In this lecture we shall discuss the sources of business finance which include equity finance, debt finance – loan, bills of exchange. ,factoring ,trade debtors ,accrued expenses ,credit card buying (plastic money) ,debenture finance, invoice discounting (confidential factoring) ,factoring ,sale and lease –back ,sale of an asset, and purchase.
General objectives
By the end of the course the learner should be able to identify the appropriate sources of funding for entrepreneurship. At the end of this lecture you should be able to:
1. Explain the Various sources of finance for entrepreneurship
2. Discuss the advantages and disadvantages of the various sources of finance
3. Identify factors that influence the various sources of finance sought
5.1 Sources of Business Finance
The entrepreneur may obtain finance from the following main sources.
- Debt financing
- Equity financing
- External and internal sources.
Debt financing requires a borrowing system and the entrepreneur is bound to pay back the funds borrowed together with interest payable. Debt financing can be long term or short term. Depending on the lender collateral, amy be required. Equity financing does not require collateral and offers the investor some form of ownership position in the business. Internal financing are funds generated from several sources within the company, they include profits sale of Assets, reduction in the working capital accounts
receivable, retained profits e.t.c External sources of finance may come from family members, credit suppliers, government programmes, grants e.t.c.
5.1.1 Equity Finance
It the largest source of finance to a business organization and usually forms the base of which other finances are raised. Equity is the total sum of the business ordinary shares plus the retained earnings also known as revenue reserves.
1. Ordinary share-capital
It that finance contributed by ordinary shareholders of a business. It is raised through the sale of the company’s ordinary shares- who are the real owners of the business. The finance type is only raised by limited companies and is permanent in nature and can only be refunded in the event of liquidation. It earns ordinary dividends as a return to the investments. The investors carry voting rights and usually each share is equal to one vote. The ordinary shares are quoted at the stock exchange where they are sold and bought. The finance carriers the highest risks in the company because it gets its return after other finances have got their and also in the event of liquidation is it paid last. The ordinary dividends are not a legal obligation on the part of the company to pay.
Where the profits are good ordinary shareholders get the highest return because their dividends are varied. This type of finance grows with time and this growth is equity which basically is facilitated by retention earnings.
Advantages of Ordinary Share Capital to Shareholders
- Ordinary shares have a right to vote and their votes influence the company’s activities.
- Ordinary shareholders can use their shares to secure loan.
- Ordinary shares are easily transferable.
- The owners of the ordinary shareholders earn dividends in perpetuity.
- The fluctuating nature of dividends is earned.
- The ordinary shareholders benefit from the residual claim in the event of liquidation.
Disadvantages of Ordinary Shareholders.
- Carry variable returns in case of low or non-profit dividends are not paid..
- Incase of liquidation an ordinary shareholder may lose everything.
- The sale of more ordinary shares dilutes ownership of the existing shareholders.
- The dividends of an ordinary shareholder are double taxed.
2. Retained earnings (revenue reserves)
This is a source part of equity finance which arises out of undistributed profits over and above dividends paid to shareholders. It is a cost free source of finance and its cost is opportunity cost in terms of foregone dividends to ordinary shareholders.
The retained earnings constitute growth in equity which is a cost of equity because the company may declare retained earnings as extra dividends or inform of bonus issues.
Arguments in Favour of Retention
1 Acts as a stabilizer to future dividends (ordinary dividends) especially when profits perform poorly.
2 No cost are incurred for it’s acquisition
3 It is able to be raised at no notice especially during unforeseen events e,.g
- Abrupt increases in the prices of raw materials
- Fire hazards e.t.c
4 Promotes savings promoting investments and growth.
5 Large volumes of retained earnings influence the company’s shares positively.
6 A good source of finance to those very urgent short-term ventures whose returns are immediate
7 The boost the company’s creditability to the company’s creditors.
The advantages of using retained earnings as a source of finance to the company.
1. It is the largest internal source of finance which the business will use without paying any costs.
2. The use increases the equity base of the company making it possible to generate more debt finance.
3. Retained earnings are used to finance new fixed assets whose value cannot be met by other sources
4. It is used without pre-conditions or restrictions making it the most flexible source of finance.
5. It boosts confidence among the company’s creditors
6. It is a permanent source of finance to the company to be used on long –term investments.
The disadvantages of using retained earnings as a source of finance to the company.
1. Easily misused by the management as it may be invested in areas which are prejudicial to majority shareholders.
2. Retained earnings once used will leave not shield to take care of contingencies exposing the company.
3. The finance can easily be mis-invested in areas of quite low returns.
4. the source involves a lot of sacrifice to the ordinary shareholders inform of opportunity cost
5. Easily invested in high risk investments.
Capital reserve
these are reserves which cannot usually be classified as normal trading profits arising out of the company’s ordinary trading activities – but are created with say shares are sold at a higher price than the per value and the excess is profit – such are credited to he capital reserve account and is used to offset the issuing expenses. It can also be created from revaluation of assets ( fixed assets)
3. Quasi equity finance (preference share capital)
This is finance contributed by Quasi – owners or preference shareholders. It is called quasi – equity because it combines features of debt finance and those of equity finance. It is called preference share capital because it is accorded preferential treatment Over ordinary shareholders.
Similarities between Ordinary & Preference Shares Capital
Both finances earn a return in the form of dividends
- They are a permanent source of finance especially the irredeemable preference shares
- Both receive perpetual dividends ( irredeemable preference shares)
- Both form the company share capital
- Both are difficult to raise due to prolonged formalities.
- Both claim on assets residual and in profits after debt finance has had it’s claim.
- Payment of dividends not a legal obligation
- Both finances are not secured
- Both are long –term finance to the company.
5.1.2 Debt Finance – Loan
This is the type of finance which is obtained from persons other those actual owners of the company i.e creditors to the company. The finance can be in any of the following forms;
- Loans
- Debentures
- Bank overdrafts
- Trade creditors
- Borrowing against bills of exchange
- Lease finance
- Mortgage finance
- Hire purchase finance
All the above finances have a legal claim or change against he company’s resources or assets. Requirements a Company must meet before raising Debt Finance.
1. The company must provide a summary of history of the business and its nature. This is used to assess the risk of the company’s business line.
2. Details of management – names, ages, qualification and experience of managers and directors. If these are of questionable integrity, such as a company may not get debt finance.
3. To produce five years audited accounts which will reflect t he company ‘s financial ability to service debt finance.
4. the purpose of the loan must be;
- within the lender’s priority
- Within the government areas of priority for development purposes.
5. Furnish lenders with cash flow forecast and proposed trend of repayment.
6. Major shareholders of the company must give consent to the loan.
Reasons why Commercial Banks prefer to lend short-term
1. Majority of deposits with these banks are subject to withdrawal on demand and short-term notice these cannot be lent long term. The violation of this principle led to the downfall of a number of financial institutions in 1986/87 in Kenya.
2. Commercial banks are subject to sudden credit squeeze imposed by the central Bank and as such they have to keep their investments in short-term investments to meet the requirements of the central bank.
3. Short-term forecasts are usually accurate and also short-term investments are less risky which is thus preferable to commercial banks.
4. Short-term investments are usually more profitable to the banks e.g overdrafts which carry higher rates of interest than long-term loans.
5. Usually short-term investments are not secured e.g overdrafts and thus are easier ad more flexible go give.
Limitations of debt finance/ disadvantages of using debt finance to the company.
1. Interest is a legal obligation and failure to pay it may lead to company into receivership and consequently liquidation.
2. Using debt finance entails conditions and restrictions as to its use and this makes it non-flexible finance which can only be invested in those ventures approved by the lenders.
3. Its use on large scale increases the company’s gearing level which exposes the company to incidences of receivership and thus liquidation.
4. It is not usually long-term finance and the payment of principal leaves the company in financial strain and may cause liquidity problems to the company.
5. the use of excessive debt finance i.e beyond 67% level puts the company at the mercy of the lenders because they can come in to control their interests which dilutes the control of owners and this may lead to lower share prices. Moreover,
6. This finance calls for a security i.e it is usually secured against a collateral security which may be rare or lenders may be rare or lenders may restrict the use of such asset thus reducing the company’s operations and thus its profit.
7. The lenders usually insist that the security be compressively insured which will compound the cost of this finance as it will entail an implicit cost to the company.
8. This finance is available only in big businesses which are known to lenders and as such small companies will not be able to raise it easily as they are assumed to be risky and are in most cases unknown to lenders.
Advantages of using Debt Financing.
1. Most debt financing is short-term and as such it will not burden the company‘s cost of financing for long i.e cost is short-lived.
2. Interest on debt is a tax-allowable expense and thus the effective/real cost of debt will be equal to interest less tax on interest I,e interest is less by the much of tax on it. ( refer to cost of finance)
3. the principal is later reduced in real monetary values by much of inflation on it I.e the company pays less on long- term loans by virtue of inflation reducing the real monetary value of the principal and interest.
4. The use of debt finance does not necessarily entail dilution of control to existing shareholders are these shareholders may only lose the control if the company has used 67% of debt finance in its financing i.e in its total capital employed.
5. it is usually invested in viable ventures whose return is higher than its cost, thus it is used with a good investment policy
6. This finance does not call for a lot of formalities in its use in as much as it does not involve a lot of floatation costs.
Circumstances under which a company should use short-term debt finance.
1. Under situations when the company has identified a venture which calls for finance on short-term notice and will pay back early enough to facilitate repayment of the loan.
2. Under situations where the company’s venture promises higher returns that the cost of debt finances.
3. Under high debtor’s turnover where the company wants to boost sales through further investment in stock.
4. Under boom conditions when the company’s cost of debt is relatively lower as profits will increase relatively and the company can be able to service debt finance. This will raise the earning per share of the company’s shares.
Characteristics of Debt Finance
1. It is a fixed return finance i.e interest on debt is fixed regarding less of the profits made by the company.
2. Interest of debt finance is a legal obligation on the part of company to pay and failure to pay it may lead the company into receivership in the extreme.
3. It is usually given on conditions and restrictions except for overdrafts.
4. It carries a first claim on profits and assets before other finances.
5. It does not carry voting rights and as such it does not participate in the decision making process of the company.
6. Its use rises the company’s gearing level.
7. It is always refundable except for irredeemable debentures.
8. it is usually a secured type of finance
9. Interest on debt finance is a tax-allowable expense.
Similarities between Debt finance and Ordinary Share Capital
1. in the case of irredeemable debentures both form a permanent source of finance to the company
2. Both carry explicit costs to the company I. e interest on debt finance and
3. Dividends on ordinary share capital.
4. both are raised by financially strong companies
5. In case or irredeemable debentures both will entail a permanent cost to the company.
6. In case the company has used overdrafts then both are not secured finances.
7. Both are external sources of finance to the company.
8. Both have control over the company if the company has used debt finance of up to 67% of the company’s total financing.
Classifications of debt Finance.
1. short-term finance
This ranges from 1 month up to 4 years and is given to customers known to the bank or to lenders. The agreement of this loan will mention both the repayment of principal and interest, and must identify whether it is simple or compound interest. For principal, it
has to be paid over some time. This finance usually secured and the terms of the loan will be restrictive. Usually be invested in an area acceptable to the bank or lender. Usually this finance should be used to solve short-term liquidity problems.
2. Medium –term finance.
This finance will be in the business for a period ranging between 4-7 years. This term is relative and will depend upon the nature of the business. This type of loan is used for investment purpose and is usually secured but the security should not be sensitive to the company’s operations. The finance obtained must be investigated while respecting the matching approach to financing i.e the term and pay back period must be matched. This type of finance if the most popular of all debt financing because most of the business will need it both in their growing stages and also their mature stages of development.
3. Long-term finance
This is a rare finance and is only raised by financially strong companies. It will be in business for a period of 7 yeas and above. This finance is used to purchase fixed assets in particular during the early stages of a company’s development. It is always secured
with a long-term fixed asset. Usually land or buildings. Its investment, however must obey the matching approach. In all, the companies needing such finance do not have to be known to the lenders.
Reasons why long term loans are difficult to raise on Kenya’s financial markets/ limitations of using long-term debts.
1. This finance calls for long-term securities such as land and buildings which most businesses in Kenya may not have.
2. There are no long –term savings to back-up these loans due to low income of average Kenyans and as much most of the savings are short-term and cannot be made available on long-term basis.
3. Most business in Kenya are agro-based and these are risky and as such lenders cannot avail their finance to such businesses of long-term.
4. The central bank has tended to stimulate the development of money markets that capital markets which have not been fully developed to avail such finance to meet the development needs of industry and commercial sectors of the economy.
5. Long-term loans are not usually profitable because interest and principal repayment are eroded by the by the impact of inflation and thus banks may be reluctant to give such.
6. The size of the businesses in Kenya is small and such businesses are not going concerns so as to be able to attract this finance on long term basis.
7. A number of companies in Kenya are multinational companies which obtain long-term finances from parent companies abroad and this has limited the development of capital markets in Kenya as demand by such companies is low.
8. there are been a tendency by the financial institutions to avail long term debt for building purposes and little attention has been paid to long-term finances for businesses.
9. This finance is given on conditions and restrictions to avail long-term debt for building purposes and little attention has been paid to long-term finances for businesses.
10. This finance is given on conditions and restrictions which make it less ideal for profitable ventures as such restriction may reduce profitability of companies concerned.
11. Long-term forecasts by commercial banks are inaccurate and filled with a lot of uncertainties thus the banks are very reluctant to shield such potential risks and prefer to lend short term which they can forecast with some degree of accuracy and certainty.
Solutions to the above problems.
1. The government should diversify the security such that the same asset acquired acts as its on security and also to allow guarantees as securities in particular personal guarantees
2. The government or individual commercial banks should undertake mass education campaigns to businessmen so as to induce them to save/keep their money in banks so as to avail such money of long –term lending.
3. the government should participate in the development of this capital market by;
- Allowing some parastatals to go public i.e. to sell shares to the public.
- Selling or purchasing long-term debt instrument or creating a market for these and allowing the forces of demand and supply for money to operate freely in Kenya so as to determine the prices of securities in the financial market.
4. The government should introduce insurance schemes to cover agro-based industries so as to reduce their risk and so as to be open to long-term finance.
5. There should be diversification in the economy from over-dependence on agro-based industries to manufacturing which will create employment and thus boost the incomes of average Kenyans and thus saving which will be available for lending.
6. The government should stabilize the value of the Kenyan currency so as to attract foreign long-term investors and aim at exporting more as means of gaining foreign exchange which can be used to stimulate long-term growth through importation of more capital goods and less consumer goods.
General Limitations of Debt Financing
1. The economic life of the asset to be used a security act as an outer limit to debt financing both the terms of principal and the term.
2. If the balance of debt outstanding in the company’s capital structure is high it means t hat the company is highly geared and this cannot allow lenders to give further finance to such a company as it will be viewed as risky.
3. Debt financing may be expensive because it carries both implicit and explicit costs. These may out-weigh the returns from the investments.
4. Ordinary shareholders may limit the much a company can use in debt financing as the level of the gearing is influenced by this finance thus putting them at risk.
5. The size of the company may influence its ability to raise debt finance this size works better for quoted companies and unquoted companies usually find it difficult to raise such finance.
6. General economic conditions may limit the availability of debt finance because in recession it is quite dangerous to use large sums of debt finance as these may not be serviced under conditions of low profits and may lead to the company’s receivership in extreme.
7. The management for the company may also limit the availability of this finance either by virtue of its nature (if its integrity is questionable) or if it is conservative in the use of debt.
Advantages of using an Overdraft
1. it can be used to bail the company out of short-term financial liquidity problems
2. Usually it is not secured as the company’s goodwill is all that matters in obtaining this finance as long as the company is known to lenders.
3. It is used without pre-conditions or restrictions which makes it a flexible source of finance,.
4. It can be raised fast thus very useful in emergency financing endeavors.
5. It is not expensive to raise i.e there are no costs paid to obtain it such as floatation costs. ‘
6. Its cost and financial constraints are short lived.
7. it can assist the company to meet its obligations in particular short term obligations thus sustaining the goodwill from creditors.
8. Overdraft finance does not increase the company’s gearing level, at least in the long run.
9. Overdraft finance is used without consent of shareholders thus it is flexible as it can be used as and when it is needed.
Disadvantages of using Overdrafts
1. It is very expensive finance and its lending rate is usually 1-2 % higher than the usual lending rates.
2. Its constant use of a sign of bad/poor financial management policy and this may endanger the company’s ability to raise long-term finance as longterm lenders view constant use of overdrafts as a sign of lack of overdrafts as a sign of lack of cash forecasts and budgeting policies on the part of the economy.
3. It is not easily available to every business thus it is obtained by companies know better to the bankers,.
4. In some cases this finance may be used in a manner flexible to the management which most cases may not be in the interest of shareholders it may be used in areas which may not directly benefit shareholders i.e it
5. It is only available is small quantities and as such may not be useful for bigger ventures.
6. The bank may recall this overdraft in part or in whole at any time and this may inconvenience the Company affected.
7. Overdraft finance may only be used to finance non-profitable operations e.g working capital and cannot be used to finance fixed assets which are the most important ingredients in the company’s production and profitable
operations. Other Sources of Debt Finance
Bills of exchange.
As a source of finance, bills of exchange can be:-
- discounted
- endorsed
- given as securities for loans
The commonest type of bills of exchange. Accommodation type of bills of exchange is that type where two parties A and B are B is known to bankers. The two enter into an agreement where A draws a bill on B and B accepts it an agreement whereby A draws a bill on B and B accepts it and thereafter A can either discount the same bill or endorse it to another party to get finance which A will have to
refund later to B. However a bill of exchange is defined as 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 at a fixed or determinable future date a certain sum of money to the order of the person or to bearer. Most of the bills mature between 90-120 days although they could be
sight bills i.e payable on sight be valid and to serve as a source of finance it should be
- signed by the drawer
- accepted by the drawee
- be unconditional
- bear appropriate revenue stamp
Advantages of Bills of Exchange as a Source of Finance.
1. It does not involve a lot of formalities and as such will allow the drawer to obtain finance faster.
2. It is highly negotiable making it a liquid investment which the company can liquidate fast ( if the drawee is of high credit rating)
3. Since it is unconditional the drawer will use the same finance obtained on the strength of the bill without preconditions and restrictions.
4. It does not affect the company’s gearing level.
5. It is cheap to obtain and to retain – retention cost is discounts which are usually lower than bank rates.
6. it does not call for any tangible security because the good will of the drawee is all that is necessary to use
Disadvantages of Bills of Exchange
1. It is a very short-term source of finance and as such it may not be profitable as its duration cannot warrant any profitable ventures i.e finance from the bill cannot be invested in profit table ventures.
2. There are possibilities that the bills may be dishonored by the drawee and drawer may have to settle any liabilities incurred thereon.
3. It is a foreign bill of exchange this may delay the finance in that it may require the approval of the central bank before discounting it.
4. Its negotiability and thus liquidity as an investment will depend upon the goodwill of the drawee which will be lacking in some cases.
5. Finance from this bill may be misused (misinvested) by the management thus may not benefit shareholders.
6. There are chances of getting a fake bill of exchange which cannot be discounted nor endorsed which will constitute a fraud to the company.
7. It may involve some costs in particular discounts which may be high depending on conditions some of which may be a bit expensive to fulfill e.g stamp duty.
Factoring
This can be defined as an outright sale of the company’s debtors to a factor (which is usually a financial institution that specializes in purchasing of debtors) this factor will pay the selling company up to 80% of the face value of debtors and is left with 20% to
care of bad debts if any, and also his discounts, this type of source of finance is rare in Kenya mostly because it is an expensive source of finance due to high discount costs. Savings in this source are in form of costs of credit management which are transferred
to the factor. However, the factor takes up risks in debts (of default) which previously were supposed to be borne by the selling company.
Reasons why factoring is not popular in Kenya (disadvantages)
1. Most transactions in Kenya are strictly on cash basis, due to low creditability of most of the small firms in Kenya.
2. It is costly source of finance because the discount rate may even be higher thank bank rates, thus companies may prefer to use overdraft finance than factoring.
3. After selling a debtor, chances are that one might lose such a customer completely and such this method can be used by monopolies only.
4. Sale of debtors reduces the company’s liquidity position in a way and this may not be preferred by companies which depend on trade credit as their liability rates will not be acceptable to trade creditors.
5. There is ignorance amongst the business community in Kenya about the use of this facility as a source of finance.
6. It is difficult to legally enforce collection of debtors in Kenya and this may discourage would be factors.
7. Kenya’s money market is not fully developed and as such the factor may find it difficult to liquidate these debtors or pass the title in this asset to another party.
8. Trade credit is very popular in Kenya and this has made up for factoring.
Advantages of using Factoring
1. The selling company can obtain ready finance from the factor which can be used to solve its liquidity problems.
2. the selling company transfers the risk of bad debts to the factor company thus reducing its losses
3. It minimizes the burden of collecting debtors’ i.e debt collection expenses.
4. this finance can be raised fast thus does not entail a lot of formalities
5. It does not carry collateral security thus a flexible source of finance to raise.
6. it can be raised by any company regardless of its status as long as it has good debtors i.e of reputable companies.
7. it does not affect the company’s gearing level thus no loss of control to the company by its use.
Trade Debtors
This acts as a source of finance in such as the company holding; such debtors can discount them with a bank and obtain immediate finance. They can be used as security for loans in particular overdrafts. The company can continue to sell on credit and as
such this source can be a semi –permanent source of finance.
Accrued Expenses
Examples of these are;
- accrued electricity bills
- accrued telephone bills
- accrued water bills
- accrued rent
- Accrued rates.
These are a short-term source of finance and can be big sources if the company has a number of these outstanding expenses. However, a company should use these in as much as they cannot affect its future operations and only pay such on the last date when these are due.
Credit Card buying (plastic money)
These are arrangements whereby a company or an individual enters into an agreement with a credit card organization to use their card to purchase a number of goods and services and pay after agreed period of time. Usually repayment carries interest charges. These cards are used to obtain such goods and services as:
- fuel expenses in particular for tour companies
- stationery
- Medical expenses for employees and their families.
- Vehicle maintenance
- Air transport
- Purchase of inputs such as oils, spare parts e.t.c.
Reasons why Plastic Money has Developed Fast in Kenya of late
1. Due to high incidences of frauds by dishonest employees these cards e.g in tour companies.
2. They minimize the use of liquid cash thus reduces chances of petty cash frauds and also solves the company’s liquidity problems and those of individuals.
3. Kenyan society has developed fast (in sophistication) and the use of these cards is a sign of high social and economic status.
4. There is a lot of awareness amongst Kenya’s elite community as regards credit facilities and as such have responded to the introduction of this type of money fast.
5. There is a lot of risk associated with carrying lots of cash which is open to theft and as such people prefer to carry finance in card form.
6. A number of companies and establishments have quickly recognized these cards as a means of settling bills and some even give discounting to card holders which has boosted their popularity.
7. It is a source of finance to individuals who depend on monthly earnings who settle their bills using the credit cards and later pay at the end of the month when their liquidity position warrants it.
Disadvantages/ limitations of using credit cards as a source of finance.
1. It is expensive to obtain (because the bolder has to deposit some amount of money with credit card
2. Organizations) and later pay interest on all his expenditure.
3. It may lead to unwarranted spending which may lead to financial strain on the part of the holder when it comes to settling his bills.
4. The majority of Kenyans are unaware of these credit card facilities in particular the rural Kenyans
who form the majority of Kenyans.
5. The card is limited only to those establishments which have formal arrangements with credit cards
Debenture Finance
Debenture has its origin in the latin word Deboe which means “ I owe” it is a document that is evidence of a debt which is long term in nature, and confirms that the company has borrowed a specific sum of money from the bearer or person named in the debenture certificate. Most debentures are irredeemable thus forming a permanent source of finance to the company. If these are redeemable then these will be long-term loans which range between 10-15 years. They can be endorsed, negotiated, discounted or used as securities for loans. They carry a fixed rate of interest with is payable after six months i.e twice a year.
Classification of Debentures
1. Classification according to security
Secured debentures– these are secured against the company’s assets or have a fixed charge against the company’s assets. In the event of the company’s liquidation such debentures will claim on any or all of the company’s assets not yet attached by other secured creditors. A debenture holder with a floating charge has a status of a general creditor, however floating charge debentures are rare and they are sold by financially strong companies.
Unsecured (naked) debentures –these carry no security whatsoever and such they rank as general creditors. They carry a residual claim to the first class creditors but a superior claim to the first class creditors but a superior claim over ordinary shareholders. These are rare sources of finance and are sold by financially strong companies with a good record of dividend payment to the shareholders.
2. Classified According to Redemption
Redeemable Debentures – these are bought back by the issuing company. Like preference shares, these have two redemption periods which are minimum and maximum redemption periods. This usually between 10-15 years. i.e. the company has the option to redeem these after 10 years but before expiry of 15 years. In most cases redeemable debentures are secured against specific assets e.g. land or buildings ( mortgage debentures) their interest is a legal obligation on the part of the issuing company.
Irredeemable debentures (perpetual debentures) these can never be bought back by the issuing company except in the event of liquidation and as such they form a permanent source of finance to the company. These debentures are rare and are only sold by financially strong companies which must have had some good dividend history. These are unsecured and thus are known as naked perpetual debentures.
3. Classified according to convertibility.
Convertible debentures– these are the type of debentures which can be converted into ordinary share capital and this conversion is optional as follows;
- At the option of the company i,e at the company’s option.
- At the option of both parties i,e debenture holder and the company
- At the option of the holder.
However the conversion price of the debenture is given by
- Conversion price= nominal value of the debentures No. of shares received
- Conversion ratio = Nominal value of debentures Nominal value of shares to be converted.
In all, convertible debentures are never secured. - Non- convertible debentures – these cannot be converted into any shares be it ordinary or preference shares and are usually secured.
4. Subordinate debentures (naked)
These are issued with a mutuality period of 10 years and above and usually they carry no security and depend upon the goodwill of the company. They are so called subordinate because they rank last in claims after all classes of creditors except trade creditors. Nevertheless their claims are superior to those of shareholders both preference and ordinary shares.
Advantages of using debenture finance (to the selling company)
- In case the company sells irredeemable debentures these will form a permanent finance to the company which can be invested in long term venture or fixed assets.
- Their use does not entail dilution of the company’s control as they carry no voting rights with which to influence the company’s policies.
- In case of convertible debentures, once converted into ordinary shares will be permanent finance to the company and can be used in finance to the company and can be used in financing of long- term ventures.
- Interest on debentures is tax –allowable expense and as such it will be less by the much of the tax on interest.
Disadvantages of using debenture finance (to the selling company.)
1. Interest on debenture is a legal obligation for the company to pay and failure to pay it may put the company into legal wrangles.
2. it raises the gearing level of the company which may expose it to risks of receivership and, in extreme, liquidation
3. In case of redeemable debentures once redeemed may leave the company in financial strain.
4. Since interest is paid twice a year it may be cumbersome to the company to pay and may pose liquidity problems.
5. For irredeemable debentures these place a permanent commitment in terms of cost to the company.
6. If they are redeemable and reach maximum redemption period before they are redeemed these may force the company into receivership and consequently liquidation.
7. For secured debentures, these may be expensive because they will carry implicit costs. i.e insurance and maintenance of the security and later explicit costs . i.e interest on these debentures.
Similarities between Debentures and Preference Shares Capital.
1. They both carry fixed rate of return.
2. Both increase the company‘s gearing level.
3. both can be converted into ordinary shares, if convertible
4. both carry no voting rights in the company
5. both may be unsecured if the company sells naked debentures
6. both claim on profits and assets before ordinary share holders
7. If they are both redeemable they can force the company into receivership after the expiry of the maximum redemption period if not yet redeemed.
Advantages of using Debenture Finance to Ordinary Shareholders.
1. The use of debenture finance does not dilute the shareholders control of the company unless they are convertible and are converted.
2. Under boom conditions ordinary shareholders may benefit from higher dividends due to fixed charges on debentures which is paid under conditions of high profits.
3. Interest on debentures is tax-allowable expense and as such this may allow the company to retain more and even pay higher ordinary dividends to its shareholders.
4. In case the company issues irredeemable debentures, these will be invested in long-term ventures with not only have the effect of raising the shares pieces of the company’s ordinary shares but will also increase the company’s future ordinary dividends.
5. After debentures are redeemed, the company will benefit from the asset/ investment they had financed which will increase the net worth of shareholders.
Trade Credit
This finance is obtained by companies by which purchase goods on credit and pay for such goods later. This “kind” and is available to companies which can pay bills on time as and when they fall due. It the largest source of finance to sole traders and wholesalers in Kenya. This is cheap source of finance and it does not entail any explicit cost except discounts foregone. This finance may be long-term in particular if the company meets its bills regularly such that after settling a given bill the same company obtains further credit immediately, thus may become a continuous source of finance. In order to be a source of finance, credit received must exceed credit given.
Advantages of using trade credit in Kenya a source of finance (reasons why trade credit is popular in Kenya)
1. Most businesses in Kenya lack collateral securities which are necessary to raise other forms of debt finance thus resort to trade credit.
2. it is cheap source of finance because the only cost involved is discounts lost I,e no implicit or explicit costs.
3. most other finances need the borrower to maintain healthy accounts which small businesses in Kenya may not have thus resort to trade credit.
4. The fact that small businesses in Kenya are not known to lenders makes trade credit the best source of finance as they may not qualify for other finances which require that the borrower be known to the lender.
Disadvantages (limitations) of using Trade Credit.
1. The debtor company will undergo the opportunity cost of the discount foregone by the very buying company.
2. This finance is not reliable because in the event of default on the buyer’s side the seller cannot give it and this way cut the buyer’s credit line which may lead a lot of inconveniences and in some cases stoppages in production or sales of the debtor.
3. It is usually restricted to working capital items and as such may not be available for fixed assets which are important for profitability reasons.
Promissory Note
A promissory note is a bill wherein one party promises to pay another party on a specific date and conditions, a specific sum of money. It is a short term source of finance to the company, usually up to 3 months. This type of finance is used when the two parties know each other well. It acts as a source of finance in as much as it can be discounted or endorsed. It can also used as security for loans.
Advantages and disadvantages promissory note
Advantages of promissory note
1. It does not involve a lot of formalities and as such will allow the drawer to obtain finance faster.
2. It is highly negotiable making it a liquid investment which the company can liquidate fast ( if the drawee is of high credit rating)
3. Since it is unconditional the drawer will use the same finance obtained on the strength of the bill without preconditions and restrictions.
4. It does not affect the company’s gearing level.
Disadvantages of promissory note
1. It is a very short-term source of finance and as such it may not be profitable as its duration cannot warrant any profitable ventures i.e finance from the bill cannot be invested in profit table ventures.
2. There are possibilities that the bills may be dishonored by the drawee and drawer may have to settle any liabilities incurred thereon.
3. It is a foreign bill of exchange this may delay the finance in that it may require the approval of the central bank before discounting it.
Invoice Discounting (confidential factoring)
This is an arrangement where the selling company discounts its invoices usually with a bank or financial institution and will receive a large percentage of its invoices in cash in advance. Usually it is expensive source of finance and should only be used if the
company cannot obtain overdraft finance from commercial banks. The invoice discounter analyse which invoices to discount and in this case he will request the selling company to send original invoices to the customer and a copy to the discounter. The invoice discounter has not only lien on the debts but also recourse to the borrower in which case the seller or borrower will have to pay the discounter should any debtor default to pay his bills on the due date.
Advantages of using invoice discounting as a source of finance
1. it is useful as a solution to short term liquidity problems
2. it does not call for a collateral security and as such it is a flexible of finance to raise.
3. it is easy to raise as it does not entail a lot of formalities
4. Normal credit will be extended to customers as the discounting of invoices does not affect the relationship between the selling company and its customers.
Disadvantages of using Invoice discounting as a source of finance.
1. The discounter has resource to the borrower and in case may debtor fails to honour his obligation then the discounter can turn to the seller to pay such debt and interest on finance advanced to him.
2. It may be an expensive source of finance in particular if the invoices are small and numerous in which case the costs of collecting these may be too high.
3. This type of finance is usually available to those companies whose debtors are highly rated in credit payment point of view thus may be discriminative if a given company has unknown debtors in which case they cannot be discounted.
Similarities between invoice discounting and factoring
1. Both are raised on the account of the company’s debtors or invoices.
2. both are expensive sources of finance to the company because discount rates in both case will be higher than the bank rate on borrowed funds
3. both fall in the family ( group) of short term sources of finance to the company, thus are aimed at solving the company’s liquidity problems
Differences between invoice discounting and factoring
Invoice discounting
1. the bank has recourse to the borrower
2. the borrower keeps the debtor’s ledger
3. Chances of bad debts are high and this may increase the cost of the company of using such finance.
4. invoices act more or less as securities for a short term loan
5. the discount rate is usually low
Factoring
1. the factor has no recourse to the borrower
2. The factor takes over the debtor’s ledger.
3. The chances of bad debts are minimal and even then these are borne by the factor.
4. The invoices are sold outright to the factors and cannot act as securities for loans.
5. The discount rate is relatively high.
Advantages of leasing as a source of finance
1. It may be a long –term source of finance e.g for land leased for a period of 99 years
2. In case the lease agreement gives the option to purchase the asset after the expiry of the lease term then Such a company will have known which asset it is taking over, and thus make a good investment decision based on experience.
3. Lease charges are tax-allowable expenses thus will reduce the company’s tax liability.
4. The lessee enjoys the benefits of wear and tear which reduce his tax liability.
5. The company does not risk holding assets which may turn to be technologically obsolete.
Disadvantages of leasing as a source of finance.
1. This type of finance is available for fixed assets and as such does not have provision for working capital which is important in generating sales.
2. the periodic rental charges may outweigh the cost of the same asset in the long-term i.e in the long run the leasee may pay more in rental charges that the cost of this asset.
3. The lessor may not renew the lease agreement and this may put the lessee out of business.
4. It is limited only to those assets which are available from the lessor’s business thus is not useful in all financial requirements of the company.
5. Lease finance entails implicit costs e.g maintenance and insurance of the same asset leased which may compound the cost of this finance.
Sale and Lease –Back
This is an arrangement whereby a company which owns some assets arranges to sell the same assets and at the same time agrees with the buyer to lease the same asset back at an agreed rental charge. This type of arrangement is possible if the asset back at an
agreed rental charge. This type of arrangement is possible if the asset is fixed asset whose return must outweigh the cost of the same finance. Also the parties involved must have had an intimate relationship before i.e. they should be acquitted to one another.
Advantages of using Sale and Lease Back
1. The company gets finance in cash and finance in kind which boost its operations tremendously
2. Since the lessor and the lessee are known to each other, this finance may not entail any conditions or restrictions on the part of the lessee.
3. This arrangement does not involve tedious formalities, thus is flexible to raise for financing reasons.
4. The risks of obsolescence shifts from the lessee to he lessor thus will entail less risk of capital loss the lessee.
5. It is easily available i.e faster because the two parties are known to each other.
Disadvantages of using sale and lease back.
1. The company’s asset will be removed from the balance sheet which will in essence affect its financial position i.e reflect a bad financial picture.
2. The lessee may not enjoy the benefits of wear and tear as such this will increase his tax liability.
3. The finance is limited to the cost of the asset leased, and cannot be versatile.
4. If it is an operating lease, then it will be used for short-term purpose.
5. It entails implicit costs such as repairs and maintenance costs of the asset leased.
Conditions under which sale and lease back is ideal as a source of finance
1. If the asset is required for seasonal purpose
2. If the asset is technologically sensitive i.e may soon be technologically obsolete.
3. If the asset cannot meet the company’s contemplated expansion programmes
4. Where the asset has a tendency of depreciating fast
5. If the asset is not sensitive or central to the company’s operations.
Sale of an asset
For companies with assets which are not very necessary for their operations, such assets can be sold to raise finance for the company. These assets should only be sold if the funds from the sale of assets can be invested in ventures which can generate returns
higher than those the asset sold was generating.
Hire Purchase
This is an agreement whereby a company acquires an asset on hire by paying an initial installment usually 40% of the cost of the asset and repays the other part of the cost of the asset over a period of time. The source is more expensive than bank loans. Companies that use this source of finance need guarantors as it does not call for collateral securities to raise. The company hiring the asset will be required to honour all the terms of the agreement which means that if any term is violated then the hiree may repossess the asset e.g in Kenya if the hirer fails to pay any installment before he clears 2/3 of the value of the assert the hiree may reposes it.
Companies that offer this finance in Kenya are;
- National industries E.A ltd
- Diamond trust (K) ltd.
- Kenya Finance Corporation
- Credit Finance Co. Ltd.
They avail hire purchase facilities for such assets as;
1. plant and machineries
2. vehicles
3. tractors
4. heavy transport machines
5. aircrafts
6. Agricultural equipments.
Conditions under which Hire Purchase is an ideal source of finance.
1. If the asset is so expensive that there is no single source of finance that can finance it e.g aircrafts.
2. Under conditions of credit squeeze or restrictive credit control.
3. If the company cannot obtain securities to cover a loan to finance this type of asset.
4. if the asset will meet the company’s future expansion programmes
5. If the asset is not very sensitive to technology.
6. If the company is highly geared and cannot borrow to finance such an asset.
Advantages of using hire purchase as a source of finance.
1. It does not call for securities in acquiring it an as such it is a flexible source of finance.
2. this finance is a long-term finance and as such it can be used to acquire fixed assets which are very essential for the company’s profitability
3. It is useful under conditions where the company cannot raise finance due to the amount involved i,e if it is substantial.
Disadvantages of using hire purchase as a source of finance
1. it is an expensive source of finance and in most case the interest on it may outweigh bank rates and at the end of the hire purchase contract the total installments paid may double the cost of the asset.
2. it involves a lot of formalities to obtain e.g legal implications and accounting formalities prior to
Signing Hire Purchase Agreement.
1. the hiree has a lien over the asset until the final installment is cleared in which case if the hirer defaults the hiree may repossess the asset in particular if the hirer has not paid 2/3 of the value of the asset this will entail a capital loss to the hirer once the asset is repossessed by the hiree.
2. It may be difficult to get a guarantor for expensive purchases e.g huge machinery as their value may be beyond the financial capabilities of a number of guarantors making it difficult to acquire heavy fixed assets necessary for the company’s operations.
3. By not purchasing the asset outright, the hirer foregoes discounts which will be an opportunity cost as a result of hire purchase.
4. Hire purchase is limited to those assets which are available with the hiree and as such may not cover all areas of the company’s financing needs e,g for working capital.
Institutional Investors
These are body corporates which avail finance for long term use, and avail their finances though purchase of shares in the stock exchange, debentures and through mortgage finance to deserving financially strong companies. Companies that avail this finance include trustee companies, pension organizations, insurance companies, and investment companies’ e.t.c. these avail finance in
large quantities and usually do this to earn a return on the same finance or to acquire ownership in those companies so as to safeguard their investments. Companies which are financially strong will attract institutional investors.
Advantages of using finance from institutional investors.
1. it is cheaper to raise this finance because it will be available in large sums and from a few companies i.e flotation costs will be low.
2. These institutions using their financial experience can advise the company in its investment activities so as to utilize such finance more profitably.
3. the cost of servicing their finance is low as these will be paid with a few cheques unlike the case with a company having a large number of shareholders with will issue many cheques this increasing the cost of servicing this finance.
4. These investors will come to the rescue of the company permanent finance if they purchase ordinary shares and this will be used in long term ventures.
5. Being major shareholders they will contribute valuable ideas during the annual general meetings and such ideas may improve the running of the company benefiting from such finance.
Disadvantages of raising finance from institutional investors.
- They may disrupt the company’s running through the various ideas they would want the company to implement which may not be in the interest of other shareholders.
- They influence the company’s dividend policy and as such this may be to the detriment of small shareholders.
- In case they decide to sell their shares this will lead over supply of shares which will lower the price of the company’s shares in the stock exchange; this may erode the company’s credibility.
Factors affecting the type of finance sought.
Finance to be raised by accompany should be at a cost than the return expected from the project where such finance has to be invested , for this reason two types of costs should be considered before raising any finance:
1. Explicit costs
These are costs that the company has to pay directly to the lenders for using their money this could be either interest payable for using debt finance or dividends payable for using share capital; these two costs are paid to retain such finance in the business.
2. Implicit costs
These are costs which are not necessarily paid to lenders directly but which must be paid to obtain finance these include such costs as; insurance of the security, its maintenance costs and floatation costs for raising share capital. These two costs should
be weighed against benefits to be derived from the use of such finance.
Need for finance.
- A company may raise finance to finance its working capital needs, this finance is known as bringing finance such as finance will be raised form such sources as overdraft and short-term loans.
- To acquire a fixed asset this will be raised from long-term sources of finance
- Ordinary share capital
- preference shares capital
- long term debt financed or sell of debenture
- hire purchase finance
- lease finance et.c
3. The company’s gearing level.
The gearing level will influence the company’s ability to raise further finance in as much as highly geared companies are viewed as highly risky as they have used more debt finance than equity finance. This exposes it to chances of receivership and consequently liquidation as creditors can recall their money at short – notice. This means that high gearing will not allow the company to raise
debt finance as creditors will be reluctant to lend to a highly geared company. Also such a company cannot raise equity finance as the demand for its shares will be low due to such indebtedness.
4. The size of the company
The size of the company will determine which finance it can raise. This is so because small companies may not be able to raise difference finances due to the following reasons;
1. such companies will find it difficult to have access to different finances because:
- They may be unknown to the lenders and as such their credibility will be questionable.
- Such companies may not have the necessary securities to pledge in order to raise various finances available in the financial market.
- They may be ignorant of the various finances available on the financial market.
2. They may not meet the requirements of the stock exchange so as to float their shares e.g for a company to go public such a company must have a minimum of shs. 2,000,000 or such £ 100,000 which very few companies may have.
3. Lenders also discriminate against small companies in their lending activities in particular due to ownership of small companies most of which are sole traders whose life span is equivalent to that of the owner, this means that they viewed as highly risky areas of investment.
4. Big companies not only are they able to raise share capital, but also can sell their debentures even under credit squeeze, which condition usually makes it difficult for small companies to raise finance.
Repayment Patten
These include the repayment of principal and interest. Ideally a company’s repayment of principal should be spared over such a period as can enable the asset and or the project financed to pay back. In case of interest the company.
