How the Capital are Raised for Your Business?

admin

By: Site Engineer, Staff

full bio

All economic activities require the use of resources. In economics, resources are called factors of production. For a business establishment to engage in production and selling activities, the land must be acquired, machines, equipment, and raw materials must be purchased, labor must be employed and salaries, wages paid along with other fringe benefits. Thus, funds will need to be available to the business establishment to start and continue operations, before it is in a position to generate resources from the sale of its products.

In many cases, customers do not pay immediately for the products they consume. Therefore, the business establishment will need to wait for a few weeks before goods sold are paid for. Meanwhile, the business establishment must continue to purchase materials and pay for labor in order to continue in production. For all these, the business needs funds. The pertinent questions then are: How much funding does the business establishment need? In other words, what is the optimal of funds to be raised and how quantum to be allocated for the purchase of assets needed for profitable operations? Financial management seeks to provide answers to these questions.

How to Determining Need for Funds

A primary function that the financial manager has in the business is to determine the need for funds of the enterprise.

Determining the optional amount of funds needed in the business enterprise serves two purposes. In an established enterprise, it enables the financial manager to plan how to invest any funds that would not be immediately required to finance operations. It also enables him to recognize any deficit in the financing, and to arrange to borrow any additional funds that may be needed. Funds, like other assets, have alternative uses. Thus, funds that are employed in excess of what is required in the business are not being used in the best way possible. Imagine that an enterprise keeps $60,000 in its current account to enable it to pay bills promptly. If at any time, its need for cash does not usually exceed $20,000, the excess cash of $50,000 is not being utilized in the most profitable way. It is obvious that such an enterprise could have earned additional income by investing the excess funds in additional assets, or at least in an interest-yielding account.

Similarly, the enterprise will make less than maximum profits, if the funds employed in it are less than what is required at that point. Inadequate funding is a serious constraint on the operations of the business. It forces the manager to make decisions on a short-term basis, without due regard to the long-term impact of such decisions. For example, the manager may be unable to take advantage of discount arrangements of suppliers, even though he is aware that the discount conserves cash in the long run. He may also be unable to extend credit facilities to his distributors and customers, thereby losing sales to his competitors. Thus, determining the optimal amount of funds needed by a business provides an opportunity for advanced financial planning, and therefore flexibility in decision-making.

The optimal amount of funds to be employed in the business is not static. It is related to the size and level of operations of the business. Therefore, a corresponding problem which has to be faced is the determination of the size of the business and the rate at which it is to grow.

How the Funds are Needed to be Raised?

In a small business, such as a retail shop, the proprietors might be able to use their savings and earnings from previous operations to pay for the resources that are needed by the business. In a large business, however, these internal sources may be inadequate to sustain the scale of operations. There may, therefore, need to raise funds from sources other than the savings of the proprietor(s), or earnings from the business to sustain operations.

If additional funds are to be raised from outside sources, it is necessary to examine the alternative sources available to the business establishment, with the aim of selecting that which provides the most favorable terms. Businessmen are concerned with the maximization of profit from their businesses. They will raise funds from outside sources if such funds will hence their profit maximization goals. However, when funds are raised from outside sources, certain costs must be met. In making decisions about the alternative sources to use, such cost should be taken into consideration.

Allocation of Funds to Assets

The business establishment uses a variety of assets in the production and distribution of goods and services. How are the limited funds of the business to be allocated to these assets, in order to ensure maximum profits for the owners?

Assets are acquired because of the benefits expected to be realized from their use. Since the benefits are in the future, they are uncertain. There is, therefore, an element of risk associated with the use of assets.

Different assets have different streams of benefits, as well as associated risks. In the allocation of the limited funds of the business to assets, the benefits, as well as the risks associated with the asset, must be carefully considered, if the goal of profit maximization is to be realized.

The major concerns of financial management are:

(a)        The efficient allocation of funds to specific assets;

(b)        The determination of the optimal amount of funds to employ in the business; that is, how large the business is to be, and how fast it will grow;

(c)       The raising of funds the most favorable terms possible.

Finance in Non-business Organizations

In many organizations, financing tends to be limited to the raising of funds on terms which are as favorable as possible. When resources are scarce, funds must be efficiently and effectively utilized in the business, to guarantee the maximization of profits.

Financial management is also relevant to non-profit organizations and government agencies. Even though the goal may not be an animation of profits, yet the need for funds has to be determined, and the funds raised at the minimum cost to the organization. They must also be utilized effectively and efficiently, to meet the specific goals decided upon.

Until recently, the important role of finance in the public sector in Africa, Nigeria in particular, was not adequately recognized, because it was widely believed that finance was unlikely to be a major problem in the execution of development plans. But by 1982, oil revenues had dropped considerably and the Federal Government and many State Governments had to raise loans internally and from external sources, at a high cost. In spite of such loans, many development projects were suspended, and in some cases, the government could not pay salaries and other recurrent bills. These developments emphasize the need to raise and utilize funds efficiently and effectively, even in the public sector. Financial management is as relevant to government organizations as it is to business establishments.

Need for Funds

The need for funds in an enterprise depends on several factors. These are the size of the enterprise, the type of asset required for efficient operations, its future expansion programme, the credit policy of the enterprise, and the credit policy of its suppliers.

Before an enterprise can decide on the amount to invest in its operations, it must first decide on its production capacity and its expansion programme over a definite future period. Normally, the production capacity is based on the expected future sales of the enterprise. Similarly, no expansion programme can be envisaged if the additional products cannot be sold. Once the product has been established, the amount to invest in land, plant and machinery and other fixed assets can easily be established. The enterprise expansion programme indicates the timing of the need for additional funds.

The credit policy of the enterprise also affects its need for funds. The amount of investment in raw materials, inventory, and labor depends on the volume of production and sales. In an attempt to stimulate sales, business enterprises generally resort to giving credit facilities. Such a policy increases the need for funds in two major ways.

First, since creditors would not pay immediately for goods purchased, the business enterprise has to have funds from other sources to continue production.

Secondly, with the expansion of sales as a result of the credit policy, additional funds are needed for the increased raw material usage, larger finished goods inventory, increased wage bills and other operating expenses. The additional funds needed to sustain a higher level of operations arising from increased sales can easily be computed.

While credit facilities given by the enterprise increase the need for funds, credit facilities received from suppliers decrease fund needs of the enterprise.

Sources of Funds

The business enterprises can obtain funds from either internal or external sources.

(i) Internal Sources

Funds generated from the normal operations of the firm are said to be internal. The internal sources of funds are:

(a)        Special reserves, that is, an amount set aside by the business to enable it to undertake a specific project at a future date;

(b)        Deferred taxes and other deferred payments.

(c)        Retained earnings or profits that are plowed back into the business;

(d)       Depreciation reserves which consist of an amount set aside by the business to replace old or obsolete plants and equipment;

The size of funds that can be generated from retained earnings depends on the size of the profit, government incomes’ guidelines, and the dividend policy of the business. In a study of corporate profitability in Nigeria shows that Nigerian companies are, on the average, highly profitable. With a 1978 average return on capital of 11%, and an average return on equity of 67% for 40 companies quoted on the Nigeria Stock Exchange, shows that Nigerian companies were more profitable than their counterparts in other parts of the world, particularly the developed countries. However, Nigerian companies are in a position to finance a substantial part of their operations from retained earnings.

Since 1976, the proportion of profits that can be allowed for the distribution of dividends is determined and monitored by the Productivity, Prices and Incomes Board. During the 1976/1977 financial year, for example, dividends were restricted to 30% of gross issued capital, while in 1982 it was 60% of net profit after tax. As a result of the incomes guidelines therefore, it is mandatory that a certain proportion of profits should be plowed back into the business annually.

The enforcement of the incomes guidelines is difficult, as far as small business enterprises are concerned. Consequently, the dividend policy of the business plays an important role in the decision to retain earnings for further investment. Even in businesses where the incomes guidelines are adhered to, management must still decide how much of the earnings available for distribution should actually be paid out as a dividend. The decision must take into consideration the need to satisfy the stockholders’ desire for the largest return on their investment, and the need to reinvest earnings in order to increase profits in the future. The ultimate decisions must represent a compromise between these conflicting needs.

The amount that can be generated from depreciation reserves depends on the size of the assets of the business and the depreciation policy of the management. The government has attempted to stimulate the generation of funds through this process by its Accelerated Depreciation of Capital Investment Scheme. The scheme allows business enterprises to quickly write-down their capital assets in their formative years, so as to build up liquid reserves.

The use of special reserves to finance operations depends entirely on the policy of the management. While some business enterprises may prefer to finance an expansion programme through savings, others may decide to depend on alternative sources. The decision of the management in this respect depends on the history of the business, its attitude to risk.

Taxes that are due to the government may be delayed for a few weeks, or sometimes months, without penalty. Funds from this source may be used to finance operations.

Business enterprises generally depend on internal sources to finance their operations, for several reasons. Money obtained from internal sources can be used by the firm as it deems necessary. It can be invested in fixed or current assets, or it may be used to pay off loans. Since the money belongs to owners of the business, it does not create additional rights or obligations for the business. There are no interest charges or repayments of principal to be made in the future. Financing from internal sources puts the business enterprise in a solid position to raise external loans, without unduly exposing it to risks. Internal sources are thus the most flexible and attractive means of financing a business.

(ii) External Sources

There are various sources of external finance for the business enterprise. It is, however, useful to categorize the sources according to whether they provide short-term or long-term finance.

The external sources of finance are as follows:

Short-Term

Long-Term

  • Loans from friends and relations
  • Bonds (mortgage or debenture)
  • Lease financing
  • Proprietors’ savings
  • Sale of ordinary and preference shares

Short-Term Finance

(a)        Trade Credit From Suppliers

The second main source of short-term finance is the supplier of the business enterprise. Most suppliers of raw materials attempt to increase their sales by extending trade credit to their customers. Goods are supplied or services rendered, and the customer is allowed some definite time to pay for the goods or services.

To encourage prompt payment of bills, suppliers allow some discount, of say 2%, to customers who pay on or before the due date. Thus, the business enterprise is required to pay the full value of the goods supplied if the bill is paid after the due date.

As with commercial banks, suppliers extend credit to business enterprises that are judged to be creditworthy. Creditworthiness may be established through analysis of the financial statements of the firm applying for credit facilities. Banks often provide confidential information on the creditworthiness of a business enterprise. The supplier’s own experience and the experience of other companies are useful sources of information on the credit history of the business enterprise.

(b)       Loans Form Associated Companies

The surplus funds of one company may be borrowed by another for a short period. This is usually possible if the lending company and the borrowing company are under the same control, as in a holding company or group of companies.

(c)        Small Scale Industries Credit Scheme

The government provides short-term finance mainly through the Small-Scale Industries Credit Scheme. Under the scheme, the government may grant a working capital loan of a maximum of $50 for small-scale industries.

(d)       Loans and Overdrafts from Commercial Banks

Short-term finance includes trade credits and bank loans. The sources of short-term finance are commercial banks, suppliers, other companies and government. The commercial bank is the principal source of short-term finance for a business.

The method by which commercial banks provide short-term funds is to open an advance request, a line of credit, or overdraft facilities for the customer. By this process, the commercial bank agrees to accommodate the request for cash loans, up to a certain amount.

Overdraft facilities enable the business enterprise to use funds in excess of its cash balance in the bank to pay its suppliers or staff salaries, or to meet other operating expenses. Interest is paid on the overdraft facilities used.

Commercial banks by nature are short-term lenders. As much as 90% of their loans and advances are repayable within one year. While they may require security or collateral for a loan advanced to the business enterprise, it is not the only factor in the decision to grant loans. They are also interested in the soundness, profitability, and viability of the project, as well as the borrower’s managerial competence and technical skill in executing the project.

A prospective borrower must, therefore, demonstrate its managerial competence by maintaining simple records, developing prudent financial policies and plans, and operating the business as an ongoing venture. Invariably, the commercial banks depend on their own experience with the business enterprise to make their lending decisions. Therefore, this underlines the need for the business enterprise to establish and maintain a good relationship with the bank, in order to be in a position to obtain loans from it when necessary.

The assets that are usually accepted by commercial banks as securities include fixed assets and charges on floating assets, government securities, and other marketable securities. The security provided by the businessman forces him to be prudent in the management of the borrowed funds. It also enables the bank to recover the loan by selling the mortgaged assets in the event of a default.

Long-Term Finance

1. Proprietors’ Savings

This may take the form of equity, loan or lease. The source of equity finance includes personnel savings of proprietors and sale of shares. Unincorporated and small-scale business depend almost entirely on the savings of their owners for long-term finance. However, in Africa, only limited funds can be generated from this source.

Not only are incomes and savings generally low, but there are also psychological and sociological constraints to savings and capital accumulation. These barriers include the extended family system, conspicuous consumption, and the tendency to spend huge sums of money on funerals and other non-productive activities.

The proprietor’s savings may be augmented with loans obtained from friends or relations. As a source of long-term financing, this is generally negligible.

2. Sale of Ordinary and Preference Shares

An important source of capital for incorporated companies is the sale of shares. The memorandum of association of the company stipulates the authorized or nominal capital of the company, the classes into which it is divided, and the number into which each class is further divided.

The authorized capital may be divided into two broad classes – preference and ordinary shares. As an illustration, the authorized capital of Jack and Co. Limited may be $10 million, made up of $2 million preference stock, and $8 million ordinary stock. The preference stock is further divided into 2 million shares of $1 each, while the ordinary or common stock is divided into 16 million ordinary shares of 50 cents each. Any person may invest in the company by subscribing to the number and class of shares desired. As evidence of the investment, a share certificate is issued, in which the number of shares subscribed, as well as the class, is indicated.

Preference shares are so called because they have priority over ordinary shares, both in the distribution of dividend and in the distribution of assets, in the event of a liquidation. This means that the dividend due to preference shareholders must be paid, if profits are realized before any dividend is paid to ordinary shareholders normally do not have voting rights in the management of the enterprise. They do, of course, have voting rights when dividends are in arrears, or the company is being wound up.

Preference shares may be sub-divided into participating preference shares, cumulative preference shares, and non-cumulative preference shares. A participating preference share is entitled to a fixed dividend rate, and to an additional dividend out of any surplus profit after a specified rate of dividend has been paid to ordinary shareholders.

Cumulative shares mean that if the fixed dividend is not paid in a particular year, it is carried forward until it can be paid out of profit realized by the business enterprise. All such arrears of dividend must be paid before any ordinary shareholders have a right to dividends, only if profits are made.

Ordinary shareholders do not have a predetermined rate of dividend. They are entitled to any surplus profits after preference shareholders have received all their dividends. What the ordinary shareholder receives depends on the size of the surplus. If the surplus is large, it becomes possible for a high dividend to be declared for ordinary shareholders. If there is no surplus, no dividends can be declared, and ordinary shareholders will go without any dividends for that year.

Ordinary shareholders also receive the residual assets in the event of liquidation; after all other claims have been settled. Hence, ordinary shareholders assume the highest risk in the company.

Under normal circumstances, only ordinary shareholders have voting rights at the annual general meeting of the company.

Since every ordinary share is entitled to one vote, an ordinary shareholder’s right in the control of the affairs of the company depends on the number of shares he owns. However, not all shareholders exercise their right to vote personally. A shareholder can appoint anyone to attend and vote on his behalf at a general meeting of the company. The person so appointed is called a proxy. When voting is exercised in this way, it is called ‘voting by proxy’.

3. Long-Term Debt Financing

A company can raise a long-term loan by issuing bonds. A bond is a certificate of indebtedness. It attracts a fixed interest rate which must be paid, whether the company makes a profit or not. The principal must be fully repaid at a specified future date.

Bonds may either be secured or unsecured. A bond may be secured by mortgaging or pledging the assets of the company to the bondholder (lender). If the company is unable to repay the principal when it matures, or when the company goes into liquidation. The bondholder may recover his money by selling the mortgaged asset bond.

A bond is unsecured in the sense that no particular assets of the company are pledged against the repayment of the loan, the bondholder may recover the principal by selling any property of the company that is not already mortgaged to another bondholder. Such an unsecured bond is called a debenture.

Bondholders have no other rights other than the fixed interest, priority in the receipt of a share of assets in case of liquidation, the repayment of the principal when due and any other rights that may be agreed upon between the company and the bondholder.

One of such conditions may be the right of the bondholder to convert his bonds into ordinary shares. Usually, the rate at which the bonds are to be converted is stated in the bond certificate. For example, it might be stated that a $1,000 bond can be converted into 100 ordinary shares at $10 each. Bonds that can be converted in this way are called convertible bonds.

The issuer of the bonds may also have the option of liquidating the bond agreement or indenture. In this case, the specific rate at which the bonds may be retired is stated in the indenture. A bond that can be redeemed in this manner is known as a callable bond.

By issuing bonds, a company is able to acquire additional capital to generate earnings. If the earnings on the additional capital are more than the interest rate on the bonds, issuing of bonds will be clearly more beneficial to the company.

However, issuing of the bond increases the risk of the company. The interest rate, through tax-deductible, is fixed and payable for a long period of time. The loan too must be repaid when it matures. If there are fluctuations in the earnings of the company, it may have some difficulty in meeting these financial obligations. This risk element must be taken into consideration in a decision to issue bonds.

4. Lease Financing

A company may find it desirable to lease equipment rather than buy it. It may not have the cash to purchase the equipment, or the equipment may be required for only a short period. The equipment may also be one that quickly becomes obsolete, and it is undesirable to invest scarce funds on it.

Under these conditions, leasing or renting the equipment enables the company to use the asset without having to find the funds for outright purchase. However, the company is required by the lease contract to make periodic rental payments over a specified period of time. The contract may also stipulate other terms, such as the maintenance and repairs of the asset, the conditions for renewal of the lease and an option for purchase. Several companies specialize in lease financing. The best-known ones are merchant banks and some commercial banks.

 

Don’t forget to share this post!

share:
Whatsapp Share Icon