Discuss sources of finance in a business?
Introduction
The sources of financing a business or an enterprise are all those avenues that funding for a
business can be obtained from to finance a new project. Companies use the budgets to weigh the
cost implications of all the different sources of funds and their sole benefit to the business. Some
sources of financing are very suitable for short term financial periods while others are best for
long term periods. Large capital investments require longer financial periods while short term
financing are suitable for short term investments and in acquisition of revenue expenditure and
which are mostly repayable within the same financial year (Securities and Exchange
Commission, n, d).
The following are the sources of finance;
Before deciding on any suitable source of funds, the business manager must consider the cost
and the period of time that the funding is required. The cost of funding plays a critical role in
determining the kind of funding. The total funding required and the amount of risk involved in
the business or investment to be undertaken can also influence the source of funding that the
business would go for.
Short Term Internal Source Financing
Bank Overdrafts
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Bank overdrafts are short term loans that business men with current accounts qualify for. These
loans are advanced when requested for but their interest rates depend on the type of bank and the
amount required.
Retained Earnings
Retained earnings can be used as a source of funds depending on the amount of financing
required. Retained earnings are reserves that a business sets aside from the profits for future use.
These reserves can be used as a source of revenue. Retained earnings are retained in bank
accounts as reserves and they mostly influence the payment of dividend in a company. Retained
earnings are often utilized to finance new investments in most companies as they provide flexible
sources of funding with no conditions attached (FAO, Corporate Document Repository, n, d).
The major problem is that it reduces the reserves available to the business and it may also affect
the company’s policy on dividend payment.
External Sources of Funds
Loan Stock
This is a long-term debt capital that is raised by a company and it attracts the payment of
interests. Loan stock holders are mostly long-term company creditors (Gitman, 2000).
- Ordinary (equity) Shares
These shares are normally issued to the shareholders of the company. The nominal value of the
shares is mostly $1 or even $0.5.The market value of the shares are not related to the nominal
value of the shares. The only exception occurs when the shares are handed out for cash, then the
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price at which they were issued must be equal to the nominal value of the shares nominal value
(FAO Corporate Document Repository, n, d). The company can offer new ordinary shares to the
existing share holders or to new prospective investors. The following are ways of raising
financing through the issue of shares;
Deferred ordinary shares
These shares are issued to any investor who may be interested but they carry limited voting
rights and they are mostly limited to dividends only (FAO Corporate Document Repository, n,
d).
Rights issue
Rights issue is a process where a company sells its shares to the existing shareholders in
proportion to their holdings. For example, an offer maybe for one share for two held for all the
shareholders. However a company may decide to issue shares directly to the public to raise
financing plus also to float its shares on the stock exchange.
New Shares Issues
Another way that a company may raise some funds is through additional equity funds.
Unquoted company can be able to get a quotation from the stock market is through;
An offer for shares to be sold can be made in several ways through a prospective issue, a placing
or an introduction to the stock exchange (FAO Corporate Document Repository, n, d).
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An unquoted company can issue shares and then later sell them to the stock exchange in order to
raise money for the different purposes and also for the issued shares in the market to be
marketable.
Preference Shares
These are shares that have a right to a fixed rate of dividend before the ordinary shareholders are
paid for their dividends. Private companies and businesses use preferential shares to classify
different forms of ownership rights in the company. The rights of dividends to the owners of
preference shares are cumulative, for example, ordinary shareholders would not be entitled to
any dividends until all preference shareholders have been paid all their dues and arrears even if
it’s for a five year period or more. However, all the interest due on all the debentures and loans
must be paid when due and they are strictly not cumulative. Since all preference shares don’t
participating in voting activities, they mostly do not dilute the shareholders control in any
company. Unless the company’s preference shares are redeemable, the frequent issue of the
shares lowers the gearing ratio for the company as they are considered as debts for the business.
Loan Stock
Loan stock is a long-term debt capital that is raised by a business and it attracts the payment of
interests. Loan stock holders are mostly long-term business creditors. The interest is mostly paid
at a particular Coupon yield on the said amount.
For instance a business can issue 10% loan stock and where the coupon rate is 10% of the
nominal value hence some $1000 value of stock would earn an annual total interest of $100. But
the rate quoted is before taxes.
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Debentures
These are debentures that have coupon interest rates that the issuer can change in accordance to
the market interest rates. They are attractive mostly when the interest rates in the market are
volatile (FAO Corporate Document Repository, n, d).
Debentures: Fixed and floating charge security
Debentures and loan stock are mostly secured. When debentures are secured on particular assets
like on building, land or other assets then the asset would not be available for sale until the
charge is fully removed or transferred to another asset of equal value and the lender must be
consulted. Floating debentures are placed on general assets for example on debtors and company
stocks but the business is allowed to operate in the normal way. It’s even allowed to dispose the
general assets which have been secured on a floating charge unless the company has defaulted on
the payments (FAO Corporate Document Repository, n, d).
The major benefit of debt capital is that the interest rates chargeable are allowable and they
facilitate in reduction of taxes under corporation tax (FAO Corporate Document Repository, n,
d).
2). Profitability Ratios
These are ratios that indicate how profitable a business unit is. Profitability is a relative term and
it’s mostly equated or compared to the company’s competitors or to industry’s average ratio
rates. Profitability ratios indicate the rate of profit that a company is making compared to the
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industry’s average. The ratios also indicate whether the company’s market share is on the rise or
if it’s falling
The following ratios are used to indicate the profitability of a business.
a). The Net Profit Margin = Profit after taxes/sales.
A higher ratio indicates how profitable a company’s position is while a lower ratio shows a weak
company. However, some company’s prefer to invest their funds in investments hence retain low
levels of profit margins.
b). Return on Assets (ROA) = Profit after taxes/Total Assets
The returns on asset also reveal the rate of profitability of the company. The higher the ratio the
more profitable the company is.
c). Return on Equity (ROE) = Profit after taxes/shareholders equity
The returns on equity also reveal the rate of profitability of the company. The higher the ratio the
more profitable the company is. This ratio is more frequently used to reflect a company’s
financial position.
d). Earnings per common share (EPS) = profits after –Preferred dividend/(the number of
common shares outstanding.
This ratio is very critical to investors as it indicates the company’s ability to earn income for the
investor. A Company with higher rates of earnings per share have greater demand and their
shares are more expensive.
5). Payout Ratio = cash dividends/Net income
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The payout ratio is also critical for the investor as it reveals the rate of dividend payments
compared to the net income. The higher the rate the better it is for investors. However, a
company may be paying most of earnings as cash dividends at the expense of other investments
or the company maybe making less profit hence the ratio should be used in comparison to the
rate of profits the company is making.
3). Ratios that assesses how risky a business are;
Liquidity Ratios
Liquid assets are those assets that can be quickly converted to cash. Short term liquidity ratios
indicate a company’s ability to honor its short term commitments. A higher ratio indicates
greater financial liquidity and consequently lower risk susceptibility for the short term borrower
or lender. Most standard ratios are 2:1 for current ratios and 1:1 for quick ratios.
Higher liquidity reflects a financially sound company that cannot literally default on all its short
term commitments. However, maintaining large assets as cash collaterals may tied capital on
unproductive assets when investment on valuable projects would have generated far much more
income for the company. Cash generates no return if not invested but one can benefit in future if
the money is invested wisely. The following are the ratios for liquidity ratios.
The current and quick ratios are commonly used to assess the liquidity and riskiness of a
business. Current ratio is obtained by dividing the current assets with current liabilities while the
quick ratio is obtained by dividing the current asset less the closing stock and dividing the
balance by the current liabilities.
Leverage Ratios
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Leverage ratios reveal the rate at which a company relies on debt to finance its projects and
investments. If a company cannot pay its debts then it would mean that it would be declared
bankrupt. Such positions are very risky for any kind of business hence when the leverage ratios
reflect a negative trend for the business it indicates the nature of risk that the business is exposed
to. The following are the ratios that indicate the rate of leverage that a company posses.
a). Debt to Equity Ratio = Total Debt/Total Equity
This ratio indicates the company’s degree of leverage or the rate at which the business is relying
on external debts in its operations. The higher the ratio the more risky is the business. When the
debts of a company exceed its total equity, the company’s financial position would be threatened
as lack of funds to repay back the debts would mean the closure of business.
b). Debt to Asset Ratio = Total Debts/ Total Assets
This ratio also indicates the company’s degree of leverage. The higher the ratio the more risky is
the business. When the debts of a company exceeds the businesses total asset then the company
would not be in a position to repay back the debt as the total value of the assets are less than the
total debts owed. The risk of insolvency would be very high.
Most industry average indicates that the total debt of a company should not exceed 50% of either
its total assets value or its equity.
Interest Coverage Ratio = Earnings before Interest and Taxes/Annual Interest Expense.
This ratio indicates the company’s ability to pay its fixed interest rates using its current earnings.
A company with a very high margin would reflect a company that is more risky as it would mean
the ratio of interest payable are higher than the earnings of the company.
Conclusion
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Finally to conclude, the company can settle for a long term bank loan because of the large
financing required. A short term bank loan would be for a maximum period of three years but the
interest chargeable depends on the business credit worthiness and also the nature of risks that the
business is predisposed to. Long term loans have better payment terms and the interest rates are
not so high. The interest rates depend on the purpose of the loan, the duration, the amount
involved and whether there is security (Garber, C. (1997)
The major advantages of retained earnings is that the company retains total control of the
company unlike when new shares are offered and some form of ownership rights is also
surrendered. Retained earnings also have tax advantages when capital projects are involved
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References
FAO Corporate Document Repository (n, d) Basic Finance for marketers, ACP,
Wesley.
Garber, C. (1997) Private Investment as a Financing Source for Microcredit. The North-South
Center, University of Miami
Harrison, W.T. & Hongren, C.T., 2001, Financial accounting (4th Ed). Englewood Cliffs, NJ:
Prentice Hall.
Securities and Exchange Commission (n, d)
