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Sources of Finance
We have seen that one of the tasks of the Financial Manager is to raise funds for the business, using the type most appropriate in the circumstances, or the best mix of funds.
The total amount of capital required by a business should be sufficient to pay for the fixed assets and to provide adequate working capital. There is long-term and short-ormedium term capital. What should be the proportion between these different types of capital?
It is generally accepted that in normal circumstances long-term sources of capital (ownersâ€™ equity + long-term loans) should exceed long-term capital uses (fixed assets
+ investments held). The basic reason for this is that if the situation were reversed, with long-term capital uses being financed by short-term sources, then the firm would be very vulnerable to short-term influences. This may result in an instability which is not conducive to the firmâ€™s long-term performance.
The actual margin by which the short-term commitments should be financed by long-term sources will, however, vary, amongst other factors, with the industry, with particular factors, with size, and with the general economic situation.
Share Capital + Reserves (E) Loans + Debentures (M) Liabilities (C)
Current Liabilities (D)
Fixed Assets investment (F) Investments Current Liabilities
E + M + C = F + I + D
Thus, if we know or have estimated the cost of plant, buildings, stocks and debtors â€“
i.e. the total resources required â€“ and can estimate the level of credit we will take from suppliers, then:
E + M = ( F + I + D) â€“ C
Over-capitalisation will exist if the amount of capital is too large in relation to the volume of business, with the result that profits are insufficient to give a satisfactory return on the capital employed. One reason may be excessive â€˜ploughing backâ€™ of profits, because the extra business created will be inadequate in relation to the funds invested.
Too much loan capital is another aspect of over-capitalisation. If trade declines the interest burden may become insupportable. Profits will be insufficient to cover interest charges and leave sufficient amounts after tax to pay a satisfactory return to the shareholders.
Where over-capitalisation exists, management should attempt to sell off surplus assets and, with the cash obtained, either find new investments which give a satisfactory return; or distribute the cash as dividends; or use it to redeem some loan capital.
Under-capitalisation occurs when there is inadequate working capital to sustain the activities of the business. This may lead to insolvency problems and the winding up of the business. Many firms in Malta are probably under-capitalised, and rely excessively on bank overdrafts and current liabilities for their financing requirements.
A companyâ€™s funds are usually made up of Long, Medium, and Short term finance.
1) Long and Medium term Funds
These include Share Capital and Loan Capital, which together make up the permanent capital of a company. As far as Loan Capital is concerned, the distinction between medium and long term debt is somewhat arbitrary, but most financial observers place it somewhere about seven years.
The following are the various components of long and medium term funds:
A) Ordinary Shares:
These are the foundation of any companyâ€™s financial structure. Business requires that capital be placed at risk, and the ultimate bearers if that risk are the ordinary shareholders. The main features of ordinary share capital, or Equity, as it is generally called, are the following:
1 Shares must have a nominal value e.g. LM1 shares. This nominal value is often the price at which the shares were first issued, but it usually bears no relationship at all to their current market value. Occasionally, a company may issue â€˜stockâ€™ rather than shares, in which case the capital is offered in bulk, so that one subscribes for a company of it measured in terms of nominal value. A stockholder would own, say, LM100 of stock, while a shareholder would own 100 shares of LM each.
2 Shares issued subsequently to a companyâ€™s original issue may be offered at a price equal to their nominal value (at par); at a price exceeding their nominal value (at premium); or at a price less than their nominal value (at a discount). Issues may be offered to the general public (a public issue); or restricted to the existing body of shareholders (a rights issue).
2 Sometimes a company will issue bonus shares. These are always issued to existing shareholders in proportion to their existing holding, and are free of charge to them. A bonus issue, is therefore, not a source of funds, but a
capitalisation of what were previously legally distributable reserves.
3 The shares of a quoted company (i.e. quoted on the Stock Exchange) may change hands frequently. This has no direct financial effect on the company, except that it must maintain up-to-date register of shareholders.
4 The income of the ordinary shareholder is the residual profit of the company, after prior outside claims have been met. This may be either paid to him as a dividend, or retained in the business for expansion. The decision as to how much of the profit to distribute is made by the directors.
5 In normal circumstances the company is barred from law from repaying capital to its ordinary shareholders. Thus, the only way they can â€˜withdrawâ€™ their capital as individuals is by selling their shares on the market. In the event of a winding-up, the ordinary shareholders are entitled to the proceeds of the whole of the residual assets of the business.
B) Preference Shares These are different from ordinary shares because they have preferential rights over profits and, in the case of a winding-up, over surplus assets. Theoretically they are part of the Equity since, like ordinary shares, they are risk-bearing. In practice, it is necessary to make their preferential rights attractive in order to sell them, and this is achieved by usually keeping the number low relative to that of ordinary shares. Nowadays preference shares are rarely issued because they have certain tax disadvantages when compared to loan capital.
Preference shares may be preferential: 6 As to income: the preference shareholder is entitled to a dividend of up to a stated amount before any dividend is paid to the ordinary shareholder. Dividend rights may be non-cumulative i.e. if not paid in a given year the dividend is low; or cumulative i.e. any arrears of dividend are carried forward and are given preference against future yearsâ€™ profits. 7 As to capital: in the event of a winding-up, any surplus assets after prior claims (e.g. outside creditors and lenders) have been met, must first be used to repay up to the full nominal value of the preference shares. Only after this may the ordinary shareholders be allowed to start receiving anything.
Preference shares may sometimes be redeemable. Company law in Malta requires that this be done either out of profits set aside or out of the proceeds of a new share issue.
Some reserves arise as the result of mere book-keeping transactions and are not, therefore, sources of finance. For instance, a General Reserve created from existing revenue reserves, or a Capital Reserve arising from revaluation of property, would give rise to no inflow of funds. However, reserves arising from a genuine inflow of cash are a source of finance. One example is the Share Premium Account. More importantly, revenue reserves representing retained profits are a vital source of finance for most companies. They have the advantage to the company of being readily available, merely by restricting dividend distributions. This way of raising capital also keeps costs to a minimum as there are no issue costs. The disadvantage is that the amount available is restricted to that generated from the companyâ€™s own operations. If companies had to rely solely on this source for funds, the result could be a very small rate of growth.
D) Loan Capital:
Loans and debentures are capital raised by a company for which interest is paid at a fixed rate at stated periods. The holders are not members of the company. The loan capital has a nominal value, which may differ from the current market price. The latter depends mostly on the relative interest rates of the loan compared to current interest rates of loans of the same level of risk. The main features of the loan capital are:
8 The interest payable to the loan holders is a charge against revenue, and not an appropriation of profits, as is the case with dividends. Therefore, the fixed rate of interest is payable in full whether profits are available or not.
9 The capital value of the loan may be repaid, although irredeemable debentures are sometimes issued. A company is sometimes empowered to reduce its indebtedness by purchasing its own debentures in the market.
10 There is security for the interest and capital. This arises primarily from the contract between the company and the lender/s. The loan holders may sue if
there is any breach of the agreed terms.
Companies will sometimes issue convertible debentures, which carry the additional right that they may be converted into ordinary shares at the option of the holder. The terms of the conversion and the dates on which it can be exercised are set out by the company. Convertible debentures give the holder all the security associated with normal debentures, but with the additional advantage of becoming a shareholder at a later date if the companyâ€™s performance makes this desirable.
Share warrants, also known as subscription rights or options, are documents that entitle the holder to subscribe at some future period and at pre-determined price to an issue of shares in a company. They carry no interest, and may entitle the holder to one share any quoted figures are given per share. Warrants are usually offered as an added inducement to subscribe for loan stock. Thus, a company might issue, say, 12% unsecured loan stock with option to subscribe for 50 shares at 80 cents per share for every LM100 of loan stock held during the years 2002 â€“ 2007. Note that in the case of a warrant the investor does not subscribe funds now, but merely has the option to subscribe additional funds to the company at some future date. Warrants are negotiable, so that the initial holder can transfer his options.
2) Short Term Funds
Short-term debt is particularly attractive to financial managers for 3 reasons:
11 it is easily available to most companies;
12 it is the cheapest form of financing available;
13 it is a form of financing that provides the company with a high degree of
Of all types of financing, short-term debt is typically the easiest to obtain. Accruals (wages payable, taxes payable, interest payable), are built into the firmâ€™s normal business arrangements and require no further effort to acquire. Most suppliers extend trade credit without any special negotiation. Banks compete to make short-term loans to companies of all sizes. In fact, for small firms, short-term debt may be the only source of financing available from sources outside the company.
Short-term debt is normally a low-cost source of financing relative to debt of longer maturity and is usually cheaper than long-term debt. Some short-term financing is actually free. It also provides a high degree of flexibility in that a company can change its level of funding quickly and easily as its needs change.
The main types of short-term financing are:
a) Bank Credit:
This usually takes the form of either an overdraft or a loan. The overdraft is probably the most flexible form of borrowing. The borrower is usually granted by the bank an agreed maximum up to which to borrow, and generally has the right to repay the overdraft in whole or in part at any time. Interest is charged on daily outstanding balances, so that the user pays only for what he has actually borrowed.
Although theoretically overdraft advances are repayable on demand, they are never, in practice, called in without reasonable notice. The bank usually formally reviews and renews the facility every year.
The principle limitation on the extent of bank borrowing of a firm is its current ratio. The firm must maintain a constant watch over its liquidity position, since the bank will be watching this; and if the firm is seen to be heading for liquidity problems, the overdraft may be withdrawn, thus worsening further the firmâ€™s position.
Bank Loans are considered as medium-term sources of finance. They differ from overdrafts in that they are negotiated agreements for the advance of particular sums for stated periods at a stable interest rate (normally) over the life of the loan. Such loan agreements will be specific as to cover, the payment of interest, and the repayments schedule. The borrower will therefore incur defined commitments. Sometimes, the interest charged may fluctuate over the term of the loan.
b) Trade Credit.
The use of credit from suppliers is a major source of finance. It is particularly important for small and fast growing firms. The cost of making maximum use of trade credit includes:
14 the loss of suppliersâ€™ goodwill;
15 the loss of cash discounts.
The effect of the first one is difficult to quantify in money terms. However, one should remember that although a company may delay payment beyond the final due date, such a policy is inadvisable, as it will worsen the companyâ€™s credit rating and make additional credit difficult to obtain. Remember that trade credit is a valuable source of short-term finance, being relatively easy to obtain and flexible. It is the largest source of short-term finance for companies as a whole.
The question of loss of cash discounts must be carefully considered, as the cost of this may be higher that you possibly imagine.
c) Bills of Exchange:
A trade bill is essentially a post-dated cheque which a seller draws in his own favour for signature by the purchaser. Bu signing, the purchaser â€˜acceptsâ€™ the bill, which normally refers to specific goods received, and is made out against the value of such goods. Its function is to enable the seller to obtain cash prior to the date of payment set out on the bill. If the acceptorâ€™s name has sufficient standing, the bill may be accepted for discounting by third parties at a price below its face value. The difference between the discounted value and the face value of the bill represents the interest costs to the seller.
A LM100 bill payable 33 months hence is discounted immediately for LM98.50. What is the rate of interest?
1.50 365 —-* —-= 6.4%p.a.
d) Efficient stock control:
Though not a direct source of income, a reduction in excessive stock levels can lead to great cash savings, and thus a decrease in finance required.
Factoring means selling trade debts for immediate cash to a factor who charges commission. Most factors offer three basic services, although clients are under no obligation to accept them all. These are:
16 Finance: when the factor receives each batch of sales invoices from his client he will pay about 80% of its value in cash immediately, charging about the same interest rate as banks. Many factoring firms are in fact controlled by banks. The finance would not, therefore, be cheaper than the bank credit, but will be attractive if further bank credit is not available.
17 Accounting: the factor becomes, in effect, the firmâ€™s accounting department, as duplicate copies of all invoices sent to customers by the firm are sent, in batches, to the factor, who keeps a full set of sales ledger accounts for each customer. He handles all the invoices, and chases the payments due. The client has, therefore, just one debtor, the factor, who pays promptly and regularly.
18 Credit Insurance: the factor is a guarantee against bad debts, provided excessive credit is not allowed by the client. The amount of the commission varies, and depends mostly on the clientâ€™s type of customer.
The savings of factoring include:
a) Tangible Savings
19 bad debts losses insurance;
20 cost of services of credit agencies;
21 salary costs of sales ledger personnel;
22 overhead costs of sales ledger department;