Appropriate Sources of Finance for NIKERT Plc - Research Paper Example

Sources of finance Table of Contents Introduction 3 Sources of finance 3 Implications of sources of finance 6 Appropriate sources of finance for NIKERT Plc 8 Cost of different sources of finance 9 Conclusion 9 Reference list 10 Introduction A company requires finance so as to be able to continue its operations and generate revenue. Without adequate finance, a firm will not be able to meet the expenses that are associated with its daily operations and also will fail to invest in different assets so as to support its operations. Large amount of finances are required for a company to finance the purchase of assets such as, machines, land, plant and equipment. Smaller amounts of finance are required for meeting regular operations of business such as, purchase of raw materials, payment of salaries and so on and so forth. The finance requirements for meeting such type of expenses are generally long term in nature. A company can rely upon both its internal and external sources for meeting financing requirements (Beck, Levine and Loayza, 2000). Sources of finance In external sources of financing, a third party gets involved in meeting monetary requirements of a company. External sources of financing accrue cost to the business in respect of their obtainment. The external sources can be of long, short or medium term. Short-term sources of external financing are generally of less than a year’s duration, before it becomes accrued for repayment. Some of the short-term sources of finance are discussed as follows (Beck and Demirguc-Kunt, 2006). Trade creditors are the most common type of short-term finance option, which is available for small, medium and large organizations. Trade creditors refer to the purchase of different items on credit. In this type of a transaction, suppliers allow the business a certain period of lag in payment for the goods purchased. Business can take advantage of the extra time period and invest money elsewhere for generating higher revenue. Factoring is another method of short-term financing whereby a company can receive funds earlier than the due date of its debts. A company may have a large number of debtors, who have purchased goods on credit. As a result, revenue from sales is earned only after a considerable period of time. Fund, therefore, gets trapped for a longer period, harming firm’s liquidity position. Factoring helps a company to procure the finance trapped in credit by way of providing value of debts as security to the factor agent (Goldstein, Ju and Leland, 2001). Discounting of invoice is another very popular means of obtaining short-term credit facilities. In this type of a financing arrangement, a company exchanges its receivable invoices with a finance house, which provides the business with immediate cash. The cash provided is generally equal to 75% of the value of invoices. On the due date, the company is required to realize debt as per the invoice amount and transfer the same to the finance house. Bank overdraft is a highly convenient means of short-term financing whereby a bank allows a company to withdraw cash above the specified limit. It is similar to credit facility. However, company is required to bear the cost of procuring additional finance by paying interests. Long and medium term sources of finance generally consist of more than one year’s time period. The sources of long-term external finance are discussed as follows (Rioja and Valev, 2004). Long-term bank loans for limited period of time forms an important medium of finance. The company is required to pay interest on such borrowings. The interest rate may be fixed or variable based upon nature of the loan. Organizations taking such loan are required to provide a collateral security against the same. Issue of shares is a form of permanent capital. This type of capital is only available for limited companies. Public limited companies can issue shares up to the value of their authorized share capital. Nonetheless, private limited companies are allowed to sell a higher number of shares to shareholders. There are two types of shareholders in this type of financing, namely ordinary shareholders and preference shareholders. The preference shareholders have greater advantages in comparison with ordinary shareholders, in terms of dividend payment and settling of dues (Korajczyk and Levy, 2003). Debentures are essentially a long-term financing contract. The debenture holder extends a sum of money to the company on acceptance of the contract. In this type of financing, the debenture holder is entitled to receive a fixed amount of interest at definite intervals of time. On maturity of the debenture contract, the company is required to pay back the principle amount. Leasing is also a popular financing method undertaken by companies. Instead of buying an asset, the company may opt for taking it on lease. A lease contract allows the lessee (person using the asset) to use equipment or property for a definite period of time. However, the lessee is required to pay fixed payments to the lessor (person who owns the asset). A bank may be involved in this type of a transaction, providing the lessee with required finance for obtaining the asset on lease. After expiry of lease contract, lessee is required to return the asset to the lessor. Hire purchase allows organizations to purchase an asset through payment of fixed installments over a given period of time. The total cost of an asset gets divided into a number of installments that are required to be paid over an agreed period of time. This type of financing allows a company to prevent bulk drainage of funds, thereby retaining a major portion of its funds for longer. The company can utilize this opportunity by investing money in profitable ventures. Internal sources of finance include those, which arise from the business itself. Retained earnings are a form of internal source of finance. Retained earnings are portions of fund set aside by the business from its profits, which have not been utilized. Current assets are also considered as an important source of business finance. Current assets can easily be converted into liquid cash in a short duration and provides business with necessary liquidity and financial stability. It is also possible for a firm to generate finance by selling fixed assets (Rioja and Valev, 2004). Implications of sources of finance In this section of the assignment, different advantages and disadvantages of some of the sources of finance have been discussed (Carlin and Mayer, 2003). In case of raising capital through issuing shares, a company enjoys the advantage of not being obliged to repay the fund. It helps to diversify risk of the business. Since there is no repayment, payment of fees also gets avoided. Stock issuance also takes into account bringing together experts who strategically analyze the business and accordingly suggest ways for a company regarding issuance of shares. Major shareholders of a public limited firm have substantial interests in growth and development of the company. On the other hand, issue of shares also has certain disadvantages such as, payment of dividend. A company is required to pay out a certain portion of its revenues in the form of dividends to shareholders, thereby reducing excess reserves of a company. If the company earns low profits, then the amount paid as dividend are low. Issuing of shares also results in losing certain amount of control over governance of a firm. The control over business is passed on to the shareholders whose suggestions and decisions are given high importance. Long-term debts are generally acquired by a firm for investing in property and equipments. The repayment of loan is generally spread over a long-term. Hence, business is not required to pay back the finance acquired immediately. Debt financing also helps a firm to enjoy tax reductions. Most firms obtain debt capital so that they can enjoy tax benefits. Debt capital also adds leverage to the business structure. The most significant disadvantage of acquiring debt finance is that the company is required to pay periodical fixed rates of interest. It is not taken into consideration whether or not the firm is generating revenue while paying interest. Moreover, there is risk of losing the asset if interest and principle amount of the debt are not paid on time (Frank and Goyal, 2009). Lease finance helps a company to procure and use an asset without making actual payment paying for it. Sometimes, a business requires using an asset temporarily for a short duration. Under such circumstances, a business may consider acquiring assets on lease. This kind of financing is also adopted when there is a necessity of constantly updating firm’s assets structure. The company also remains free from incurring maintenance and repair expenses associated with the asset. Even so, major advantage associated with this type of system is that the company has no ownership rights over assets. The asset is required to be returned to the lessor, once lease period expires. Factoring provides a firm with the advantage of acquiring finance immediately without waiting for the firm’s receivable debts to mature. Also, risk of realizing the debt from debtors gets transferred to the factoring entity. This prevents occurrence of bad debts in business. Therefore, risk of the firms associated with not being able to realize revenue gets minimized significantly. The major disadvantage associated with this system of financing is that the company does not attain full value of its debts through such a financing strategy. The factoring agency only provides 75% of the net value of the debt. The 25% reduction is done because of additional risk factor that the factoring entity undertakes, while entering into such an agreement. Trade credit also provides certain advantages and disadvantages to a business unit. Trade credit does not involve payment of interests as it is only a single time payment to be made within a stipulated time. Trade credit helps a firm to delay the payment to suppliers, until the firm produces its goods and services and sells the same. Furthermore, when the payments are delayed, it helps the business to retain revenue within for a longer period. Nevertheless, not all companies benefit from obtaining trade credit. New business firms are less relied upon by suppliers and are, therefore, not willing to provide credit period. Also, before providing such credit terms, suppliers go through production system of the company and provide credit facilities if it considers the firm to have sufficient capabilities of earning profits (Carlin and Mayer, 2003). Appropriate sources of finance for NIKERT Plc NIKERT Plc is a public limited, sports goods manufacturing company. The company is planning to expand its business. For this, the company is considering to acquire additional capital. The firm requires both long and short term capital. Long-term capital is required by the firm for investments in land, equipment and transport vehicles. Short-term capital is required to meet the day to day operations (Joeveer, 2006). Land and equipment- In order to purchase such assets, the company requires acquiring long-term sources of capital such as, issue of shares or that of debentures. The company may also consider obtaining long-term loans from financial institutions. It is, however, essential that the company is able to suitably manage its debt to equity ratio. A higher level of debt would induce risk factors into the business. It is also not ideal to completely eliminate acquiring debt capital as this would lower the leverage factor. Hence, it is important for the company to finance its expansion project largely by the issue of shares and showing low dependence on debt capital. This type of a capital structure would be ideal for purchase of land and equipment (Desai, Foley and Hines, 2004). Transport vehicles- NIKERT can opt for purchasing transport vehicles on lease. Since the company is planning to expand acquiring, it can consider maintaining certain portions of its asset structure as non-permanent. Later on, when the company starts to earn profits through its expansion plans, it can consider acquiring assets permanently. Day to day operations- In order to finance company’s day to day operations, it can decide to acquire short-term capital such as, trade creditors, factoring, bank overdraft and discounting of invoices (Desai, Foley and Hines, 2004). Cost of different sources of finance If NIKERT considers raising capital through issuing equity, it needs to concentrate upon certain cost aspects associated. This involves the initial expense of informing the public at large about company’s issue of share units. NIKERT is required to take periodical measures to generate awareness among shareholders about company performance by dispatching them annual reports. Also, the major cost involved in the issue of shares is payment of dividends out of earnings. Debt capital involves the payment of interest at fixed intervals of time. In addition, the company has to incur initial expenses in order to acquire debt capital such as, informing the financing institution about projected expansion plan and company’s expectations regarding inflow of revenue. In case of factoring, the company has to bear the cost of losing certain percentage of book debts. Other forms of short-term capital have very low or no additional costs (Biddle and Hilary, 2006). Conclusion A company’s success largely depends upon maintaining a balanced and adequate capital structure, which supports all needs of the business. It is essential that a company estimates net revenue by hypothetically considering different sources. As NIKERT is acquiring capital for expanding the business, it is essential that the financing structure is not only productive, but also is supportive towards meeting expansion related needs. It is, therefore, important for the company to decide upon an adequate debt-equity ratio. 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