Factors to Consider When Sourcing for Finance

Amount Required

One key factor to consider when sourcing for finance is the amount required arising from the liquidity position of a company. When the finance available to a company is not sufficient to undertake viable investment opportunities or run the day-to-day activities of the business, there may be need to source for funds to account for the shortfall. Company will need to ascertain the amount required to address its liquidity. The size of finance required will determine the cost the company will pay to the provider of funds. This is because each source of finance has its own underlying cost, and every company will strive to minimize the overall cost of borrowing.

Purpose

When a company needs money to finance its operations, it may approach banks or investors for loan facility. One of the questions a potential lender will ask is the need for the funds. Therefore, the reason for and the use of the finance is very vital. May be the finance is required to acquire non-current assets or to address shortfall in working capital. Hence, before you set out to source for loan or finance, you should know the purpose for which the funds are required.

Risk

The risk of default is one of the determinants when sourcing for finance. The default risk is the risk arising from the inability of the company to settle its financial obligations as they become due. Imagine the consequential effect of failure to pay debt owed to a bank, relation, or friend. A business is exposed to various kinds of risks and the perceived risk of the company by each investor or financier differs. Generally, banks considered new or small companies riskier than the well-established organizations. Risk is a function of cost of capital, because the higher the risk associated with a company; the higher will be the cost of finance and vice versa. Generally, the risk associated with debt finance is lower and that is why its level of return is also lower.

Cost of Finance

The cost of finance is the compensation required by the supplier of funds from their investments. It is a function of the size of finance required and the perceived risk. The higher the amount of finance required and the level of risk, the higher will be the associated costs. A higher cost of finance will lower the profitability of a business, and a lower cost of borrowing will increase the profitability. In a company capital structure, debt finance is presumed to be cheaper than equity finance because of tax deductibility benefits.

Duration

Finances are arranged for different time horizon. There are long-term and short-term sources of finance. Funds should be matched with the duration of the finance. The matching principle states that, ‘long-term assets should be financed with long-term funds and short-term assets by short-term funds’. This principle should be applied when sourcing for finance. Short-term source should be used for financing working capital and long-term source should be used for purchase of non-current assets. Also, long-term finance is more expensive than short-term finance because borrowers perceive the risks associated with long-term financing to be higher on long-term loans.

Gearing Level

Gearing represents the ratio of debt to equity finance in a company. A company that finances its operation with more of debt can be regarded as a highly levered or geared company, whereas a company with small amount of debt in its capital structure is considered to be lowly geared. Company should maintain a balance between debt and equity finance. This is because the optimal capital structure of a firm follows the objective of minimization of overall cost of capital of the firm. When a company defaults in the payments of interest and principal, the debtholders can file for liquidation of the company, or may result to dilution of ownership of the business.

Dilution of Control

When more equity security is issued, especially to new investors when sourcing for finance, it can bring about dilution of control in the management of the company. New shares issued to investors will impair the proportionate shareholding of the existing shareholders, because of the increased number of ordinary shares. Hence, promoters or owners of the company who do not want to lose control, and prefer to keep major decisions making to themselves, will strike a balance between the amount of equity to be issued to investors and the level of control that is required in the management of the business. A controlling interest of about 51% should always be maintained, in order to remain in-charge of the major decision making in the organization.

Repayment Plan

Company should establish a repayment plan and ascertain how it intends to repay a loan facility as they become due. This is because for a company to remain in business, it must generate consistent cash flows that will be sufficient to cover its costs. A company must therefore strive to create value and generate high return that is greater than its cost of finance. Therefore, when you are sourcing for finance or loan, your potential lender may want to know how you intend to repay the loan and the source of your cash flow generation. For this purpose, you may need the service of a Chartered Accountant to help you develop the 12-month or 3-year cash flow projection, including full-year profit or loss account, and statement of financial position of your business. This is because you need to demonstrate to the potential lender that the business is profitable and that you have the capacity to pay both the annual interest and the principal amount at the maturity date.

Legal and Regulatory Considerations

Companies must consider the legal and regulatory requirements that are associated with each source of finance. Every detail of the terms and conditions of the loan facility, including the responsibilities and rights of all parties should be clearly understood. All regulatory matters including guidelines issued by Central Bank (CBN), Securities and Exchange Commission (SEC), Bank of Industry (BOI), and other agencies of the government, that relate to the transactions should be considered. Particular attention should be paid to the terms of the agreement and carefully review every line item in the debt indenture when sourcing for finance.