs	1,500.00	1,000.00	500.00	33.33%
Depreciation	1,400.00	1,250.00	150.00	10.71%
Dues and subscriptions	130.00	120.00	10.00	7.69%
Employee benefits	8,500.00	7,500.00	1,000.00	11.76%
Insurance	1,500.00	1,400.00	100.00	6.67%
Interest	1,000.00	1,000.00	0.00	0.00%
Legal and auditing	450.00	400.00	50.00	11.11%
Maintenance and repairs	700.00	595.00	105.00	15.00%
Office supplies	1,100.00	1,050.00	50.00	4.55%
Postage	100.00	100.00	0.00	0.00%
Rent or mortgage	13,000.00	12,000.00	1,000.00	7.69%
Sales expenses	12,000.00	10,000.00	2,000.00	16.67%
Shipping and storage	7,500.00	6,700.00	800.00	10.67%
Supplies	250.00	180.00	70.00	28.00%
Taxes	8,000.00	6,650.00	1,350.00	16.88%
Telephone	700.00	650.00	50.00	7.14%
Utilities	1,800.00	1,500.00	300.00	16.67%
Other	1,300.00	1,000.00	300.00	23.08%
Cost of Products	200,000.00	150,000.00	50,000.00	25.00%
Total  Expenses	Budget	Actual	Difference ($)	Difference (%)
	280,530.00	217,095.00	13,435.00	4.79%
Operations	Targeted	Actual Income in 2010	Difference ($)	Difference (%)
Sale of New Products	335,000.00	255,000.00	80,000.00	23.88%
Repairs & Workshop	95,000.00	75,000.00	20,000.00	21.05%
Parts and Pieces	40,000.00	35,000.00	5,000.00	12.50%
Total Income	Targeted	Actual Income in 2010	Difference ($)	Difference (%)
	470,000.00	365,000.00	105,000.00	22.34%
Net Income	189,470.00	147,905.00	41,565.00	21.94%
Total Shares	11,000.00	10,000.00	1,000.00	9.09%
EPS (Earning Per Share)	17.22	14.79	2.43	14.13%

As evident from the financials of this company this needs no extra finances for the next year to run as they have earned enough in the previous year to fulfill their budgeting requirements. But what is interesting to note is that they do not have a large base of owners. Considered as a close knit business where the shares are distributed among the directors of the company. For the purpose of enhancing their base of operations and going to increase their capital hence to increase their earnings from a mere 200K to more than millions a lot of planning would be required.

Seemingly looking at the financials their net income from the previous year is almost 60% more than their income, whereas the Earning per share is almost 15 dollars. In-order to expand their business they can arrange about 5 dollars per share meaning there by 50,000 dollars. This can be used to buy more items which can be sold off with the next year’s sales. This method would lead to the company to a million dollar enterprise slowly and steadily in 7 years time. With every passing year the organization can increase their re-investments with just only 10 dollars per share as income and keep re-investing the rest.

A very straight forward and simple method yet it would take a lot of time and a span which can also change the course of the economic situation of the country hence the method may lead to sustained growth but with a very long time.

Where in case they would take a loan against their cash flows and their assets or even their income it would provide them with a good advantage to half their progress time yet for the first 5 years of that progress it would be more break even than any profit.

If the company goes public after the first 5 years with good prospects of it would be considered as the best strategy with the finances coming in by going public they could pay back any loans that they might have taken and then all of the interest that is being paid monthly would go into the income. Interest plays a very strong role in stopping the growth of the company as more the interest the more is the possibility of them being tied down by the sheer weight of their creditors.

Conclusion

The importance of any financial decision and the importance of financial analysis can be seen as a very important aspect of the business as those are the decisions that would make them a high yielding organization. With better financial planning we can have better decisions for our business.

References

1.       Financial resources by the Food & Agricultural Organization of UN.

Accessed on Wednesday 22 June 2011.

Available from:

http://www.fao.org/docrep/W4343E/w4343e08.htm

2.       Financial Planning by Michael Toten Chapter 1 Why financial Planning? Page 7.

3.       Gikas A. Hardouvelis & Panayiotis Theodossiou, 2002, “The Asymmetric Relation Between Initial Margin Requiremnts and Stock market Volatility Across Bull and Bear Markets”, The Review of Financial Studies, V 15, No 5, pp 1525 [electronic].

Accessed on June 22, 2011

Available from:

http://www.jstor.org/stable/1262663        

4.       Sources of Finance. (n.d.).

Retrieved on 06/ 22/ 2011

Available at :http://www.teachnet-uk.org.uk/2007%20Projects/Biz-GCSE%20Finance/sources/index.htm