Sources of business finance can be classified into two major categories:
• Long term sources
• Short term sources
LONG-TERM SOURCES
These are sources which provide funds which can be used for a long period of time say more than three years. The sources include:
1. SHARE CAPITAL
Under share capital we have two classes of capital:
a. Ordinary share capital
This is capital contributed by the real owners of the company. It is a non-redeemable source of capital which forms a permanent source of capital for the company. The holders of these shares have the voting rights and they control the affairs of the company. However, the ordinary shareholders carry the greatest risk in that they are not secured against the assets of the company. In addition, they are paid last in case of winding up and they are the last to receive dividends after all the other shareholders have received theirs.
b. Preference share capital
This is capital contributed by the preference shareholders. They do not carry any voting rights and the holders do not have any control on the affairs of the company. They receive a preferential payment of fixed dividends from profits and in case of winding-up; they are paid first before the ordinary shareholders.
These shares may be of various types:
i. Cumulative – the shareholders receive full payment of their arrears before any other shareholders are paid.
ii. Non-cumulative – the shareholders only receive a fixed dividend when sufficient profits are available.
iii. Participating – the shareholders receive their fixed dividend and also participate in the surplus profits
together with the ordinary shareholders at a specific rate.
iv. Redeemable & Irredeemable – they can be redeemed at a specific date in the future and vice versa.
v. Convertible & Non-convertible – they can be converted into ordinary shares and vice versa.
2. DEBENTURES
A debenture is a written acknowledgement of a debt incurred by a limited company. Some interest is paid on the debentures to the debenture holders either annually or semi-annually. Debentures can have a floating charge on all the assets of the company or a fixed charge on specific assets of the company.
They are of various types:
i. Naked/Unsecured & secured – the first do not give any security while the second give security in terms of either a fixed or floating charge.
ii. Redeemable & Irredeemable – the first are redeemable at some specific time in the future while the second cannot be redeemed.
iii. Convertible – they can be converted into ordinary shares.
3. RETAINED EARNINGS
These are funds raised from the undistributed profits of the company. They are a cheap and easy method of raising capital for any company.
4. PROVISIONS
These can be classified into two:
a) Provisions for depreciation
Depreciation is charged to the statement of comprehensive income but it does not involve any cash payment. This leaves the company with money it can use in its expansion plans.
b) Provisions for taxation
Due to the time lag between the time the profits are made and the time tax is actually paid on those profits to the government, the company is able to use the tax funds to undertake its development plans.
5. MORTGAGES
Companies and partnerships can raise funds through getting loans by mortgaging their freehold properties with any mortgage broker or any other financial institution. In this case, the mortgagor deposits the title to the assets to the mortgagee and repays the loan through specific installment over a specific period of time.
6. SALE AND LEASE BACK
This is a situation whereby a company or a partnership which owns property sells the assets to an insurance company for immediate cash and then rents back the property. This is done as a result of lack of another viable option of raising capital for the company.
SHORT TERM SOURCES
These are sources of funds to be used for one to three years. They include:
1) BANK CREDIT
These are short-term loans offered by commercial banks to companies in terms of over-drafts. They carry comparatively high interest rates although they can be a source of funds in times of emergencies.
2) TRADE CREDIT
This involves the use of credit from suppliers as a source of finances. This acts as a source of credit for financing purchases as well as it is a use of funds to the extent that the firms finances credit sales to customers. Companies should ensure that their net credit i.e. the difference between credit purchases and sales is as large as possible.
3) BILLS OF EXCHANGE
A bill of exchange is an unconditional order in writing addressed by one person to another signed by the person giving it requiring the person to whom it is endorsed to pay on demand or at a fixed time a sum certain in money to or to the order of a specific person or bearer.
A trader can get a credit facility by signing a bill of exchange or; it can also be discounted with a commercial bank where the bank will pay the face value of the bill less discount charges and on maturity, it will be collected by the bank from the acceptor.
4) FACTORING
This involves selling debts for immediate cash to a factor who charges commission. When the factor receives each batch of invoices from his clients he pays about 80% of its value immediately.
The factor bears the loss in case the debtor defaults.
5) INVOICE DISCOUNTING
This is similar to factoring only that it is more of assigning the debts as opposed to selling them as is the case in factoring.
Invoice discounting is characterized by the fact that the lender not only has lien on the debts but also has recourse to the borrower (seller) if the firm or person that bought the goods does not pay. Invoice discounting firms act as agents of the seller.
6) HIRE PURCHASE
This is where the company buys its assets through installment paying after paying the deposit. It is a very common way of acquiring new assets for most firms.
7) LEASE FINANCE
This is a contract between the lessor and the lessee under which the owner gives the right to the lessee to use the specific asset for a given period of time against the payment of the lease rentals. They are of two types:
i. Operating lease
This is a contract which is for short period of time and can be cancelled at a short notice.
ii. Finance lease
This is a lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee. It is long-term and non-cancellable.
iii. Equipment lease
This involves obtaining equipment on lease hire basis for a given period of time against payments known as lease-hire charges.
8) ACCRUED EXPENSES
These are expenses which are still payable. The services obtained against the services of these outstanding expenses generate income which can be considered as short term source of finance.
• Long term sources
• Short term sources
LONG-TERM SOURCES
These are sources which provide funds which can be used for a long period of time say more than three years. The sources include:
1. SHARE CAPITAL
Under share capital we have two classes of capital:
a. Ordinary share capital
This is capital contributed by the real owners of the company. It is a non-redeemable source of capital which forms a permanent source of capital for the company. The holders of these shares have the voting rights and they control the affairs of the company. However, the ordinary shareholders carry the greatest risk in that they are not secured against the assets of the company. In addition, they are paid last in case of winding up and they are the last to receive dividends after all the other shareholders have received theirs.
b. Preference share capital
This is capital contributed by the preference shareholders. They do not carry any voting rights and the holders do not have any control on the affairs of the company. They receive a preferential payment of fixed dividends from profits and in case of winding-up; they are paid first before the ordinary shareholders.
These shares may be of various types:
i. Cumulative – the shareholders receive full payment of their arrears before any other shareholders are paid.
ii. Non-cumulative – the shareholders only receive a fixed dividend when sufficient profits are available.
iii. Participating – the shareholders receive their fixed dividend and also participate in the surplus profits
together with the ordinary shareholders at a specific rate.
iv. Redeemable & Irredeemable – they can be redeemed at a specific date in the future and vice versa.
v. Convertible & Non-convertible – they can be converted into ordinary shares and vice versa.
2. DEBENTURES
A debenture is a written acknowledgement of a debt incurred by a limited company. Some interest is paid on the debentures to the debenture holders either annually or semi-annually. Debentures can have a floating charge on all the assets of the company or a fixed charge on specific assets of the company.
They are of various types:
i. Naked/Unsecured & secured – the first do not give any security while the second give security in terms of either a fixed or floating charge.
ii. Redeemable & Irredeemable – the first are redeemable at some specific time in the future while the second cannot be redeemed.
iii. Convertible – they can be converted into ordinary shares.
3. RETAINED EARNINGS
These are funds raised from the undistributed profits of the company. They are a cheap and easy method of raising capital for any company.
4. PROVISIONS
These can be classified into two:
a) Provisions for depreciation
Depreciation is charged to the statement of comprehensive income but it does not involve any cash payment. This leaves the company with money it can use in its expansion plans.
b) Provisions for taxation
Due to the time lag between the time the profits are made and the time tax is actually paid on those profits to the government, the company is able to use the tax funds to undertake its development plans.
5. MORTGAGES
Companies and partnerships can raise funds through getting loans by mortgaging their freehold properties with any mortgage broker or any other financial institution. In this case, the mortgagor deposits the title to the assets to the mortgagee and repays the loan through specific installment over a specific period of time.
6. SALE AND LEASE BACK
This is a situation whereby a company or a partnership which owns property sells the assets to an insurance company for immediate cash and then rents back the property. This is done as a result of lack of another viable option of raising capital for the company.
SHORT TERM SOURCES
These are sources of funds to be used for one to three years. They include:
1) BANK CREDIT
These are short-term loans offered by commercial banks to companies in terms of over-drafts. They carry comparatively high interest rates although they can be a source of funds in times of emergencies.
2) TRADE CREDIT
This involves the use of credit from suppliers as a source of finances. This acts as a source of credit for financing purchases as well as it is a use of funds to the extent that the firms finances credit sales to customers. Companies should ensure that their net credit i.e. the difference between credit purchases and sales is as large as possible.
3) BILLS OF EXCHANGE
A bill of exchange is an unconditional order in writing addressed by one person to another signed by the person giving it requiring the person to whom it is endorsed to pay on demand or at a fixed time a sum certain in money to or to the order of a specific person or bearer.
A trader can get a credit facility by signing a bill of exchange or; it can also be discounted with a commercial bank where the bank will pay the face value of the bill less discount charges and on maturity, it will be collected by the bank from the acceptor.
4) FACTORING
This involves selling debts for immediate cash to a factor who charges commission. When the factor receives each batch of invoices from his clients he pays about 80% of its value immediately.
The factor bears the loss in case the debtor defaults.
5) INVOICE DISCOUNTING
This is similar to factoring only that it is more of assigning the debts as opposed to selling them as is the case in factoring.
Invoice discounting is characterized by the fact that the lender not only has lien on the debts but also has recourse to the borrower (seller) if the firm or person that bought the goods does not pay. Invoice discounting firms act as agents of the seller.
6) HIRE PURCHASE
This is where the company buys its assets through installment paying after paying the deposit. It is a very common way of acquiring new assets for most firms.
7) LEASE FINANCE
This is a contract between the lessor and the lessee under which the owner gives the right to the lessee to use the specific asset for a given period of time against the payment of the lease rentals. They are of two types:
i. Operating lease
This is a contract which is for short period of time and can be cancelled at a short notice.
ii. Finance lease
This is a lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee. It is long-term and non-cancellable.
iii. Equipment lease
This involves obtaining equipment on lease hire basis for a given period of time against payments known as lease-hire charges.
8) ACCRUED EXPENSES
These are expenses which are still payable. The services obtained against the services of these outstanding expenses generate income which can be considered as short term source of finance.
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