Sources of Finance For Small-Scale Industries: Modern and Traditional Source

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By: Site Engineer, Staff

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There are basically two sources of funds open to small-scale industries, they are internal and external sources.

Internal Sources of Fund

The fund said to be derived from an internal source when the supplier of such funds is members of the company or enterprises that are receiving or benefiting from such fund. Funds obtained internally consist of equity fund.

Funds of this nature are supplied by owners of the business and they are usually made available to the company by ways of:

1. Retained Earning

This is the profit of the company which is plowed back in the business. It is commonly used by small-scale enterprises. When a business retains part of its profit, it can always resort to it when the need for finance arises. Retain earning is a costless source of finance and its use does not dilute ownership. It allows for financial flexibility.

However, companies using this source should be careful since it could affect the prospects of the company, which is measured by the rate of dividend declared. Some shareholders at times react against this source. Though it is still a source of the fund for many companies.

2. Personal Savings

It is the funds accumulated from individual savings. It serves as the primary source of fund of most enterprises setting up small-scale business. But when business commences operations the expansion will depend on the increase in the personal saving of the owner and the profit of the business. This source of fund is primarily used by small-scale firms and as they heavily rely on it, for it is a cheap source of fund. But when it is solely depended upon, it leads to a limited rate of expansion of the business.

3. Call Money

This is a money surplus invested on an overnight basis and withdrawable on demand.

4. Commercial Paper

This consists of promissory notes issued by large firms when they need to borrow money from insurance companies, pension, funds, and banks.

5. Deposits From Customers

This represents fund received by a firm to supply goods and services at an agreed future date. This receipt increases the firm’s liquidity in form of advance payment made by customers due to high demand and short supply of the product. This source is common amongst the small-scale enterprises and it is a costless source which provides short-term finance.

6. Leasing Financing

A lease can be defined as a contract by which the owner of a tangible asset allows another person or firm to benefit from the economic use of the asset for a specified period of time and for a fixed rent. The owner of the asset is called lessor while the person who holds the lease is called leaseholder or lessee.

There are different forms of leasing assets and they include:

  • Financial Lease: This is a contract under which a payment of a specified sum of money that is sufficient to amortize the capital outlay of a lessor is made over a period of time which is regarded as basic or primary. The lessee is given a choice when the primary period lapses to either purchase the asset or have the lease extended to a second period. Amortization of capital outlay means the recognition of the expense of purchasing an asset in a historical framework with a view to marching it with revenue while the asset is being used.
  • Operating Lease: Under this leasing arrangement the asset is not wholly amortized during the primary period of the lease. This is because the lessor does not rely on rentals for his probably for some profit when he decides to sell the returned asset. In an operating lease, which can be construed as a short-term lease the lessor claims capital allowance because he bears maintenance costs and retains ownership of the asset. In a financial lease, the lessee owns the asset that is why he agrees to pay money which exceeds the purchase price of the asset.
  • Sale and Lease-Back: Here the owner of an asset sells it to another person or firm and then leases it back.
  • Leverage Lease: This involves a lessor a lessee and a lender. The lender could be a bank which agrees to provide a substantial part of the amount required by a lessor to acquire an asset.
  • Syndicated Lease: As the name implies this is a leasing arrangement in which a group of individuals or firms form a syndicate with a view to pooling their resources together to acquire and subsequently lease an asset. In Nigeria, leasing facilities include civil engineering equipment, office equipment, and machines, real estates such as petrol stations and transport equipment and airplanes. There are also mining and mineral leases such as the rights given to foreign firms to prospect oil from leased areas.

7. Debt Factoring

Debt factoring applies to an important current debtor. A company may sell its bad debts (at a discount to allow a profit to the buyer) in order to avoid tying down capital in the credit it allows to customers. In another form of this, the factoring company advances a proportion say 80% of the number of credit sales as they are made without it actually acquiring the debts. This is then sorted out of the cash paid by customers as it is received.

The moment sales are made the invoice is stamped to notify the buyer to make payment directly to the factor provided the credit unit has not been exceeded by the sale. Factoring is usually undertaken without recourse, the factor becomes liable for the bad debt that arises subsequently.

The main advantage of factoring to a firm using the services of a factor may be summarized as follows:

(a) There are clerical and administrative savings particularly for forms selling repetitively on credit as follows.

  • There is an economy in management and staff salaries since fewer supervisors and clerical works are needed.
  • The firm is no longer concerned with bad debt creditors.

(b) There are also the following financial matters.

  • Capital locked up in the sundry debtor’s balances is available for use with the business as well as sales becomes in effect cash sales.
  • With this improved liquidity, it can offer improved credit term to its customers in order to increase orders.
  • It can take advantage of the supplier’s cash discount and make prompt payment.
  • This improves its credit rating.
  • Since factoring is not borrowing, the company’s balance sheet liquidity is not weakened nor its borrowing potential impaired.

Despite all these advantages enumerated above factoring leads to loss of customers goodwill and it can be expensive especially of the changes is above bank rate. Like leasing, it is not normally used among small scale industries.

8. Invoice Discounting

This is similar to factoring except that in his case only the financing service is used. It is a financial agreement which enhances the liquidity position of the user; it is designed to overcome the problem of tying up working capital in trade debts (debtors). The procedure is that a firm can convert invoices (sent to customers) into cash by discounting the invoices through specialized finance companies. This may involve either separate invoices to be discounted or a proportion of a firm’s bad debt truly the full face value of the invoice is not usually advanced.

It has some advantages such as:

  • The firm does its own accounting and debt collection instead of paying someone else to do it and this enables the company to not lose contact with customers.
  • It is quick to arrange and it is not expensive and can be ended easily.

However, there is no protection given against bad debt since the finance house is not in charge of debt collection, therefore, he must reserve a right to claim back advances from the firm if debts turn bad. It is therefore not commonly used as sources of short-term finance by small-scale enterprises probably due to lack of awareness or the existence of those who provide such services.

9. Hire Purchase

Hire purchase is a financial arrangement between a hire purchase company and its customers whereby the latter is allowed to take possession of equipment or any goods without immediate cash payment.

The legal framework of the hire purchase agreement is that the hire purchase company hires the equipment to the intended purchaser who is given an option to purchase the equipment for a nominal sum when the hire charges have been paid. The legal title of the equipment remains with the owner until the aide exercises his right of option to purchase then the ownership passes to him.

Initially, a deposit of between fifteen percent (15%) to thirty percent (30%) of the agreed amount will be required followed by series of installment payment which includes interest charges spread over an agreed period of time rather than making one large cash outlay at the time of first using the equipment.

It is mainly used by the small-scale firm for rapid growing at an early stage of their development. It is particularly useful because it is one of the ways in which new business may become established and service the difficult initial stage of setting up and growth. As the firm grows and its financial strength improves the need for such method is less and bigger companies rarely use it.

Advantages of Hire Purchase

  • Interest payments on hire purchase are tax deductible that is they are allowable deductions from the profit and loss account for tax purposes.
  • The hiree has the advantage of the use of the equipment over the period he is making the payment and so obtains some benefits from using the equipment without having to increase a large capital outlay.
  • There is no need to provide security in the usual form since no actual loan is provided and the ownership of the goods by the finance is security in itself.
  • It is quick and not expensive to arrange.
  • Ability to raise further funds is not improved by hire purchase management.

The disadvantage of Hire Purchase

  1. Hire purchase is not cheap and charges are much high than market rates of interest.
  2. It is usually provided by non-bank financial houses and merchant banks and due to their limited number; they are available only in highly urbanized areas where small-scale enterprises cannot have access to.

Obtaining Bank Loans

Banks also provide long-term finance by giving long-term loans to a firm which may not necessarily be quoted on the stock exchange.

When approaching banks for loans a borrower must assess his tending relationship with the bank from the bank manager’s point of view and from his/her own point of view.

The key considerations in lending decisions from a bank manager’s point of view include the followings:

  • How capable is the bank in monitoring the progress of the business?
  • How quickly could the assets of the borrower be sold if the business gets into trouble and how valuable will the assets be?
  • What is the character of the borrower?
  • Is the loan to be given profitable that is, does the interest rate provide adequate return given the customer’s risk of default and the cost of managing the loan?
  • Is there adequate security for the loan?
  • If the loan is secured on the profits of the enterprise how profitable is the business?
  • What clauses or covenants should be incorporated in the loan agreement to stop the borrower from changing to another business and what accounting ratios could be used to predict the financial t distress of the borrower?

Considerations from the borrower’s point of view include:

  • Competitiveness of interest rates offered by banks
  • Matching loans with borrower’s capital requirement
  • Borrower’s ability to repay loans, and
  • The kind of relationship existing between the borrower and the bank officials.

Factors Determining the Use of Funds

Firms require funds for various purposes such as the purchase of fixed assets, payment of salaries and wages, and the financing of business expansion. The sources of these funds and the conditions under which they are obtained differ, so firms need to consider a number of factors in order to decide on the most appropriate source to be used to meet given financial requirements.

These factors include:

  • Accessibility to the Funds: Not all funds are accessible to all firms, for instance, a firm that is not quoted on the stock exchange cannot obtain funds by selling shares and bonds.
  • The Nature of the Financial Requirement: Short-term funds will be more appropriate for meeting short-term financial requirement while a long-term investment such as opening a new branch should be financed with long-term funds as its cash flow in the short-term could be zero or very small.
  • Security Required: Short-term credit facilities can be obtained without any collateral, unlike long-term debts which in most cases require collaterals.
  • Flexibility: Some of the sources of finance provide flexibility in terms of a borrower’s right to refund money that is no longer required or to obtain additional funds on short notice. Short terms funds are easier to refund than long-term funds, but ordinary shares are not refundable.
  • Conditions of the Economy: Prevailing economic or market conditions also need to be considered when choosing a source of finance. For example, in a period of rising interest rate, it is more appropriate for a firm to go for long-term loans because the rate of interest will remain the same up to the maturity date.
  • Cost Associated with Sources of Finance: Short-term funds are generally cheaper than long-term funds and with the former; the user can minimize cost by not obtaining funds that will not be used immediately.

Prerequisites for Raising Capital

It is generally agreed that the best aid for raising money is to prepare a first-class business plan. The business plan can even be used to raise money in the absence of the promoter of the business. It is one of the most important tasks the entrepreneur undertakes in his career. Your plan cannot afford to have defects, it must be a masterpiece, showing your personality, your capabilities and your enthusiasm backed up with meaningful statistics.

As a young entrepreneur, there are several odds up against you concerning your level of experience. It would be best to spend quality time in the preparation of the business plan that you intend to use in raising money. This is the main and only yardstick used to measure whether your company is worth investing in.

Adequate care should be taken to ensure that there is a realistic, unassuming, well as an accurate projection. Just because there is a big market for your product or services do not necessarily mean that you will get your fair share of it. Your evidence as to how you will go about obtaining your market share regardless of the size of the market is very important.

Investors want two major things from you in order to keep their money safely with you and make more money in addition. They are not always interested or impressed with sales. Sales cost money. What the investors care about are profits. Show them how you will make profits, profits and more profits.

To convince potential investors that they will meet their goal of high returns if they put their money on you and your business venture provide them with a detailed explanation of how your business will make profits. Your potential investors do not want to know a lot about your product or service. What they want to know is how you are going to run the business to their interest. They want to know what your business is all about and why they should invest in it. Break down your spending strategy. Break it down again until you can explain exactly how you are going to spend the funds judiciously. Make it explicit to prospective investors.

Finally, note that no investor is going to make a decision without meeting you face-to-face. So do not write an operations manual. Always write a marketing tool that will get you an appointment. Other important considerations to be taken note of by the entrepreneur or the business organization in need of venture capital are:

  • How do you wish to spend the money if raised?
  • What is the total amount of money needed to establish or expand the business?
  • How marketable are the products or services of the company?
  • What is this amount needed for?
  • How are you sure that the returns would be sufficient to repay the capital to be raised?
  • At what interest rate do you think you can accept the funds if available jeopardizing the company’s interest?
  • Can the enterprise produce any collateral to the lender if go for loan facilities?

To achieve realistic answers to some or all of these questions, the organization or the enterprise needs to conduct a business feasibility study. There on, a comprehensive and realistic business plan or proposal would be developed.

Raising Funds with Collaterals

Raising funds for investment becomes easier if there is enough collateral to up the required funds. At times, small-scale businesses find it difficult to produce the required collateral. The collateral is an asset whether tangible or intangible that can be legally transferred to the lenders by the borrower. It can easily be converted to cash by the lender in case of default in repayment by the borrower at a stated period of time. It protects the lender in the event of non-repayment of the principal borrowed funds and the interest accrued thereon.

Collaterals that are generally acceptable by lending organizations are highlighted below:

  • Marketable securities, debentures and other types of securities/stocks.
  • Due bills – representing I Own You (IOUs) from brokers who are required to deliver securities to the bank. They are a promise by the broker in lieu of the physical deliverance of the stock. Thus clue bills do not compromise an unconditional obligation on the broker to deliver the respective securities and the bank is dependent on the underlying transaction and ultimate delivery.
  • Escrow proceeds, inventory and commercial papers
  • Trust receipts, promissory notes and chattel papers
  • Account receivables and contract proceeds receivables
  • Cash collateral accounts for account receivables and inventory cash proceeds
  • Demand, savings, and other money market instruments
  • Land installment sales contracts, real estate contracts for deed
  • Motor vehicles, automobiles trucks, and trailers
  • Equipment, fixtures, and fittings
  • Assignment of leases, equipment
  • Crops, livestock and farm equipment
  • Pleasure crafts, motor boats, motors, and boat trailers
  • Builders and mechanic, construction contracts – contract proceeds assignments
  • Secured real estate – commercial and residential
  • Land acquisition, development construction, and loans installation
  • Sales contract loans (mortgages)
  • Oil and gas, energy-related (pipelines construction, drilling contracts, equipment fabricators)
  • Warehouse receipts order or straight bills of lading and other negotiable and non-negotiable documents of title including warehouse and bale or dock receipts. Life assurance policies and assigned letters of credit-aircraft and documented vessels. Trade and bankers acceptances bank drafts, etc.

The various types of collateral cannot be exhausted in this write-up. The most important thing is that small-scale enterprises are not big and buoyant enough to procure some of the collateral. Therefore their ability to obtain funds in conventional financial institutions is severely curtailed. Where they succeed in getting funds the interest rates are always very high. For the benefit of small-scale entrepreneurs who may already possess some of the acceptable collateral the discussion below will treat how to raise funds in these organized financial institutions.

There are some notable financial institutions specifically meant to finance small and medium scale enterprises.

These financial institutions include:

  • Nigerian Bank for Commerce and Industry (NBCI)
  • Nigerian Agricultural and Cooperative Bank (NACB)
  • National Economic Reconstruction Fund (NERFUND)
  • Commercial and Merchant Banks
  • Nigerian Export and Import Bank (NEXIM)

The Nigerian Bank for Commerce and Industry (NBCI) had been the major medium for providing funds for small and medium scale enterprises. However, in recent times the bank has not lived up to expectations due to the paucity of funds for onward disbursement to these small and medium scale enterprises, This followed the stoppage of fund transfer by international organizations that usually make some allocations to national governments for the development of their local business enterprises.

In the case of Nigeria, it resulted from the face-off between the government of the late General Abacha and the international community. Unfortunately, also the federal government on its own part could not make contingency provisions to the NBCI. Consequently, the organization virtually collapsed with its activities nearly crippled. However, with the coming of the democratic government of President Obasanjo, it is expected that the problems affecting this sector would be sorted out and that the bank would be able to discharge its duties henceforth creditably.

Generally, when the collateral is available and acceptable to the bank or financial institution in question, the raising of funds is done through the following process:

  • Application for loan
  • Presentation of feasibility studies and/or loan proposal
  • Analysis by the credit analysts of the lender
  • Approval with conditions communicated to the applicant
  • Communication of acceptance of offer and disbursement

Strategies for Tackling the Problem of Collateral

  • Personal Guarantee: Income cases, the personal guarantee can be used to obtain venture capital from the financial institutions. A reputable and wealthy person in the society can stand on behalf of the borrower with a promise to repay should the person fail to honor the obligation. This strategy has seen some small and medium scale enterprises through their financial needs.
  • Equipment Leasing as Source of Venture Capital: There have been instances when our clients have raised part of their venture capital through equipment leasing. Some organizations have gone into the manufacturing of plants and machinery. Some also concentrate on their importation and sales under the equipment leasing arrangement. Some of these companies are registered with the equipment-leasing department of the Nigerian Society of Engineers. These companies can give out their plants on the agreement that some down payment is made and the balance paid later along with the interest. The advantage of this arrangement is that the enterprise will have the opportunity of using the machines without bearing the financial outlay completely at once. The borrower can now produce and plan how to complete the payment and in the long run, owns the asset.
  • Commercial and Merchant Banks and Overdrafts: Business organization whether big or small can also obtain some credit facilities from commercial and merchant banks. To benefit from this the small-scale enterprises must have been well known to the bank. In addition, the turnover on transactions or operations of the accounts must have been very high to attract credit facility either a loan or overdraft. When the bank is in doubt of the integrity the promoter or promoters of the venture the banker may require a personal guarantee or small collateral to cover the credit facilities extended to the borrower.

 

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