SOURCES OF FINANCE FOR PRIVATE AND PUBLIC SECTOR ORGANIZATIONS
By The End Of The Subtopic Learners Should Be Able To;
Identify main needs for funds and how these needs can be met.
State the main sources of private sector finance.
Make decision on the available sources of finance.
Explain the importance of cash flow in the management of finance.
Refers to the management of money in an organisation.
It also means providing funds.
Individuals need finance to acquire services and/or basic commodities.
Entities need finance for different reasons.
Reasons why finance is a need
To commence a business.
To expand a business that has already been established.
The need for increasing working capital.
For capital expenditure.
For revenue expenditure.
Commencing a business
To commence is to start.
When starting a business, there is need to take into consideration the resources to use; such as buildings, equipment and land.
The owners have to source finance to buy inventories (stock), say groceries when operating a grocery shop.
Expanding an existing business
When a business is viable or making profits, usually the owner will make a decision to expand its operations.
Therefore it entails that some assets will have to be acquired by the business.
The assets to be acquired include machinery, buildings and furniture.
Example of business expansion:
If Power Sales clothing shop needs to expand its operations to Gokwe, it means that the management of Power Sales will have to source finance to build premises for their operation at Gokwe.
Increasing working capital
Capital entails money or resources invested in starting a business.
Working capital refers to cash that is available for paying day-to-day trading activities of a business.
It is calculated as current assets minus current liabilities.
Day to day activities include paying wages, buying raw materials, payment of electricity bills, telephone bills, buying goods for resale etc.
It is very important for a business to meet all its financial obligations.
A business is able to meet all its financial obligations when there is adequate working capital.
When the business entity does not have adequate working capital, it may not be able to carry out its day-to-day activities.
It refers to money used for acquiring fixed assets such as machinery, office computers and vehicles.
It can also be used to upgrade fixed assets for example expanding a building.
Upgrading is done in order to improve capacity and efficiency.
Capacity is the amount that a machine can produce.
Efficiency entails doing things right.
It refers to money used for paying day to day expenses, for example, electricity, rates and rent, repairs and maintenance of equipment.
Sources of finance
A business entity can get finances from internal or external sources.
Internal sources of finance
Refers to sourcing from within the organization.
Examples of internal sources include:
This is profit that re-invested into the business after deducting cooperate tax and dividends.
Advantages of using retained earnings
There is no need for repayment.
No interest payment to be paid unlike taking a loan.
Disadvantages of using retained earnings
It is impossible for firms not generating profits to have retained earnings.
Shareholders’ dividends may be limited.
It is impossible for businesses to expand when they are no/ not enough retained profits.
2. Sale of assets
An asset is an item or property that a business or an individual owns.
There are two types of assets which are fixed assets (non current) and current assets.
Examples of fixed assets include a computer, a machine and furniture.
Current assets include stock and debtors.
Sometimes the business may have redundant assets or surplus assets which they no longer use and opt to sale.
Advantages of selling assets
By selling assets, the business will get finance and it will be able to use the finance to pay its debts.
Capital tied in assets will be utilized for other useful things.
No interest to be paid as it is an internal source of finance.
Disadvantages of selling assets
Time consumption in selling assets.
New business entities will not have surplus assets to sell.
Sole traders and those in partnerships can save money in their personal bank accounts or can keep money for themselves as cash in hand.
Advantages of owners’ savings
There is no interest charge attached.
Its availability is quick.
Disadvantages of using owners’ savings
The savings may not be enough.
Due to unlimited liability, it is risky.
External sources of finance
Refers to sourcing finance from outside the organization.
These are divided into three groups which are:
Short term sources
Long term sources.
The following is a diagram which shows how Limited Companies source finance.
Short term sources of finance
These are made available on a period of one year or less.
1 Trade credit
It involves delaying payments for goods that have already been received from suppliers.
It allows the business to be able to deal with their finances.
Profit is earned before paying for the goods.
Finance is raised freely.
It is costly for the business if it pays at a later date as it attracts interest.
It creates poor relations with suppliers if not managed properly.
2 Bank overdraft
This is when a business withdraws the amount which is more than what is in the bank account.
It is arranged when emergency cash is required.
Advantages of bank overdraft
Interests are charged only on the amount withdrawn.
Overdraft turns to be cheaper as compared to taking a loan.
It is quick to arrange.
Less paper work is required.
Disadvantages of bank overdraft
The interest rate may be high.
It is very costly and expensive.
The bank allows a shorter payback period.
There is a limit on withdrawal.
3 Debt factoring
Debt factoring is when the business sells its debts (debtors) to a company (debt Factor Company) which deals with collecting debts on behalf of the business.
Debt factor charges a certain percentage on the amount to be collected.
The factor agent will buy at a discounted price and then collect the whole amount from the debtor hence get a profit.
An example of debt factoring, Zuva Petroleum has its debtors owing $5000 and sells its debts to a factor for $4500 which is to be paid promptly to the seller. The factor will then collect the whole $5000 from the debtor and pay the business $4 500 then the remaining amount is the factor’s profit ( $5000 - $4500= $500 [factor’s profit])
Advantages of debt factoring to the business
Risk of bad (doubtful) debts is reduced.
Cash received immediately.
Disadvantages of debt factoring to the business
Full amount from debtors is not received.
Medium term sources of finance
It is available for a period above three years
The sources include:
1 Hire purchase
This is the purchase of fixed asset (non-current asset) on credit, for example, tractor.
The payment is made in installments.
The buyer is allowed to use the asset whilst making installments.
The item does not belong to the buyer, that is, it will still remain the property of the seller.
Upon full payment, the buyer will have full ownership of the product.
This is in accordance with the Hire Purchase Act.
Advantages of hire purchase
The buyer uses the asset whilst making payments.
It gives an opportunity to acquire expensive assets especially to small entities.
The business does not have to find a large sum of cash to purchase the asset.
Instead of using large sum of cash to buy the asset, the cash can be used for other projects.
Disadvantages of hire purchase
The seller will remain the legal owner of the item until the buyer pays the last installment.
The buyer is supposed to pay deposit before collecting the item.
It is more expensive to buy an item using hire purchase because of interest attached to it.
It is a contract entered by a lessor (who is the owner) and the lessee (who is a tenant) to use an asset for payments which are called leasing premiums.
Examples of items that can be leased are buildings or machines.
Advantages of leasing
There is no deposit paid.
The lessor (owner) carries out the repairs and maintenance of the asset.
Disadvantages of leasing
If you lease for a long period of time, a greater amount of money is used.
The agreement may limit on the usage of certain products or materials.
Leasing does not benefit from the value of disposing an asset.
3 Bank loan
A loan is the amount of money that is lend to an individual or organization which is payable over a fixed period of time.
Loans are obtained from different sources which includes banks.
Advantages of a bank loan
Payback period varies.
Arrangement is quick to make.
Large firms can be offered loans which attract low interest rates.
Disadvantages of a bank loan
There is interest attached when paying back.
Collateral security is usually required.
Long-term sources of finance
This source of finance is available for a period of more than ten years.
The sources include:
This source of finance is made available to purchase assets like real estate (property consisting of land and buildings).
Usually obtained from commercial banks and building societies.
Taking a mortgage requires collateral security.
Mortgage has to be secured against premises in most cases or some other large assets.
Advantages of Mortgages
It increases the buying capacity.
It can be repaid over a long period of time.
The amount of tax paid to the government is reduced.
Disadvantages of Mortgages
It is costly, that is, you pay more than borrowed.
Property value will be affected as there are fluctuations on the market.
2 Issue of shares (equity finance)
A share is a unit of account for various investments.
Issuing shares is an act of allotting shares to individuals or companies.
Shares can be issued to friends and family when it is a private limited company.
Individuals who own shares are shareholders.
Public limited company can issue shares to public.
Issuing shares may help arrange finance for expanding the company.
Shares can be divided into ordinary shares and preference shares.
3 Ordinary shares
They are also called equities.
Shareholders’ dividends depend on the profit earned and how much directors wish to retain in business.
Ordinary shareholders have voting rights on strategic decision making at Annual General Meeting (AGM).
They do not get a fixed dividend.
They receive dividends after preference shareholders have received their dividends.
4 Preference shares
They are also known as preferred stock.
Preference shareholders are not exact owners of the company.
Preference shareholders receive a fixed rate of dividend.
They receive dividends first before ordinary shareholders are given their dividends.
Preference shares can either be cumulative (dividends can fall in arrears and can receive them in subsequent years) or redeemable (can be bought back by the company or repaid).
Preference shareholders have no voting rights as compared to ordinary shareholders.
Advantages of raising finance through issuing shares
Issuing shares provides credit worthiness of the company as well as confidence to loan providers.
Assets of the company cannot be used as collateral security as done on mortgages.
It serves as permanent capital and can be paid when the company turns to be insolvent.
Insolvency is when a company is unable to pay its debts.
Disadvantages of raising finance through issuing shares
More formalities are involved and it will cause delays in raising funds.
It is costly to raise funds through issuing shares.
Investors are not interested to invest in companies that are strongly financed by shares.
It promotes ownership dilution.
It is also called debt finance.
It is a long term loan that a business can acquire.
Debentures are tradable on the stock exchange.
It carries a fixed rate of interest.
Debentures can be converted to shares.
Debenture holders have no voting rights.
The business pays interest to the debenture holder so that the holder will be able to recover the debt from the company if it becomes insolvent.
Advantages of debentures
Huge sums of money are raised and are payable for a long period of time.
The amount of tax is reduced because of interest allowed on debenture.
Disadvantages of debentures
There is interest attached when repaying.
Some company assets may be used as security and it will limit control for them.
6 Long-term loan
It can also be called debt finance.
Long-term loans are payable over a long period of time.
The difference between a debenture and a long-term loan is that a debenture can be traded on the stock exchange while a long-term loan cannot be traded on a stock exchange.
Advantages of long term loans
Shares cannot be diluted.
Those who lend money have no right when it comes to voting.
It attracts low interest rate.
Assets can be secured for a loan which reduces control for them.
If there is a financial need, acquiring further loans will be limited.
It increases the chances of becoming insolvent.
Other sources of finance
It is also called risk capital.
Venture capital refers to loan capital or equity capital which is provided by private investors (venture capitalists/ investors) or special financial institutions.
Venture capitalists finance small and medium sized companies which have potential of growth.
Venture capitalists usually use their own funds and they take risk.
These funds from venture capitalists attract financial institutions.
These are successful business people that seek to promote upcoming entrepreneurs, by providing funds.
They may be professionals such as doctors, lawyers, and retired business people.
Their interest is to help the next generation.
In return, Angels need equity.
It is money or something given to an individual, group of people or organization as a way of helping.
Donations fall into two categories and these are general donations and specific donations.
General donations have no specification on how to spend money. For example, a general donation given by the government to Madziwa Teachers’ College. This donation can be used for anything because there is no specification on how to spend the money.
Special donations are given in order to meet a particular need or arising. For example, a donation given to Maungwe Primary School to extend its administration block.
These are funds disbursed by the government to organizations especially small businesses so that they continue to function and grow.
Subsidies are also given to help businesses keep the price of a product low.
An example of subsidies in Zimbabwe is provision of agricultural inputs to farmers on no cost.
These are funds given by the government to individuals, educational institutions or businesses.
Usually organizations which are given grants are non-profit making.
The funds that are given are not repaid, for example, student grants.
These are owners of the company.
They finance the business by buying shares.
They provide short and long term finance.
Short term finance is provided in the form of overdrafts.
Long term finance is provided in the form of long term loans or mortgage to allow the business to purchase land and property.
Financial institutions include Stock Exchange, Banks, Finance Houses and Insurance Companies.
Financial institutions help business manage risks for example providing insurance in the case of a risk and uncertainties.
Companies are able to raise finance through the stock exchange, that is, when selling their shares.
The government can allocate funds to various organizations.
Funds are offered in the form of grants and subsidies.
Factors influencing the choice of finance
There are a number of factors that are taken into consideration when making choice on finance.
These factors include;
Amount of money required
When a small amount is required, profits will be the most suitable source of finance.
For huge amounts, a loan can be the best option.
The reason to which the finance is needed.
For example solving short-term cash flow problems or acquiring fixed assets.
If the finance is required for a short period of time, the short term sources may be used, for example; paying for one month rent, an overdraft is suitable.
For long-term project, long term sources will be suitable.
Size and form of business
Small and large business organisations choice of finance differs.
Usually small business organisations have a limited choice of finance.
Large business organisations have a wide choice of finance due to their size and they have collateral security which small business organisations do not have.
Gearing ratio describes the extent to which the business is financed by debt.
A company is highly geared when more of its finance is from loan as compared to share capital.
A company is lowly geared when more of its finance is from share capital as compared to loan capital.
For example, if a company have a total capital of $30 000. If the share capital is $7000 and the loan capital is $23 000, it is said to be highly geared.
A risk is a danger or harm that is likely to happen during the operation of business.
Usually when businesses source finance they consider risks associated with sourcing that finance.
For example, if a business is highly geared, there is a risk of becoming insolvent.
Factors to consider when offering finance
A lot of factors are taken into consideration when offering finance.
Finance providers require non-financial information and also financial information.
Examples of non-financial information required are;
Business/ entity name,
Name(s) of the owner(s) of the business,
Names of Directors (for limited companies)
Address(es) of the borrower (s) and
Examples of financial information required are;
Bank statement for sole traders,
Financial position of the business taken from the Balance sheet,
The balance sheet also provides information on the gearing and liquidity of the company.
The lenders also need information on profitability of the company taken from the trading and profit and loss account.
It is money that is in the business bank account.
Cash is what you have in hand.
Cash is not what is owned by the business (stock, property), and it does not include debtors.
Current assets can be easily converted into cash for example debtors and stock.
It is how the cash moves in and out of the business.
It can be classisfied into cash inflow and cash outflow.
Cash inflow includes cash received from investors, customers, lenders.
Cash outflow involve payment of salaries and payments to suppliers.
There is a positive cash flow when the cash inflow exceeds the cash outflow.
On the other hand, there is a negative cash flow when the cash out flow exceeds the cash inflow
Examples of cash inflow are sale of goods, payments from debtors and sale of business assets.
Examples of cash outflow are repayment of loans, purchasing fixed assets and payment of wages.
Purpose and Importance of Cash Flow Statements
It provides insights on liquidity and solvency of a business entity which are important for survival and growth of business.
Comparing cash flows of different businesses helps to reveal their earnings.
It helps to highlight priorities of management through summarizing cash flow statements.
Facilitate short term planning, for example, payment of expenses.
It helps financial manager in making cash flow projection.
Advantages of cash flow
Helps to ascertain liquidity and profitability positions.
Liquidity refers to availability of cash to meet financial obligations as they fall due.
Profitability refers to the ability of an entity to earn profit. Profit does not necessarily mean cash.
Helps to ascertain optimum cash balance.
If there is surplus cash, decisions to invest can be made and if there is shortage of cash, the firm can borrow cash to meet deficit.
It helps to make future plans.
Capital budgeting decisions can be made example, decisions to procure property.
It helps in the preparations of cash budgets.
Performance appraisals can be made.
It can be used to highlight potential problems.
Disadvantages of cash flows
Actual profit earned at a certain period can not be known if you look at the Cash Flow Statement alone since it shows the cash position.
The use of Cash Flow Statement requires some other financial statements like Profit and Loss and the Balance Sheet. It does not work in isolation.
It ignores the accruals/matching concept. The accruals concept states that expenses and revenue should be recorded in the period they occur.