This article throws light upon the top twenty sources of finance for a company. The sources are: 1. Preference Shares 2. Debentures 3. Ordinary Shares 4. Non-Voting Ordinary Shares 5. Redeemable Equity Shares 6. Stock 7. Retained Profits 8. Loan Capital 9. Sale and Lease Back 10. Equipment Leasing 11. Hire Purchase 12. Term Loans (Straight) 13. Term Loans 14. Cash Management and Few Others.
Source # 1. Preference Shares:
There are many varieties of these, each with differing rights and benefits. The holders of preference shares are usually entitled to a dividend at a fixed percentage out of profits in priority to any other class of shareholder and usually have preferential right to the return of their capital when a company is wound up. However, these shares rarely carry voting rights.
Source # 2. Debentures:
These are not shares in the company and therefore the holder to a debenture is not an owner of the company. Debentures are basically securities which have been issued by the company in consideration for a loan. They carry fixed interest rates and give no right to voting in company meeting. Since debenture holders are creditors of the company they rank with other creditors before shareholders in the assets of the wound-up company.
Source # 3. Ordinary Shares:
Holders of these shares have an equal right to share in the profits and the assets of a “wound up” company after prior claims of Preference shareholders and Debenture holders have been met. Normally these shares also carry voting rights. Whilst ordinary share capital tends to dominate the capital structure of the joint stock company the majority of companies in the U.K. have adopted other forms of capital.
The basic reason for this is that the ordinary shareholder whilst accepting the risks of a company failure desires the best return possible on his investment. If the company can borrow money from other sources at low interest rates, the difference between the return the company makes by using that money and the interest they have to pay to borrow it, adds to the profits of the ordinary shareholder.
Secondly, raising money by issuing securities which confer a variety of rights and benefits on the investor will widen the appeal of such securities and improve the revenue raising prospects of the company.
A brief sketch of some of these other securities and their characteristics follows:
The equity shareholders, a term which signifies their being entitled to the equity of the business, i.e., the profits and assets remaining after the prior claims of all fixed interest bearing stocks have been met, may rightly expect voting powers which give them some say in the running of the business, but by various methods they are sometimes divested of this.
Source # 4. Non-Voting Ordinary Shares:
The issue of non-voting shares is held by some to be justified in certain circumstances, for example where it is desired to retain control in the hands of the original shareholders. Capital transfer tax has caused problems in this respect when it has been necessary to sell certain shares in a company, and various schemes have been devised to overcome this; but if an issue of, say, one for one of non-voting shares is made, no disturbance of the original control need take place.
It is also maintained that necessary capital may be obtained without the risk of a take-over bid, as the controlling shares may be retained while no incentive is given to buy up the non-voting shares. A further justification for the issue of non-voting Ordinary shares is claimed in that the market for the company’s shares is widened.
It would seem that the objections raised outweigh the advantage claimed for such shares since they appear to be undemocratic, there being holders of equity share capital having to bear their shares of the risks but having little or no chance of exercising any power in the control of the company. Moreover, virtually complete control may be gained by a minority of the shareholders.
Source # 5. Redeemable Equity Shares:
Redeemable equity shares may be issued which must be cancelled on redemption. The rules as to their redemption is as for redeemable preference shares. These could be useful to a company which desires to obtain capital for a certain project or projects in which the shareholders may participate in the increased profits. When the projects have repaid themselves, the shares may be redeemed.
Although such shares may form only a small proportion of the total share capital they can prove very remunerative to the holders, as they may be entitled under the Articles to a very high rate of dividend. They may also confer the same voting rights as Ordinary shares or may be stated to be convertible to Ordinary shares after the lapse of a certain period.
Source # 6. Stock:
Fully paid shares may be converted into stock or stock units. Although stock may not be issued directly, it has the advantage of allowing transfer fractionally, whereas shares must always be transferred in whole units and consequently according to their numbers. Since stock is not numbered, a considerable saving in clerical work is afforded by its use.
Source # 7. Retained Profits:
In general, internal funds are a more important source of finance for small firms than for large, mainly because small firms are reluctant to seek finance from outside. Moreover smaller companies are not able to raise capital from outside sources easily. Nevertheless firms of all types and sizes plough back profits into the business. Prior to World War I the expansion of most firms came from retained profits.
Since that time the rapid rise in taxation and the rapid pace of inflation have combined to make it more difficult for firms to rely on this method. Today, although less important, it still must be considered as being very important. The term retained profits, as would be explained by an accountant, consists simply of the amount of net profit that has not been taken by taxation or used for the payment of dividends to shareholders. Ploughing back profits.
An efficient company will usually ensure that not all its profits are distributed and adequate funds are ploughed back into the business by creating reserves or sinking funds for such matters as replacement of assets or acquisition of new ones. Where reserves or sinking funds are set aside for specific purposes and not merely for strengthening the business as a whole, to ensure that such sums are available when required and to avoid their becoming absorbed in various assets of the business, they are usually invested outside the company and realised as and when required.
Source # 8. Loan Capital:
Where capital is required but not of a permanent nature, it may be obtained by borrowing either on long term loans or for more immediate repayment. The most important method of raising capital on a long term basis is by means of Debentures. A Debenture is a document given by a company in acknowledgement of a debt, undertaking to repay the stated sum on or before a certain date, and in the meantime to pay interest at a fixed rate, usually in half-yearly intervals.
(a) “Simple” or “Naked” Debentures:
Such Debentures offer no charge on the assets of the company as security for the loan and in the event of winding up, the holders of such Debentures rank pari passu with ordinary unsecured creditors and can claim no priority or repayment.
(b) Mortgage Debentures:
Debentures more usually give a charge over the assets of the company and in such a case are termed “Mortgage Debentures”. The charge may be a fixed charge, that is, on certain assets of the company, or a floating charge. Not infrequently a charge may be conferred on some specified assets of the company in the form of a fixed charge, and in addition a floating charge may be given on the whole of the company’s undertaking.
In the case of a fixed charge, the effect is to lease the property charged to the Debenture holders, so restricting the company’s right to deal in the property in any way until such time as the Debentures are redeemed.
Where a floating charge exists the property may be dealt with as if no such charge existed. If the company makes some default on a condition in the deed and action is taken by one or more of the Debenture holders to enforce the security, the charge crystallizes, or in other words becomes fixed on the assets as they then exist.
(c) Debenture Stock:
Debenture stock constitutes, as do Debentures, evidence of a debt, but instead of each lender holding a separate bond he has a certificate entitling him to a specified portion of one loan.
(d) Bearer Debentures:
Debentures payable to bearer are transferable by delivery and any bona-fide transferee for value becomes the legal owner of them. Debentures are frequently issued at a discount and may be redeemable at a premium.
Source # 9. Sale and Lease Back:
Some companies own their premises whereas others operate in rented property and buildings. The former organisations have the opportunity to use this method to obtain finance; the latter do not. The normal procedure is for the firm to sell their factory or other property, for example, a warehouse or retail outlet, to an organisation who would undertake to lease back the property to the seller for a long period of time.
The seller receives a sum of money which it intends to invest, and the purchaser receives the title to the property and a negotiated annual rental. The leases vary from a common period of 40 to 50 years and sometimes for much longer periods. Rents are reviewed and revised at intervals normally ranging from 5 to 7 years but usually never longer than 14 to 15 years.
For this method it is essential, from the purchaser’s point of view, that the property is an attractive investment. From the seller’s point it may be attractive because the rental may be lower than the interest they would have to pay had they raised their capital from a mortgage debenture.
If a company wishes to expand and to obtain immediate resources, this method of obtaining funds may be used, but it must always be borne in mind that the additional rental charges have to be met over a period of years when profits may fluctuate and the company’s own position, from the point of view of fixed assets, is not so strong.
Some basic advantages associated with this method are:
1. The method can be used to obtain funds for other investment opportunities. The argument used is that the properties sold under this method do not make profits for the firm; that it is the turnover of working assets that makes the profits. Thus the sale and leasing back of non-profitable property to invest in more working assets enhances the expansion and profits of the firm.
2. The firm is able to increase tax deductions and can, as a result, improve its cash flows.
3. It is possible to raise more funds from the sale of a specific property than it could through mortgaging the property.
The disadvantages are:
1. The flexibility of the firm can be reduced if the lease does not allow them to modify the property.
2. At the termination of the lease any residual value remains with the owner.
3. The rental paid is a fixed charge against income.
For more information on the various aspects of leasing refer to the section on equipment leasing.
Sources of Sale and Lease Back:
Insurance companies. Property investment companies, pension funds, Finance houses etc.
Source # 10. Equipment Leasing:
This method of obtaining finance is analogous to that of renting a property. The procedure employed is that the financial institution will purchase the asset desired by a customer from the supplier and then as the lessor (owner of the asset) will lease it to the customer (the lessee) in return for specified equal payments for a stated period of time. The initial lease is usually up to five years.
Source of equipment leasing:
Mainly from finance houses, specialist leasing companies, leasing departments or subsidiaries of manufacturers.
Source # 11. Hire Purchase:
Hire purchase is a method of obtaining finance from a financial company to purchase an equipment/machinery/vehicle etc., on medium length terms. The user can use the machinery without paying outright its price; rather he can earn out of the (use of) machinery and pay to the financial company in terms of hire purchase installments. The procedure for hire purchase is similar to equipment leasing.
The financial institution purchases the asset on behalf of the customer from the supplier (or dealer) and hires it to the customer. The finance provided is for a specified asset. A deposit is made by the customer and the balance due is spread by equal installments at specified dates over a fixed period of time usually up to 5 years (or more even). The reason for the longer period of time is that the working life of the asset is longer than usual.
The hire purchase company ensures itself security and reduces the risk it takes when entering into a hire purchase agreement by:
(i) Asking for a deposit, and
(ii) By shortening the period of time for repayments.
Upon satisfactory completion of the payments the hirer is given the option to purchase the asset for a small sum, and in the majority of cases this is done. It is this option to purchase which is the main difference between hire purchase and equipment leasing.
Small firms tend to hire purchase farm equipment, tractors, motor vehicles, machine tools, printing machines etc. The advantages of hire purchase are that (i) the customer has to make payments from revenue, it need not raise finance to purchase the asset (ii) the customer can conserve its financial resources, (iii) tax relief can be claimed in respect of annual (wear and tear) allowances, (iv) the hire has option to purchase the asset.
The disadvantages associated with hire purchase are that (i) a down payment is required (ii) the cost is considered to be expensive. For example, the flat (interest) rate may be, say, 15%, but the true rate may be almost twice this rate (iii) the hirer has to maintain asset in good order etc.
Sources of Hire Purchase:
Mainly from finance houses, specialist hire purchase companies. To a lesser extent from associates, subsidiaries and departments of clearing banks and merchant banks.
Source # 12. Term Loans (Straight):
A term loan refers to a method of lending whereby the lender advances a fixed sum of money at a fixed rate of interest to the customer and the sum is repaid by him by regular installments over a fixed period or paid in full at a given date.
Advantages of term loans as compared to Bank overdrafts:
(1) Term loans are not withdrawn because of changes on which the borrower has no control such as credit squeeze, (overdrafts can be withdrawn).
(2) Term loans are agreed to a fixed period and are not reduced. (Bankers can ask that overdrafts be paid on demand).
(3) Little time is taken to negotiate agreements, (overdrafts may require renegotiation every 3 to 6 months).
(4) Payments are made from revenue.
(5) Normally more money can be raised than by the overdraft method.
(6) Tends to be cheaper than hire purchase or equipment leasing from the financial (rather than servicing) point of view.
(7) Ownership of the asset can be immediate, as opposed to hire purchase and equipment leasing.
(8) The asset can be used as security for raising additional finance.
Disadvantages associated with term loan:
(1) They are not cheap. The longer the period the greater the risk to the lender and this is reflected in the interest rates charged.
(2) They are more difficult than overdrafts to borrow. Lenders require a higher standard of credit worthiness.
(3) Term loans must be repaid regardless of the firm’s business position.
(4) Repayments must be met on due date and thus lack the flexibility associated with overdrafts.
(5) Large repayments can create abnormal cash drain. Sources of term loans (straight)
Clearing banks, Merchant banks, Finance houses etc.
Source # 13. Term Loans (Others):
These loans are other than straight term loans. In most respects they take the same form as straight term loans but vary in that the terms and conditions of the loan are tailored to fit the particular circumstances of each case. Another difference is that the rates charged can change when they are reviewed every six months.
Sources of term loans (others)
Mainly secondary banks, for example, merchant banks.
Source # 14. Cash Management:
Cash is a commodity which businesses too often seek from external sources without first taking a closer look at home. Generally large companies have large cash resources and carefully manage their cash. Smaller companies are usually short of cash and generally are poor managers of their cash. There is a need for firms to improve their knowledge on cash collection and disbursement.
This requires a thorough examination of the company’s system of processing cash. Cash collection refers to ways of speeding up incoming cash and establishing procedures by which reductions in cost can be made. Getting invoices to customers as early as possible is one way to speed incoming cash. An invoice sent out early can result in cash being paid a day or more early and thus build up the cash available.
When measured over the year the total sum available can be quite considerable. Cash is in hand, discounts can be obtained/and less need to raise money from external sources are the results of the speed up in invoicing. Improvements in disbursing cash may also be possible. A cheque paid to your creditor may be delayed by a day or more without losing discounts or credit rating.
Or in drawing a cheque an analysis should be made on the time it takes to post it, the time it takes the post office to deliver it (the greater the distance the greater the time or the more obscure the location the greater the time?), the time taken by the creditor in handling the cheque before presentation to their bank and the time taken by the banks in clearing the cheque.
Perhaps 4, 5 or more days use of this money may be available to your firm, but accurate clearing times must be established. Positive cash management means cash is available for use by your firm where before it was considered that it did not exist; hidden cash. The use of this cash creates savings throughout the year; savings are greater the larger the number of times invoices are sent to your customers in the year; the same idea applies to cheques sent to your suppliers.
The result is that the minimum cash balance kept in your current account may not have to be as large as it was, and the amount of interest saved by not having to use external sources may be quite substantial. Positive cash management means that cash flows must be understood, cash and potential cash should be identified, and that cash should not be wasted, for example, holding unnecessary sums of cash in current accounts when it could be put to work and make money for the company.
Source # 15. Trade Credit:
Trade credit is a natural method of obtaining finance in that it arises from ordinary business transactions. Trade credit is an arrangement between a firm purchasing materials or supplies and its suppliers whereby the supplier delivers the goods and then agrees to defer payment of the debt. The supplier (creditor) shows this on his balance sheet in the form of a credit item whereas the receiver of the goods (debtor) will show it as a debit item on his balance sheet. It is quite normal for the deferment period to be around one month.
Nearly every firm receives credit from its supplier and most give credit to their customers. The exception to this statement is in non-manufacturing firms especially those in the cash retail trade. To small and large firms the use of trade credit is an important source of working capital, but the extent to which it is given is mainly determined by the industry and not the size of firm.
The importance of this method is that it is normally the largest single category of short term credit; even larger than Bank credit. Terms are usually arranged by the supplier to induce the customer to pay the debt before the due date. For example, a discount of 2% may be obtained if the debt is payable before 10 days, but between 11 and 30 days, the payment is net.
(1) Normally free from expenses (free of interest rate).
(2) Flexible, convenient and informal.
(3) Useful in promoting sales.
(4) Can, with wise use, promote sound customer relations.
(1) Can be risky method. Control of firm can be lost, if the debtor fails to pay large debt to a single supplier.
(2) Excessive credit given may force firm to borrow money.
(3) Every debtor is a potential source of loss of cash. Bad debts.
Source # 16. Credit Sale:
A credit sale refers to the method of selling whereby the customer agrees to purchase goods and pay by installments. Ownership of goods passes to the purchaser immediately. In the seller’s books the purchaser becomes an unsecured debtor. This method is similar to hire purchase but possibly not so expensive.
The similarity to hire purchase is that the goods are capital goods and the buyer enters into an agreement and agrees to pay off the debt in equal installments. It differs from hire purchase in that the length of credit time is normally from about 6 months to a year and ownership is immediate.
Source # 17. Bill Finance:
The term bill refers to a bill of exchange which is nothing more than a special form of cheque which has been postdated usually 90 days forward. On occasion it could be for 30 days or even 180 days. In law, a bill 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 addressed to pay on demand or at a fixed or determinate future time, a sum certain in money to or to the order of a specified person or to the bearer”.
Bills can be classified under two main headings (1) Trade bills (2) Bank bills The Trade bill relates to a bill drawn by a seller of goods (drawer) addressed to the buyer of goods (drawer) who, when receiving it, either writes across the face ‘accepted’ and signes it or pays a commission to a financial institution to accept it on his behalf. As soon as it has been accepted the person accepting it substitutes his credit for that of the drawer.
He accepts liability to pay the bill on the due date. The Bank bill refers to a bill drawn by a person seeking finance to purchase goods and expecting to pay the bill on the due date. Trade bills are not normally as acceptable for discounting as are bank bills.
Source # 18. Bank Credit:
Bank credit refers to overdrafts and short term bank loans. The source for bank credit are banks who rely for their funds largely from their depositors in the form of current and deposit accounts which can be withdrawn, respectively, on demand and very short notice.
An overdraft is an agreement made by a banker whereby the bank agrees to honour cheques drawn on a current account up to a stated sum when that account has insufficient funds to meet such cheques.
The rate of interest charged is on the amount of the total loan used. For most companies (and individuals) it is the easiest and most convenient form of borrowing, and for many small businessmen, it is the most important external source of finance outside their normal trading activities.
A loan for a short period of time is a method whereby the bank credits the customer’s current account with a deposit to a stated amount for a given period of time (as may be arranged) for example, a year, nine months or for a shorter period.
The rate of interest charged, unlike the rates charged on to overdrafts, is calculated on the total amount provided. Loans of this type are a cheap way of raising finance compared with many other methods, but, they are not as important nor so convenient (in terms of interest payments) as overdrafts.
Source # 19. Factoring:
Factoring refers to the purchase of a firm’s book debts by a factor. The factor which is a specialised type of privately owned finance company that purchases accounts receivables, receives payments directly from the buyer of goods, quite unlike invoice discounting.
The only common element between factoring and invoice discounting is that they both are involved in the purchase of book debts.
Basically, there are two types of factoring:
(i) Without Recourse:
A method whereby the factor has no claim on his client, the seller of the receivables, should the factor not be able to obtain payment from the customer. Most factoring is of this type.
(ii) With Recourse:
A method whereby the factor can claim payment from his client should the customer, who owes the debt, not pay. The factoring company combines book-keeping, credit insurance and the supply of finance; the latter being the main function.
(i) Funds can be obtained almost immediately. Liabilities can be paid and cash accumulated.
(ii) Debts can be paid promptly for the best possible cash discounts.
(iii) The problem of the client’s creditors urging debts be paid soonest are removed.
(iv) The clients’ credit image is improved.
(i) A restrictive method for most small firms.
(ii) Arrangements are for an extended period and not for 2 or 3 months duration.
(iii) The client uses a highly liquid asset as security.
(iv) When invoices are large in number the administrative costs may be high.
(v) A great deal of confidential business information is passed on to the factor.
Source # 20. Invoice Discounting:
Also known as confidential invoice discounting, because the discount firm makes no notification to the buyer of goods that the seller of the goods has borrowed money against their debt. The discount firm has no contact with the buyer; the seller collects the debt and it is the seller the discount firm goes to, to collect the face value of the debt.
Borrowing against receivables or book debt may be the answer for a company that is really in need of cash or for a company who has considerable amount of working capital tied up in receivables. It is considered to be very expensive, so companies are often advised to exhaust other possible sources of finance first.
(1) Same as (i) to (iv) as mentioned under factoring.
(2) The client’s debtors are not informed of the financial arrangement.
(3) It is flexible in that the client can discount his debts, up to an agreed limit, as and when he desires.