This article examines the various ways an entrepreneur can raise funds to run a small and medium scale business. Most potential investors regard financing as the greatest handicap in starting and running a business of their own.
In this article, we will see the ways an entrepreneur can raise funds, how he can control the funds’ how he can successfully evaluate his project and the institutions he needs to be conversant with to be able to expand his business.
No one needs to be discouraged. To raise capital requires some basic knowledge, access to information about sources of funds, values, attitudes and skills with respect to financial matters, especially the need for adequate financial planning, credit control, the role of financial institutions and the stock market. The difficulty faced by entrepreneurs who start on a small and medium scale in raising both short and long-term capital seems to be a universal problem.
Sources of Finance
There are various ways a prospective entrepreneur of a business can raise funds. However, it is better to consider personal sources first before other external sources. There is a need to mobilize personal assets to go into business, at least, for the initial take off of the business.
The sources of funds among others are:
- Gratuity and Pensions Benefits: This is a source for retirees and those that have disengaged from public service and some private organizations. It is like accumulated savings. However, the problem with this source is that gratuities and pensions are not often paid in time in Nigeria, especially in the public sector. The time between layout and payment is so long that no meaningful investments can be done with gratuity and pensions.
- Partners or Co-entrepreneurs: Rather than take a loan or a grant from friends, classmates, etc, they can be invited to contribute part of the funds needed to establish the business and to participate in running the business. Substantial funds can be raised through this source. However, care must be taken to select the partners or co-entrepreneurs to be invited. Emphasis should be on the knowledge and skill they can contribute to the business.
- Launching of Appeal Funds: The launching of appeal funds to raise capital is usually done by Organizations. A potential entrepreneur can do this. He can appeal to friends, colleagues, classmates, societies, neighbors and the general public. He must have a target audience and think carefully about his presentation, timing message, etc. Otherwise, it will be a fruitless exercise.
- Part-Payment Against Supplies: In some businesses, an entrepreneur is required to make a part payment for the goods required for business. The supplier will release the goods to the entrepreneur after paying this deposit. This must depend on the integrity of the person receiving the supplies.
- Buying Items and Materials on Credit: Most sellers allow credit purchases. This is a common feature in business. Indeed, an entrepreneur can buy some of the needed equipment or raw materials on credit. To be able to take advantage of credit facilities provided by others, an entrepreneur needs a good record of trade history in terms of honoring obligations as they fall due.
- Osusu-Group Contributions (Rotational): The entrepreneur can join an osusu group to raise funds. He needs to determine, the time he will take his turn and start a business. An efficient osusu group can be useful as a means of raising capital funds. This source is very popular. To benefit from the pooled funds generated by osusu scheme, one must be a member of the group.
- Mobilization Fees: For large contracts and businesses a mobilization fee could be paid to ensure that the entrepreneur starts the job without delay- It is expected, however, that a certain amount of the work, would have been done before any further instalmental payment could be made. Good performance leads to further payments until the job is concluded. This source of funds is very popular with government contracts. One major disadvantage to watch is a delay in instalments payment. So a potential investor must be close to the contract.
- Retained Earnings: Most successful businesses rely on retained profits for growth. Is the difficulty of obtaining loans from the banks or financial institutions, Any profit not distributed to the owners of the business in a particular period or year falls into this category. It helps further growth of the business. This source can be used by any business irrespective of size. It enhances the future growth of the business.
- Overdraft: An overdraft is a form of the loan facility. Usually, overdrafts are taken from banks. This involves the entrepreneur going to meet the bank manager to arrange a withdrawal from his own account far above what is the credit balance in his account. This means that to take the overdraft the entrepreneur must have an account with the bank. Overdrafts are usually paid once, or they are usually deducted from the borrower’s account once. There are no instalmental deductions in repayments of overdraft. It means therefore that before one qualifies for an overdraft, the cash flow size must be equal to the amount of overdraft taken. Overdraft is usually a short-term facility that an entrepreneur can take advantage of.
- Loans: Loans from banks or from other financial institutions is a popular source of funds. It involves the borrower going to meet the lender to discuss the conditions. The amount, and terms of repayments, collateral and the interest rate involved. The collateral could be sold in case of default by the borrowers.
- Leasing: Some goods, materials, tools, equipment can be hired from the seller or owner and a rental payment made periodically. For very costly and complicated goods, “apart” or all of it can be hired. This is called leasing. In leasing, the lessee (the entrepreneur in this case) pays on a regular basis a rental to the lessor. Rental payment is not a part of the purchase price of the asset.
- Hire Purchase: An entrepreneur is expected to pay a small percentage of the total purchase price of me good or asset in the first instance and spread the payment of the balance on an equal or declining basis over a stated period. The subsequent equal payments are part of the total purchase price of the asset.
- Stock Financing: Incorporated companies can sell shares to raise their capital funds. A private limited liability company can sell shares to a maximum of fifty investors but a public limited liability company sells to more investors through the Stock Exchange. The Stock Exchange makes it possible for investors who have ‘surplus funds’ to channel their funds to entrepreneurs who seek for funds to invest in business undertakings. Thus, the sale of shares or stock on the Stock Exchange ensures the mobilization of funds from the surplus sector of the economy to the deficit sector of the economy. This is a wide and lucrative area in finance to study at a higher level. For example, how one can buy shares or stock of companies quoted on the Stock Exchange and receive dividends and the capital gains involved in the business of the Stock Market, and a host of other areas.
- Personal Savings: It could be inherited savings. The advantage of this source is that the cash is readily available and can be mobilized quickly. However, there is a tendency to feel that, after all, it is one’s funds and this may lead to lack of discipline and unplanned spending or spending on irrelevant materials that will not necessarily make the business to grow.
- Deploying Personal Asset: Some personal property like vehicles, furniture or house can be deployed for use in the business. This will reduce the amount of cash required to be raised to start the business.
- Sale of Personal Assets: Funds can be generated by selling some personal assets. Because every business has a risk element, selling personal assets may look stupid at first. But if you have analyzed the opportunity carefully and you believe that the business has a good chance of success, selling personal assets to realize your dream is not stupid of all. It means that you must be concerned and committed to the business.
- Family Assistance: This is a very good source of funds. Family members are usually willing to provide assistance once they are convinced that you have knowledge of the business and the skill to manage it successfully. Family members will also take into account your personal character and trustworthiness before providing any assistance. The advantage of this source of fluids is that it is given on very liberal terms. It is important to note that as a result, you also owe an obligation to the family.
- Credit Unions and Societies: One can be a member of this body and after some time one can obtain a loan to start a business. The disadvantage is that one must be a member. Cooperative societies are encouraged to assist in raising finds with no collateral.
- Friendly Loans or Assistance: One can get financial assistance from friends, social organizations and groups. One must be trustworthy to elicit assistance from these sources.
Financial Planning and Control
The entrepreneur makes sales projections for each period. Even if the sales projection is not correct, the sales may not immediately be turned into cash if he or she offers customers credit. The entrepreneur must collect payment for sales or services rendered on credit before he or she actually has the cash on hand to use for his/her own obligations.
For many businesses, sales have seasonal peaks and valleys. The financial planning process must take this pattern of sales into consideration in order to know what cash will be available at what time during the year.
In addition to the above fact, it should be noted that cash inflows and outflows are not always constant over the year. Chances are that the entrepreneur’s plans for the year may not be realized. He could over-estimate sales for the coming period only to find that there is a shortfall of cash at the end of the period.
Financial planning involves planning for the cash requirements of the business and taking into account the changing cash inflows and outflows. Financial planning also includes budgeting for the capital assets requirements of the business.
The cash budget is usually a plan for cash inflows and outflows over a certain period of time usually one year. The cash budget is usually prepared for each month and in many businesses, on a weekly or daily basis. For this reason, the cash budget acts as a means of control to cash transactions.
Capital budgeting is the process of planning expenditure whose returns are expected to go beyond one year. For example, capital expenditures for land acquisition, building, equipment whose returns cut across a year should be the first consideration of the entrepreneur. This budget is very important because all the aspects of the business concern will be affected by capital budgeting decisions. Such decisions have a long-term effect on the business.
Methods of Capital Budgeting
There are four major ways of capital budgeting.
The four major techniques are:
(a) The Payback Method: This indicates the number of years that an asset would be used to recover the original investment in it. Now, the question is “how long will it take for the initial investment in the capital asset to be recouped?” The entrepreneur does this by estimating the possible and likely net cash inflows over the life span of the entire investment.
(b) The Accounting Rate of Return (ARR): This is the average annual net profit divided by average investment multiplied by 100. It is expressed in percentage.
ARR = Average Annual Net Profit x 100
The entrepreneur uses the ARR by comparing it with the cost of capital. The entrepreneur accepts only projects in which the ARR exceeds the cost of capital.
(c) The Net Present Value (NPV): This is the difference between the present value of cash inflows and the present value of cash outlays. If NPV is greater than zero, the project is accepted. If NPV is less than zero, the project is rejected. If NPV is zero, the entrepreneur may either accept or reject the project.
(d) Internal Rate of Return (IRR): The IRR is the discount that will make the total present value of net annual cash inflows to be equal to the present value of initial cash outlay or cost. An entrepreneur is looking for that rate which he will use to discount the sum of cash inflows that will make our NPV equation zero. It must be one rate and unique. That rate will be compared with a bench rate or cut rate. Let us call the special rate x* (k starred) and the bench rate or cut rate to be k (ordinary k). If x* is greater than x, the project is accepted. If x* is less than k, the project is rejected. If x* is equal to k the entrepreneur decides to either accept or reject the project.
This includes the processes of forecasting and setting realistic objectives with respect to:
- Distribution and selling costs
- Administrative and other expenses
- Net profit
- Sales volume over a given period
- Cost of sales
- Gross margin
The resulting budgeted profit statement then becomes the basis of control of operation over the stated period.
This is both a planning and control tool. In this method, the entrepreneur separates its costs into fixed and variable parts. The break-even point is the level of sales at which the total revenue equals total cost.
And it is given, by:
Q = F/(P-V)
F = Fixed costs
V = Variable costs
P = Price (per unit)
Q = Quantity sold
Ratio analysis helps the entrepreneur to understand the firm’s current status and performance. Some ratios can be calculated m terms of liquidity, probability, debt, and turnover.
Some relevant profitability ratios are:
(a) Profit Margin = Net income/Total Sales
(b) Return on Assets = Net income/Total Assets
For debt ratios, the entrepreneur will be interested in
(a) Debt total assets ratio = Total debt/Total assets
(b) Times interest earned = Total debt/Interest expense
(a) Asset turnover = Sales/Assets
(b) Average Collection Period = Account receivable/Daily credit sales
The entrepreneur will be interested in the following ratios:
(a) Current ratio = Current assets/Current liabilities
(b) Acid test ratio = Current assets – inventory/Current liability
Best Method to Approach a Financial Institution
Most often, any lender of the fund would be concerned with the principal and interest repayments. When a prospective borrower approaches a lender, that approach is called a proposal.
Normally, proposals are written documents so that there is a clear understanding between the two parties.
Firstly, a lender will like to find out borrower’s idea of the business, whether the borrower actually understands the nature of business and the activities associated with it.
Whether the business can generate enough funds and resources needed to cover interest charges, the requirement of the principal and other sudden financial obligations that may arise from the loan.
A lender will be interested in the following items in the proposal:
- The ability of the borrower to present information clearly and confidently is also important. He should provide as much information as is required and should not attempt to exaggerate his financial needs or how buoyant he is financially.
- His ability to respond to questions especially those which portray his knowledge of the business the limitations of his plans and risks. His alertness to important questions that are incidental to the loan helps the lender.
- His credit racing which the lender may gather from other banks his suppliers and business associates.
- His ability to be calm and be patient to get approval for the loan which in most cases, is given at a higher level of management. Hence he must provide adequate lead-time between the time the application is made and the time the funds actually needed.
- The borrower’s collateral its nature and value whether the collateral has been pledged for other loans.
- The number of borrower’s funds that are committed in the business – his commitment of funds to the business, especially in the purchase of the assets that are of critical importance to the lender.
- Personal credit history of the borrower, integrity or record. This can be revealed in his level of experience in the business.
- The attitude of the borrower during the loan procurement interview with the lender. It is unwise to introduce emotions, religion, etc or look beggarly. Loans are granted strictly for profit-making purposes.
An attempt to pressure the manager to approve the loan may look suspect. Lending decisions take time and a reasonable time must be allowed for the manager to decide.
The entrepreneur should be sure that he understands the terms or conditions under which he is taking the loan. For instance, he should be clear about the amount of the loan, duration of the loan, interest rate payment, security required method of repayment, any other fee to be paid, etc. It is important for the terms of the loan to be carefully documented and signed by the parties involved.
Important Reason Reasons why Loans are not Granted
Occasionally, loan applications are not granted. The entrepreneur must make sure that he checks why it was not granted. Remember that the lender has experience in these matters and gets many proposals so he understands better. If a proposal was rejected, the borrower should try to find out the reason and effect correction where possible.
His chances of obtaining the loan in the future will be better.
These are some reasons why loan applications are turned down:
- If past performance of such a business is poor when compared to similar competing businesses.
- Insufficient collateral.
- If the borrower is not financially committed in the business. His personal capital invested in the business is critical to the approval of the loan.
- Lack of a business plan. No lender will give out funds without knowing how the loan will be utilized and how it will be repaid.
- If the purpose of the loan to be taken is not clear. Lack of detailed explanation of the purpose of the loan will always lead to refusal to lend. The purpose must be clear and specific e.g., whether the loan is for buying a particular asset, or whether it is to expand existing production line (raw material plant).
- If the borrower’s character, confidence stability, and personality are poorly rated by the lender. For example, if a borrower has a pending divorce suit or has declared personal bankruptcy, or has contacted a terminal disease such as AIDS or cancer. These factors do not help loan applications.
Types of Security a Lender May Require From a Borrower
- Pledge of Stocks or Bonds: It is possible to use your ordinary shares (stocks) or bonds as security or surety for the borrowed funds. The title to the shares will still remain with the borrower. The lender constantly checks the value of the stocks or bonds to see if it is still within an acceptable limit. Otherwise, the lender may call on the lender to pay additional money or bring additional securities to make up the required margin.
- Assignment of Lease or Rents: This security is common in franchises. A lease can be assigned. The franchisor can assume the lease if the franchisee (borrower) goes out of business or defaults on the franchise agreement. The franchisor can then resell the franchise with a lease in place. In the case of rents, a lender may ask the borrower to sign a document that would not be used by the bank until the borrower defaults the loan obligations. In the event of default, all the rents that the borrower had previously collected from tenants or subtenants would be diverted directly to the bank. The bank would normally notify the tenants and provide them with a copy of the assignment document.
- Warehouse Receipt: In some cases, banks can lend money and use the commodities purchased with the money as security. A receipt showing that the commodities have been placed in the warehouse and in the lender’s control can be used for loans. The bank then lends up to the value or portion of the goods that can easily be sold.
- Personal Assets: Personal savings, home life assurance, cash in pension plans, are assets that can be used as security for a loan.
- Signature: His signature may be the only security that the lender may require for a loan. In this case, the borrower is required to sign a form or document to seal the agreement. However, this depends on the situation and the lender’s relationship with the borrower.
- An Endorser: Sometimes the lender may require the borrower to get some other person to pledge his own assets, or signature and note, for his loan. If the borrower fails to pay, the endorser will be liable to make good the note.
- A Guarantor: A person or group of persons may guarantee the payment of a note by signing the guarantee commitment. For example, directors of a company can guarantee the payment of a loan given to the company. If the borrower defaults (in this case, the company) the lender can sue the guarantor or the company or both.,
- Mortgage: A lender may require you to mortgage your property against funds to be borrowed. There are different types of mortgage. It could be first, second, third or collateral mortgage, depending on the value of the property or the amount to be borrowed.
Ultimately, the borrower must be very careful in negotiating a long-term loan. The lender would initially demand security whose value is higher than the value of the loan. A lender would want to be over-secured. There is need therefore to call for the services of finance experts, solicitors, and accountants when negotiating a major loan.
This is important because when the borrower has pledged all his assets for loans, he may not be able to get another loan in the future. He cannot negotiate another loan with the already pledged assets unless the first loan has been paid and the assets pledged are discharged.
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