Sources of Finance, Equity Financing, Debt Financing - Coursework Example

Sources of Finance By + Introduction According to Backhaus and Wagner (2004), limited companies canobtain finances in numerous number of ways depending to what is ideal to the company. A company has to analyse its needs carefully before sourcing of finances this is because what is ideal for one company may not work for the other company. A newly formed private limited company will require finance in order to start a business or improve its business. Before sourcing funds for newly formed company one need to consider the amount of money needed and when the money should be available. This finance should be able to manage the business and rise it up to be a profitable business. The sources of finance for new formed company are equity, debts, as well as government’s grants Equity financing In equity financing, there is an exchange of portion between the business and an investor for financial deals. This allows the investor to share the business profits. The first place where an investor can source for finance is in his personal savings or equity. Personal saving can comprise of cash value insurance policies, early retirement or profit sharing funds and real estate equity loans if any. Home equity loans where an investor can borrow a loan that is backed by the value of the equity in your home (Backhaus and Wagner, 2004). Friends and relative can also fund newly formed companies. This can be informing of equity where the friends or relative can acquire an ownership in the business. This are medium terms of sourcing income in a newly formed company. According to Eckbo (2008), British government often provide financial assistance to a company that are starting up or expanding businesses. Newly companies can sell stock directly to the public in order to raise funds. This method is effective and can be used to raise a substantial amount of funds. Warrants are long-term instrument for sourcing of finances. This method is mostly useful for newly formed companies to encourage investments through minimising of shortcoming risks while providing positive potential. Debt financing Finance through debt involves borrowing of capital from creditors with the condition of repaying the borrowed fund with an additional interest. Debt financing can be either long term or short-term depending on the intended purpose of the money. Short-term debt are used to finance operation in the company while long-term are used to finance assets e.g. buildings and equipment’s (Barion, 2010). Debts can be sourced from friends, relatives and family. This debt is mostly entitled to low interest rates but the same formality of commercial lender should be followed. Banks and other commercial lenders can lend newly formed companies although this is too risky for new companies. Federal and state governments provide lend private, newly formed companies finance to help in improving its business (Hebous and Weichenrieder, 2009). Bonds are also a source of capital to companies. This is type of debt is better because the company set its own interest rates and when the company will pay the debt. Finance through bonds offers a company a time to access its finance without paying back until the company has successfully applied the funds. Newly formed company can obtain finance through leasing of properties like buildings and equipment. This method is important because company sources fund without borrowing or equity financing (Grath, 2008). A well-established company will source it finance differently from a newly formed company. Well-established company can source finance internally from its business. This includes selling of old or obsolete assets that are no longer useful to the business. This method is advantageous in better use of capitals and is not available for new business. Companies can source finance through retention of profits. Well-established companies mostly keep part of their profits every year for future use (Heidrick and Keddie, 2000). The profit is ploughed back to the business. This method of financing is not available for newly formed companies. Bank overdraft is a short-term method of sourcing capital. Bank overdraft is a capacity given by the bank to its customers. The companies can withdraw a high amount of cash from the bank than the balance in the account. This method is advantageous to established companies than newly formed. Trade credit will act as a source of finance to established company because the supplier will give the business some period before they pay for the purchase of items they did. The supply will have confidence in a company that is well established than the newly formed company (He and Xiong, 2012). Well-established company can sell assets in hire purchase in order to acquire funds. A percentage of the total amount is paid as a down payment and the rest is paid in instalments. A long-term method of sourcing capital include bank loan that is to be paid in a period. Selling of company shares will also provide finance to the company. Private limited companies can sell share to existing shareholders. Another form of sourcing capital is through crowd funding, in crowd funding, a large number of contributors are asked to contribute small amount of money. Crowdfunding has moved a notch higher where ventures and projects involves few number of individual for huge sum of money. The method switches the ideas with the help of internet to seek funds from potential funders. Basically, those ventures develop a profile on website, they then use the social media and conventional networks of friends, work acquaintances and family members to raise capital. Crowdfunding comprises of three different type which include equity, donation, and debt. Factors that lenders take into consideration when determining whether to lend to smaller companies Lenders of finances only want to lend out money to companies that are able to pay the whole mount in time and in full (He and Xiong, 2012. Before lending of finance to small companies, lenders will analyse the worthiness of a company to repay the loan using five Cs. these Cs include I. Capacity The lender will analyse the capability of the company to repay the loan. The lender will need to know how you are going to repay the loan before it approves your loan. The lender will evaluate the cash flow of the business i.e. the amount of income the company generates to the expenses the company incurs. The value of expense should be lower than the income before the loan is approved. The lender will analyse payment histories of previous loans. The lender will evaluate other sources of income that can be used to offset the loan e.g. assets or savings (Lerner and Tsai, 2000). II. Capital The owner of the company should have his own money invested in the company before the lender will be enthusiastic to risk his/her own funds to the company. Most lenders need about 25% of the total investment to be the owners before they make approval of the loan. Capital is the amount of money the owner invests in his company. The owner of a small company should have invested too in his/her company (Lee, 2005). III. Collateral Collateral are assets that will act as security in case the borrower fails to repay the loan. Collaterals may include stocks and bonds, heavy machines and other expensive assets the business owns. For new companies that has small items that cannot be considered collateral, the owners personal assets e.g. home and automobiles will act as collateral before the loan is approved IV. Conditions This is general conditions surround the loan. These conditions include external environment at the time, which the loan is borrowed, the economic condition of the company applying for the loan as well as the economic state of the country. The purpose of the loan is also a factor to be considered. A lender will be much willing to approval a loan to a small company that will be used to acquire assets for the company rather than if it is to be used in a risky way such as expansion of the company into new markets. The lender will be willing to give out loan if the economy of a country is thriving (Lee, 2005). V. Character This refers to the record of accomplishment of an owner. Lenders must be convinced that the borrower will repay loan. For small business, the lender will look at the character of the entrepreneur. This is a highly private evaluation of the owner of the business personal history. The lender must be in no doubt about the borrower being unreliable before approving the loan. The owner’s background characteristics like education, work experience, personal credit history records of accomplishment in making money, expertise and other factors come to consideration. Good relationship between the lender and borrower also plays a big role (Jung-Senssfelder, 2006). Debt is the money borrowed by a company from another company, individual or corporations. Individuals use debt or organisation to make large purchase of products that could not be afforded in the normal circumstance (He and Xiong, 2012). A party is expected to pay the debt borrowed later with addition of some interest to it. The advantages of debt financing is that it allows investors to purchase and buy new equipment, buildings and other assets that will be used to develop the company before the owner earns his necessary funds. Through borrowing of money, the owner does not give up the ownership of the company as compared to equity. There are no more obligations between the lender and borrower after settling of debt because the only obligation is to repay the debt. The borrower can budget precisely how he/she is going to offset the debt this is because the borrower is certain on the principal and interest amount he is expected to pay. The borrower will know the amount of loan he is owed every month (Hebous and Weichenrieder, 2009). The disadvantages of debt financing Is that it has strict fixed payment terms. The debt should be paid in a specific time regardless of the state of your business. Heavy borrowing of debts will affect the cash flow of the business. Relying on debt financing will affect the business and it will be hard for the business to stay up-to-date on the debt repayments (Barion, 2010). Companies that have high level of debts are viewed to be risky by potential investors. This is because it spoils the company’s reputation and will make it hard for the company to approach potential investors for raising additional funds for the company. The company’s gear ratio i.e. the degree to which owner to that funded by debt funds a company should be kept minimal, as this is what fetches investors to a company. The higher the company’s degree in leverage the more risky it is considered. A company’s gearing ratio should be kept low to help it move on regardless of the condition in the financial sector (He and Xiong, 2012). Therefore, companies should be advised to avoid heavy borrowing of money although sometimes there is need for borrowing. Borrowing of finance should not be often and companies should try to find other ways of sourcing finances Companies having operating profits that are highly volatile should shun away from high level borrowing. This is because such companies may find themselves in situations where the operating profits are low and therefore, cannot meet the bill of interest. Such companies are highly funded by equity finance due to lack of legal obligation to offset the equity dividend. On the other hand, companies that do not need to avoid high level borrowing need to have less volatile operating profit. This is because they will be able to pay the interest bills without any problem. Bibliography Backhaus, J. and Wagner, R. (2004). Handbook of finance. Boston: Kluwer Academic Publishers. Barion, F. (2010). Profit shifting by debt financing in Europe. Munich: CESifo. Eckbo, B. (2008). Handbook of corporate finance. Amsterdam: North Holland. Grath, A. (2008). The handbook of international trade and finance. London: Kogan Page. He, Z. and Xiong, W. (2012). Debt financing in asset markets. Cambridge, Mass.: National Bureau of Economic Research. Hebous, S. and Weichenrieder, A. (2009). Debt financing and sharp currency depreciations. Munich: CESifo. Heidrick, T. and Keddie, R. (2000). Equity financing alternatives for small business. [Ottawa]: Industry Canada, Small Business Policy Branch. Jung-Senssfelder, K. (2006). Equity financing and covenants in venture capital. Wiesbaden: Deutscher Universit̃ts-Verlag. Lee, C. (2005). Advances in quantitative analysis of finance and accounting. Singapore: World Scientific. Lerner, J. and Tsai, A. (2000). Do equity financing cycles matter?. Cambridge, MA: National Bureau of Economic Research. Read More