The Sources of Finance Available to a Business Free Essay Example

Describe the main sources of finance available to companies. Evaluate the advantages and disadvantages of raising finance via equity or via debt.

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The main sources of finance available to companies are as follows:

• Equity Capital – Equity Capital means that the part of the organizations capital, which is raised n exchange for the share of ownership n the company. These shares are called equity shares. Equity shareholders are the risk bearers of the company due to their fluctuating earnings. They also enjoy higher rate of earnings or returns due to higher risks.

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  Equity shareholders also have voting rights.

• Issue of debentures- Debenture holders are the creditors of the company and debenture represents the loan capital of a company. Debentures carry a fixed rate of interest. There are various types of debentures such as redeemable, irredeemable, convertible, non-convertible, secured, non-secured etc.
• Retained Earnings- Many companies use retained earnings to finance its new investments because retained earnings are a source of fund which does not lead to the payment of cash and t can be undertaken without any involvement of the shareholders or any outsiders.

  A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for re-investing. At the same time, a company that is looking for extra funds will not be expected by investors (such as banks) to pay generous dividends, nor over-generous salaries to owner-directors.

• Loan-stock- Loan stock is long-term debt capital which is raised by a company for which interest is paid, usually half yearly and at a fixed rate.

  Holders of loan stock are therefore called long-term creditors of the company. Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at a stated “coupon yield” on this amount. For example, if a company issues 10% loan stocky the coupon yield will be 10% of the nominal value of the stock, so that $100 of stock will receive $10 interest each year. The rate quoted is the gross rate, before tax.

• Bank lending- Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium-term lending is quite common these days.
  Short term lending may be in the form of:

1. An overdraft, which a company should keep within a limit set by the bank. Interest is charged on the amount overdrawn by the company daily.
2. A short-term loan, for up to three years.

• Medium-term loans are loans for a period of from three to ten years. The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and riskiness of the borrower. A loan may have a fixed rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted every three, six, nine or twelve months in line with recent movements in the Base Lending Rate.
• Government assistance- The government provides finance to companies in cash grants and other forms of direct assistance, as part of its policy of helping to develop the national economy, especially in high technology industries and in areas of high unemployment. For example, the Indigenous Business Development Corporation of Zimbabwe (IBDC) was set up by the government to assist small indigenous businesses in that country.
• Venture capital- Venture capital is type of money put into an enterprise/company which may all be lost if the enterprise fails. A businessman starting up a new business will invest venture capital of his own, but he will probably need extra funding from a source other than his own pocket. However, the term ‘venture capital’ is more specifically associated with putting money, usually in return for an equity stake, into a new business, a management buy-out or a major expansion scheme. The institution that puts in the money recognises the gamble inherent in the funding. There is a serious risk of losing the entire investment, and it might take a long time before any profits and returns materialise. But there is also the prospect of very high profits and a substantial return on the investment. A venture capitalist will require a high expected rate of return on investments, which will compensate for the high risk.

Advantages and disadvantages of raising finance via debt

Advantages

• Maintain ownership: You become obligated to make the agreed-upon payments on time when you borrow from the bank or another lender, but that’s the end of your obligation. You retain the right to run your business however you choose without outside interference.
• Tax deductions: This is a huge attraction for debt financing. In most cases, the principal and interest payments on a business loan are classified as business expenses, and they can, therefore, be deducted from your business’s income at tax time. It helps to think of the government as a “partner” in your business in this case, with a 30% ownership stake or whatever your business tax rate is.
• Lower interest rate: Analyze the impact of tax deductions on the bank interest rate. If the bank is charging you 10% for your loan and the government taxes you at 30%, there’s an advantage to taking a loan you can deduct.

Drawbacks

• Repayment: Your sole obligation to the lender is to make your payments, but you’ll still have to make those payments even if your business fails. And your lenders will have a claim for repayment before any equity investors if you’re forced into bankruptcy.
  • High rates: Even after calculating the discounted interest rate from your tax deductions, you might still be faced with a high-interest rate because these will vary with macroeconomic conditions, your history with the banks, your business credit rating and your personal credit history.
  • Impacts on your credit rating: It might seem attractive to keep bringing on debt when your firm needs money, a practice knowing as “levering up,” but each loan will be noted on your credit report and will affect your credit rating. The more you borrow, the higher the risk becomes to the lender so you’ll pay a higher interest rate on each subsequent loan.
  • Cash and collateral: Even if you plan to use the loan to invest in an important asset, you’ll have to be sure that your business will generate sufficient cash flow by the time repayment of the loan is scheduled to begin. You’ll also most likely be asked to put up collateral to protect the lender in the event that you default on your payments.

Conclusion

Finance is required by any company to establish and run its operations is known as company finance. No business/company can function without an adequate amount of funds for undertaking various activities. The funds are required for running day-to-day operations (working capital requirement), and for undertaking growth and expansion plans in a company.