Sources of Business Finance

The entrepreneur may obtain finance from the following main sources.

Debt financing

Equity financing

External and internal sources

Debt financing requires a borrowing system and the entrepreneur is bound to pay back the funds borrowed together with interest payable.

Debt financing can be long term or short term. Depending on the lender collateral, may be required.

Equity financing does not require collateral and offers the investor some form of ownership position in the business.

Internal financing are funds generated from several sources within the company, they include profits sale of Assets, reduction in the working capital accounts receivable, retained profits etc.

External sources of finance may come from family members, credit suppliers, government programmes, and grants e.t.c.

Equity Finance

It the largest source of finance to a business organization and usually forms the base of which other finances are raised.

Equity is the total sum of the business ordinary shares plus the retained earnings also known as revenue reserves.

a) Ordinary share-capital

It is that finance contributed by ordinary shareholders of a business. It is raised through the sale of the company’s ordinary shares. It is from people who are the real owners of the business.

 The finance type is only raised by limited companies and is permanent in nature and can only be refunded in the event of liquidation.

It earns ordinary dividends as a return to the investments.

The investors carry voting rights and usually each share is equal to one vote.

 The ordinary shares are quoted at the stock exchange where they are sold and bought.

The finance carriers the highest risks in the company because it gets its return after other finances have got their and also in the event of liquidation is it paid last.

The ordinary dividends are not a legal obligation on the part of the company to pay.

Where the profits are good ordinary shareholders get the highest return because their dividends are varied.

This type of finance grows with time and this growth is equity which basically is facilitated by retained earnings.

Advantages of Ordinary Share Capital to Shareholders

Ordinary shares have a right to vote and their votes influence the company’s activities.

Ordinary shareholders can use their shares to secure loan.

Ordinary shares are easily transferable.

The owners of the ordinary shareholders earn dividends in perpetuity.

The fluctuating nature of dividends is earned.

The ordinary shareholders benefit from the residual claim in the event of liquidation.

Disadvantages of Ordinary Shareholders

Carry variable returns in case of low or non-profit dividends are not paid..

In case of liquidation an ordinary shareholder may lose everything.

The sale of more ordinary shares dilutes ownership of the existing shareholders.

The dividends of an ordinary shareholder are double taxed.

b) Retained earnings (revenue reserves)

This is a source part of equity finance which arises out of undistributed profits over and above dividends paid to shareholders.

It is a cost free source of finance and its cost is opportunity cost in terms of foregone dividends to ordinary shareholders.

The retained earnings constitute growth in equity which is a cost of equity because the company may declare retained earnings as extra dividends or inform of bonus issues.

Arguments in Favour of Retention

Acts as a stabilizer to future dividends (ordinary dividends) especially when profits perform poorly;

No cost are incurred for its acquisition

It is able to be raised at no notice especially during unforeseen events e.g.

a. Abrupt increases in the prices of raw materials

b. Fire hazards e.t.c

Promotes savings promoting investments and growth

Large volumes of retained earnings influence the company’s shares positively.

A good source of finance to those very urgent short-term ventures whose returns are immediate

They boost the company’s creditability to the company’s creditors.

The advantages of using retained earnings as a source of finance to the company.

·       It is the largest internal source of finance which the business will use without paying any costs.

·       The use increases the equity base of the company making it possible to generate more debt finance.

·       Retained earnings are used to finance new fixed assets whose value cannot be met by other sources

·       It is used without pre-conditions or restrictions making it the most flexible source of finance.

·       It boosts confidence among the company’s creditors

·       It is a permanent source of finance to the company to be used on long –term investments.

The disadvantages of using retained earnings as a source of finance to the company.

Easily misused by the management as it may be invested in areas which are prejudicial to majority shareholders?

Retained earnings once used will leave not shield to take care of contingencies exposing the company.

The finance can easily be misinvested in areas of quite low returns.

The source involves a lot of sacrifice to the ordinary shareholders inform of opportunity cost

Easily invested in high risk investments

Debt Finance – Loan

This is the type of finance which is obtained from persons other those actual owners of the company i.e creditors to the company. The finance can be in any of the following forms;

Loans

Debentures

Bank overdrafts

Trade creditors

Borrowing against bills of exchange

Lease finance

Mortgage finance

Hire purchase finance

All the above finances have a legal claim or change against the company’s resources or assets.