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Financing is one of the principal decision areas in financial management. It involved critical analysis of the various sources of finance available to an entity to achieve optimal capital structure. Capital structure is the way and manner a company finances its operations. Whilst the optimal capital structure is the one that minimize the overall cost of capital of the firm. When a company has identified viable investment opportunities, i.e. projects that can increase the value of the business, there will be need to ascertain the most economical method of financing the projects.
Basically, there are short-term, medium-term, or long-term sources of finance open to a company, depending on the amount, the underlying cost, duration, and purpose for which the funds are required.
Now, let us look at the various sources of finance available to a company, based on their time horizon.
These are funds required for financing the day to day running of the business, that is, working capital. The funding requirement may be for each component of current assets and current liabilities such as inventories, account receivables, prepayments, short-term investments, and account payables. This source of finance is usually available for a period of 12 months or less. Short-term sources of finance should not be used for financing long-term business activities including purchase of non-current assets such as motor vehicle, plant and equipment, machinery etc., because that will amount to funds mismatch and can impair the ability of the company to make repayment as agreed.
There are several short-term sources of finance. Some of them include:
Accrued expenses are those expenses that the company owes to others but not yet due for payment. It represents a liability that a company must pay for the receipt of goods or services. Salaries and wages, interest, dividend, and taxes are the major components of accruals. And they represent a readily available and interest-free source of financing, but companies should exercise care in its usage. Mostly, taxes are paid one year in arrears, and companies usually utilize the timing difference in the payment of tax, by ploughing back the tax due into the running of some of the business activities. This source of funding must be used carefully. Otherwise, there may be penalty or fine for failure to file returns.
Also, salaries and wages are usually paid on a monthly and weekly basis. But when organizations are constrained, they may dip into staff salaries and use the funds to finance other pressing business activities and defer payment of staff salaries to another period. However, companies should seldomly use this source of fund because it can have severe consequence, including absenteeism, low productivity, and morale etc. on the business operations.
This represents an arrangement by which a business purchase goods on account for credit, and settlement to the supplier is deferred into an agreed later date. Usually, suppliers can give credit for 15, 30, 45, 60 days or more, depending on the supplier’s credit policy. A discount is allowed if payment is made within a specified number of days, otherwise, the full amount will be due at a specified date. For instance, the terms of “3/10, net 30” means that a 3percent discount is granted if the invoice amount is paid within 10days; otherwise, the full amount will be paid on the 30th day. The terms of discount and credit policy differ among companies, depending on the industries, level of competitions and market conditions.
Companies should develop a guideline that align all procurement activities including inventory and payables management. The guideline will ensure efficient management of account payables, which is a key component of working capital.
This is a loan facility usually extended to a company through its bank. It represents one of the sources of finance to a company whereby the company makes payments out of its current account in the amount that exceeds its available balance. Overdrafts are a good source of working capital financing. The facility is normally available for a fixed period or can be rolled over with no end date. Overdraft facility can be arranged and available for use within two weeks or up to three months depending on the size of the facility and level of securitization. Secured overdrafts can take up to three months to be available due to the need to verify the authenticity of the documentations and securitized assets. Whereas unsecured overdrafts can be available for use on the spot or maximum of two weeks.
Overdrafts are usually provided at a cost which may include interest charges on the amount overdrawn at the end of each day, annual arrangement, or maintenance fee. Other fees and charges may be applicable, such as a non-utilization fee, depending on the size of the facility. Other conditions that may be attached to the overdraft facility by bank may include Information on current management accounts and/or cash flow projections. This information will be reviewed and agreed before final approval.
Debt factoring is a form of arrangement between a company and a factor where the company sold the outstanding invoiced amount to the factor at a discount in order to raise funds. Factoring is another source of finance to a company in that, the receivables will be paid by the factor to the company much sooner than expected and cash will be made available to run the activities of the business. The terms and conditions set by a factor may vary depending on their internal procedures and what is obtainable in the industry.
Usually, there are three parties involved in factoring transaction- the company who sells the receivable, the factor who purchases the receivable, and the debtor who has the financial liability to pay outstanding invoiced amount.
They are issued to meet short-term working capital requirements, such as inventories, accounts payable etc. or undertake new investment opportunities. Companies issue commercial papers at a discount from the face value, depending on the prevailing interest rates and credit rating of the issuer. They have a maturity period of between 30 and 270 days and are bought and sold at a discount in the money market and the returns are normally high due to high risk. It is an unsecured debt negotiable instrument not back by any collateral. Such features make it a convenient and cheap financing option for company with a good credit rating and reputation.
The costs associated with issuing commercial papers such as dealers fee, bank charges and commission, rating agency fee etc. are usually borne by the issuer. Commercial Papers may be issued to and held by individuals, deposit money banks, other corporate bodies registered or incorporated in Nigeria and unincorporated bodies, non-resident Nigerians, and foreign institutional investors.
This is a bill of exchange drawn on and accepted by a bank stating that a certain amount of money will be paid after a specified period. Bankers’ acceptances are relatively liquid, safe but with low returns although these returns are usually higher than those available on government securities. Bankers’ acceptances usually have maturities of 30 to 180 days.
It is a marketable instrument and allows a bank to finance its customers without necessarily utilizing its loanable funds. Instead, funds are provided by investors who are willing to purchase these obligations on a discounted basis. Bankers’ acceptances are used for cross-border transactions as a means of settling payment.
These are funding required for a period exceeding one year but less than 5 years. They are mainly used for financing non-current assets such as machinery, motor vehicles, furniture & fittings, plant & equipment.
Common sources of medium-term financing include:
A lease is an agreement between two parties, the “lessor” and the “lessee”. The lessor owns a capital asset but allows the lessee to use it. The lessee makes payments under the terms of the lease to the lessor, for a specified period. Leased assets are usually plant and machinery, cars, and commercial vehicles, including computers and office equipment. There are operating leases and finance leases.
This is a contractual agreement between two parties- the owner and the user, in which one party acquires an asset from the other party through regular instalment payments and ownership of the asset is transferred when the last instalment is paid. Hire purchase is similar to leasing, except that ownership of the goods is not transfer to the user of the asset until the final instalment is made to the owner. The hire purchase payments usually include the initial deposit, annual instalment, and the interest.
A franchise is a form of license usually granted to a business (franchisee) by a company (franchisor) for the use of the company’s proprietary resources such as business model, brand, suppliers, and marketing, in order to allow the business to sell a product or provide a service under the company’s name. The franchisee is required to pay to the franchisor an initial start-up and licensing fees, in exchange for gaining the franchise.
The franchisor is the original owner of the business that sells the right to use its name and idea. The franchisee is the individual or business who buys into the original company by purchasing the right to sell the franchisor’s goods or services under the existing business model and brand. Franchising generally provides you with access to an established company’s brand name. This means that you do not need to spend additional resources to register your name and promote your products to potential customers.
This is a form of private equity that provides financing to companies in their early stage. Venture capitalists play a very active role in the management of companies in which they invest their money, by also providing close oversight and regular advice.
Venture capital funds have a definite investment horizon and, depending on the type of business, they make the investment with the opportunity to exit within three to five years from the initial start-up. The exit return earned by this private equity investors is based on the price at which the investment can be sold upon decision to go public through initial public offering on the stock market or by being sold to other investors.
A business angel also known as angel investor, angel funder, informal investor, private investor, or seed investor is a high net worth individual, who provide financing to start-up companies or entrepreneurs, in exchange for ownership equity. Often, angel investors are found among an entrepreneur’s family and friends. The funds that private investors provide may be a one-time investment to help the business get off the ground or an ongoing injection to support and carry the company through its difficult early stages.
While some business angels are active board members, others act as advisers and keep out of day-to-day running of the business. Many provide the capital but have nothing to do with the running of the company. Most of the angel funders are business executives and possessed diverse industry experience and expertise.
Long-term financing is a mode of financing that is available for over one accounting period, that is, more than one year. Long-term financing is required for the acquisition of non-current assets, expansion and growth, research and development, technological innovation, and execution of new investment opportunities.
The sources of long-term financing include:
This is one of the long-term sources of finance that involved the use of fixed-income securities to finance the operations of a business. Debt is regarded as a cheaper source of financing open to a company because it attracts tax deductibility benefits. The risk and return associated with this type of financing is usually low, compared to equity financing. The providers of debt capital are entitled to annual fixed interest payments up to the maturity. When the company defaults on the payment of interest and the principal, the debtholders may file for liquidation, and the assets of the company will be realized, and the proceed will be used to settle all creditors in the order of seniority. The main debt instrument includes bonds, debentures, and loan notes.
A bond is a contractual agreement between the issuer and the bondholders. Bond is used to finance long-term financing needs of a company. Generally, the terms ‘loan notes’, ‘bonds’, or ‘debentures’ are now used interchangeably to mean any kind of long-term marketable debt securities. Debentures are a type of bonds that can be secured or unsecured.
Click here to read more about the meaning and features of bonds:
However, there are important elements of bonds that investors need to understand when making investment decisions, including the features, legal, and tax considerations.
The legal obligation to make the contractual payment is assigned to the issuer of the bond. The issuer is identified in the indenture by its legal name. Bond indenture is the legal contract that describes the form of the bond, the obligations of the issuer, and the rights of the bondholders, including information on sources of funding the interest payments and principal repayments, collaterals, or covenants. Collaterals are assets or financial guarantees underlying the debt obligation over and above the issuer’s promise to pay. Covenants are clauses in the indenture that specify the rights of the bondholders and any actions that the issuer is obligated to perform or prohibited from performing.
Investors should pay special attention to their rights in the event of default by carefully review every line item in the indenture. Investors should also give priority to where the bonds are issued and traded because it affects the relevant laws and regulations of the jurisdiction. There are national, domestic, foreign, or global bonds and all have different specific legal and regulatory requirements that investors must familiarized with.
Investors should pay critical attention to tax implication underlying the bond issued. Every country has specific tax legislation and requirements, both local and foreign. Therefore, investors should get familiar with tax considerations on the bond.
These are fixed-income security that serves as a source of financing long-term business activities of a company. Preference shares are also known as preferred stock. They are shares of a company’s stock with dividends that are paid out to shareholders before ordinary share dividends are paid. In the event of liquidation of the company, the preference shareholders are settled from the company’s assets before the ordinary shareholders. Preference shares are less risky compared to ordinary shares.
Preference shareholders are entitled to fixed dividend from the company’s annual profits and do not possess any voting rights in the company. Preference share combines the features of debt and equity because it pays fixed dividends and has the potential to appreciate in price. Preference share could be cumulative or non-cumulative, participating, or non-participating, redeemable, or irredeemable.
Equity financing is the investment in a company by the ordinary shareholders, represented by the issued ordinary share capital plus reserves. Ordinary shareholders are the owners of the company that contributed their capital to finance the operations of the company. Ordinary shares represent ownership interest in a company, and as a result, the equity holders partake in the sharing of the operating performance of the company (as a compensation for their capital contributions), participate in the governance process through their voting rights, and have a residual claim on the company’s net assets in the event of liquidation.
Equity financing is the process of raising capital by selling shares to investors for the purpose of meeting liquidity requirements of the company in exchange for cash. There are three main sources of raising equity finance and these include:
These are undistributed profits of the company attributable to equity holders. They are internally generated funds retained in the business to cater for the financing needs of the company. For a well-established company, retained profits may represent the most important source of finance of both short and long-term purposes. Internally generated fund is easy and cheap to raise, because it does not require any transaction costs, issue costs, professional fee etc.
This is an invitation to existing shareholders to purchase additional new shares in the company. A rights issue is an offer to existing shareholders to subscribe for new shares, at a discount to the market price on a stated future date, in proportion to their existing holdings. The rights issued to a shareholder have a value, thus compensating current shareholders for the future dilution of their existing shares’ value.
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