SOURCES OF BUSINESS FINANCE

1.0 INTRODUCTION

Financial sources or funds available to a business organization could be classified into short-term, medium term, and long-term, or into short-term and long-term. Sources of funds available to business organizations could be classified into two main categories:

1.  Internal 
2.  External 

These categories have different types of sources, that is a firm can generate funds internally or externally to finance its activities. External sources could also be short-term or long-term. This unit will focus on how firms acquire funds in order to acquire assets.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

1.  List and discuss the external sources of finance; 
2. Classify the sources of finance for a firm; 

3.0 MAIN CONTENT

3.1 SOURCES OF FUNDS

3.1.1 Short-term sources

Short-term sources of funds represent current liabilities (funds owed). They represent short-term obligations. Since they are supposed to be settled by cash, they represent cash payments which must be settled as at when due. Examples of current liabilities and their sources are explained as follows:

1. Owner’s Equity: The owner contributes as owner/shareholder who bears the risk of the business. 
2. Bank Overdraft: The source of overdraft is commercial banks, and they grant this to creditworthy firms. Funds could be advanced to such firms within a period ranging between one day and one year. These loans are supposed to be repaid on self-liquidating basis. 
3. Account Payable: This is trade credit. A firm can buy something on credit. Supplies could be made on credit, and they give rise to trade credits. 
4. Bill Finance: This is bill is a promissory note. But there are different types of bills and complexity exists in their meanings. In our case, a bill is a trade bill of exchange which could be domestic or foreign. If a bill of exchange (inland) is accepted from discounting operations. 
5. Deferred Tax Payment: Tax payment could be looked at from two perspectives: Self imposed (a firm will not pay when it is supposed to pay and that becomes a source) and Late assessment. 
6. Factoring: Debt could be factored. This is another source of short-term funds. Factoring involves handing over of account receivable or any other debt to factors for collection with or without recourse.
7. Hire Purchase Finance Arrangement: Firms that engage in selling on installment basis can make arrangement with hire purchase firms to make credit facilities available to customers. Alternatively, a firm may make hire purchase agreement with its customers.
8. Stock Finance: Stocks could be used to raise short-term funds in a number of ways. They could be used as collaterals for secured loans from commercial or merchant banks. Raw materials could be financed en route by means of trade bills and/or warehouse receipt. This represents another type of secured loans on the value of stock of raw materials. The bill could become negotiable if endorsed by a reputable commercial house or bank, and could thereafter be sold outright or used as collateral for a loan. 

SELF-ASSESSMENT EXERCISE

1. List and explain six short-term sources of finance for a firm. 

LONG-TERM SOURCES

Two major external sources of long-term funds are: Financial institutions (including lease finance companies), and Capital market.

Capital market is classified into: Organized and Unorganized.
The organized capital market will be our focus because it is the capital market that will assess the performance of the firm.

Firms raise money from the capital market by: Issuing common stock (C/S); And Issuing instruments of debt (long-term liabilities).

Note that a firm cannot issue debt instruments if it has no common stock.
Common Stock: Equity shares, common stock and ordinary shares, all mean the same thing, but a stock is a group of shares, that is, a stock is made up of shares. Ordinary shares could be issued by firms which have been quoted on the stock exchange. Ordinary shares constitute the equity base of a firm, and represent ownership of the firm on pro-rata basis. This implies that an individual investment is a small proportion of total investment. Each equity shareholder is entitled to a proportionate part of the firm’s residual profit and asset. The capital contributed by the shareholders is, therefore, known as risk capital. But they have some compensation like voting rights.

Preference Shares: The next class of shares which ranks above equity shares are the preference shares. They are also known as preference stocks. Preference shares occupy an intermediate position between common stock and debenture stocks. Preference shareholders are entitled to fixed dividend payment as different from equity shareholders which are entitled to variable dividend payments. They are imperfect creditors because tax is paid before fixed dividend is paid to them; they are not creditors and they are not the owners of the firm. They do not normally have voting rights unless otherwise stipulated in the terms of the issue. There are various types of preference shares:

1. Cumulative preference shares 
2.  Participating Non-Cumulative shares 
3.  Participating Cumulative shares 
4.  Redeemable and irredeemable Preference shares 
5.  Convertible Preference shares 

1. Cumulative Preference Shares

Preference shares could be cumulative or non-cumulative. Cumulative preference shares allow for dividend payment to be deferred if a firm does not make adequate profit to pay such
dividend. Therefore, such firms are normally required to pay such dividends in arrears before dividend could be paid to common shareholders. Non-cumulative preference shares do not allow for any form of deferment of dividend payment

2. Participating Non-Cumulative Preference Shares

This class of shareholders is entitled to a non-cumulative dividend at a fixed rate but without a right to participate in the residual profit of a firm after the equity shareholders has been
paid.

3. Participating Cumulative Preference Shares

This class of shareholders is entitled to participate in the residual profit of a firm in addition to the cumulative fixed dividend rate (i.e. they combine the features of cumulative and participating).

4. Redeemable and Non-Redeemable/Irredeemable Preference Shares

Preference shares could be redeemable or irredeemable. Redeemable preference shares are normally redeemed after a fixed period of time. We can say that this class of preference shares has a definite maturity period while irredeemable preference shares do not have definite maturity period (but it could be sold at the security market – an artificial maturity period).

5. Convertible Preference Shares

Convertible preference shares convey upon the holders the right to convert these shares into equity shares in accordance with the terms of issues. This is an issue with speculative features.
These shares are corporate fixed-income securities that the investor can choose to turn into a certain number of shares of the company’s ordinary shares after a predetermined time span or on a specific date. The fixed income component offers a steady income stream and some protection of the investors’ capital. However, the option to convert these securities into stock gives the investor the opportunity to gain from a rise in share price. It can be summarized that convertible preference shares give the assurance of a fixed rate of return plus the opportunity for capital appreciation.

Debenture Stocks: These are corporate bonds.

Two categories of debentures are:

1. All banks debentures This involves one to one relationship between a bank and a firm, and lending is based on the assets. 
2.  Debenture Stocks – Debenture stocks or corporate bonds are normally issued under a firm’s seal. This represents the legal evidence of a firm’s indebtedness. A debenture stock holder is a creditor to the firm, therefore, he is entitled to a fixed interest payment whether a firm makes profit or not. Debenture stock holders do not have any voting right and their interest in the firm is limited to the fixed interest payment no matter how successful the firm may be. 

Lease Financing: This is an important source of long-term funds. It may be used as a source of financing company expansion or for modernization of the productive apparatus of the firm. Thus, through leasing, a company may make use of an equipment without actually owning it. The main objective of leasing is to put at the disposal of a firm a plant or any fixed asset which serve the productive need of such a firm. The firm, in making use of that equipment, is obliged to pay to the lessor adequate sum of money which constitutes cost on the part of the firm. Three types of leases are:

1.  Operating lease; 
2. Financial lease; 
3.  Sale and leaseback. 

Self-assessment exercise

Discuss the various types of debenture.

4.0 CONCLUSION

A firm can source for funds, internally or externally, to finance its activities. These sources could be short-term or long-term, and the funds so acquired are used in turn to acquire assets. The capital market is very important to the firm in the acquisition of long-term funds.

5.0 SUMMARY

In this Unit, we have been able to classify the sources of finance for a firm and enumerate and discuss the various short-term and long-term sources of finance;

6.0 TUTOR-MARKED ASSIGNMENT

List six short-term sources of finance for a firm.