SOURCES OF COMPANY FINANCE

Methods of Raising Finance

A company can raise finance in the following ways:

  • From finance classified according to the relationship to the party giving the finance, e.g.
    1) Equity finance- This is finance provided real owners of the business i.e. ordinary shareholders.
    2) Quasi equity- This is finance provided quasi-owners of the business i.e. preference shareholders.
    3) debt finance- This is finance provided outsiders i.e. creditors: thus it include loans, overdrafts, trade creditors, bills of exchange, debentures, hire-purchase, leases, mortgages, etc.
  • Classified according to the duration i.e. term of finance i.e. how long the finance will be in the business.
    1) Permanent finance- This is finance which cannot be refunded to the owners in the short-run. Examples of this finance are:
    Ordinary share capital
    Irredeemable preference share capital
    Irredeemable debentures
    These are only refunded in the event of the company’s liquidation.
    2) Long term finance- If finance is in the business for a period of 7 years and beyond, this finance is long-term, e.g. long-term debt finance. However, this term is relative because for a kiosk a 2 years loan is long-term, and for a limited company a 2 years loan is short term.
    3) Short term finance- this is finance due to be refunded to lenders after a short period i.e. a period between one year and three years, e.g. overdrafts, short term loans, etc.
  •  Classified according to the origin of finance:
    1) Internal sources of finance- these are such finances as generated within the business, i.e. from the businesses’ own operations. Examples of such finances are
    Retained earnings
    Provision for depreciation
    Provision for taxation
    Adjustment in working capital items
    The above finances are used as follows:-
  • Undistributed profits transferred to the business i.e. ploughed back into the business.
  • Provision for depreciation if a company has created a sinking fund to replace an asset after useful economic life. This finance can be used and replaced later when the asset is due to be replaced.
  • Provision for taxation is a source of finance in as much as the tax liability falls due a bit later than when it is appropriated from the current profits, e.g. a company will provide for taxation in December and pay it at the end of March or thereafter. i.e. It can be used up to the end of March.
  • Adjustment in working capital serves as a source of finance in as much as the company will reduce the levels of working capital items to release finance which would have otherwise been tied up in those items.
  • Sale of an asset; this is a source of finance under the following conditions:-
    If the asset is obsolete
    If the asset is sensitive to technology e.g. computers, aircrafts.
    If the asset cannot meet the company’s contemplated expansion programme.
    If the asset is not sensitive/ central of the company’s operations, and its sale will not substantially affect he productive capacity of the business.
  • Classification according to the rate of return i.e. in relation to the cost of that finance.
    1) Finance with variable rate of return (VRT). In this case the return on such finance will vary with the profits made the company, e.g. ordinary share capital and participative preference share capital are VRT.
    2) Fixed rate of return capital (WFR). This will refer to the finance whose rate of return is fixed regardless of the profits made, e.g. preference share capital, loan finance, debenture finance etc.

Equity Finance
This is the largest source of finance to any limited company and usually forms the base on which other finances are raised. Equity is the total sum of the company’s ordinary share capital plus the company’s retained earnings also known as revenue reserves.

Ordinary Share Capital
It is that finance contributed the ordinary shareholders of a business. This is raised through the sale of the company’s ordinary shares. It is finance contributed real owners of the company. This finance is only raised limited companies. It is permanent finance to the company and can only be refunded in the event of liquidation, i.e. in Kenya; a company cannot buy back its own shares (ordinary shares). This finance is paid ordinary dividends as return to the shareholder’s investment.

Annual General Meetings.
Ordinary shares are quoted at the stock exchange where they are sold and bought the public through brokers. Ordinary share capital carries the highest risks in the company because it gets its return after other finances have got theirs, and also in the event of liquidation it is paid last (their voting right is assumed to be used wisely to minimize these risks.)

Ordinary dividends are not a legal obligation on the part of the company to pay. If the company’s profits are good, ordinary shareholders get the highest return because their dividends are varied. This is the only type of finance that grows with time and this growth is technically called growth in equity which is facilitated retention of earnings.

Rights to Ordinary Shareholders

  1. They have a right to vote. This right is given to them the company’s Act. They are also entitled to vote Proxy in absential
  2. They have a right to inspect corporate books e.g. Articles of association, Memorandum of Association and books of accounts.
  3. They have a right to sell their shares to other parties i.e. to transfer their ownership in shares of a company
  4. They have a right to share in residual assets of the company during the company’s liquidation.
  5. They have a right to approve the purchase of capital assets.
  6. They have a right to amend the charters and laws of the company (Articles and Memorandum of Association)
  7. They have a right to approve the sale of the company’s assets.
  8. They have a right to approve mergers, acquisitions and take-overs.
  9. They have a right to appoint directors.
  10. They have a right to appoint/remove auditors of the company who will oversee the company’s affairs.

Features of Ordinary share Capital

  1. It is a permanent finance to the company which can be refunded only during liquidation.
  2. It is the largest source of finance to the Ltd Company.
  3. This finance has a residual claim on profits and assets during liquidation.
  4. Ordinary share capital is entitled to voting powers, each share usually being equal to one vote.
  5. This finance carries a varied return i.e. its dividends will vary with the profits made.
  6. Ordinary share capital carries no nominal cost to the company. i.e. dividends on ordinary share capital are not a legal obligation to the company to pay.
  7. It is the only finance which will grow with time as a result of retention.
  8. This finance cannot force the company into liquidation i.e. it does not increase its gearing; on the contrary, it decreases the gearing.
  9. It can be raised limited companies only.

Advantages of using Ordinary Share Capital a company

  1. Being a permanent finance the company will invest it in long term ventures without inconveniencies of paying it back.
  2. Dividend payment (to ordinary shareholders) is not a legal obligation to the company, thus no threat to liquidity of the company.
  3. This type of finance contributes valuable ideas towards the running of the company during the Annual General Meeting.
  4. This finance is available in large amounts in particular if the company is quoted on the stock exchange in which case it can raise substantial amounts of money to finance the company’s operations.
  5. Ordinary share capital forms a base and thus a security on which other money can be raised.

Disadvantages of using Ordinary Share Capital to a company

  1. The cost of ordinary share capital (ordinary dividend is paid in perpetuity).
  2. This finance may disorganize a company’s policy in case shareholders’ votes are cast against the company’s present operations and policies.
  3. It does involve a lot of formalities in its raising and it may take a long time to raise as the company has to obtain permission from the capital market authority and other regulators.
  4. It is very expensive to raise as it involves a lot of costs commonly known as floatation costs e.g. printing the prospectus and share certificates, advertising expenses, cost of underwriting the issue, brokerage costs, legal fees, auditor’s fees, cost of communication.
  5. The issue of ordinary share capital means that the company’s secrets will be exposed to the public through published statements which may be dangerous from competitors’ point of view.

Quasi Equity/ Preference Share Capital

This is finance contributed quasi-owners or preference share holders. It is so called quasi-equity because it combines features of debt finance and those of equity finance. It is called preference share capital because it is accorded preferential treatment over ordinary shareholders in:-

  • Sharing in dividend- It receives its dividend before those of ordinary shareholders. Thus it is said to be preferred to dividends.
  • It is accorded preferential treatment in sharing of assets in the event of liquidation.

Preference shareholders get their claims on asset before ordinary shareholders get theirs. Thus it is said to be preferred to assets. In order for a share to be called a preference share it must be accorded the above preferential treatment over and above ordinary share capital.

Similarities between Ordinary and Preference Share capital

  1. Both finances earn a return in form of dividends
  2. If the preference shares are irredeemable then both will be permanent sources of finance to the company.
  3. In case the preference share capital is irredeemable both will receive dividends in perpetuity.
  4. Both form the company’s share capital/ share finance
  5. Both are difficult to raise due to a lot of formalities the company must go through to raise this finance.
  6. Both claim on assets and in profits after debt finance has had its claim.
  7.  Payment of dividend to both is not a legal obligation for the company i.e. neither the ordinary shareholder nor the preference shareholder can sue the company to claim their dividends.
  8. Both finances are not secured i.e. no security is attached to such finance.
  9. Both finances are raised strictly limited companies.
  10. Both finances are long-term finances to the company.

Differences between Ordinary and Preference Share capital

  1. Ordinary share capital carries voting rights whereas preference share capital does not except if it is convertible, and is converted.
  2. Ordinary share capital carries variable rate of dividends whereas preference dividends are fixed except for participative preference share capital.
  3. Ordinary share capital receives its dividends after preference share capital has been paid theirs.
  4. The share prices of ordinary shares will be higher if the company is doing well than those of preference shares.
  5. Preference share capital increases the company’s gearing level whereas ordinary share capital reduces the gearing level.
  6. For cumulative preference shares these may receive dividends in arrears ordinary shares cannot.
  7. Raising finance way of ordinary share capital is easier than raising preference share capital as in the latter case the company has to be financially strong.
  8. Preference share capital is usually secured the company’s financial soundness whereas ordinary share capital is not.
  9. Preference share capital cannot qualify for a bonus issue, while ordinary share capital can, i.e. preference shares cannot receive bonus issues.
  10. Ordinary shares have a chance to receive a rights issue whereas preference shares cannot get rights issues.

Debt Finance – Loan
This is the type of finance which is obtained from persons other than actual owners of the company i.e. creditors to the company. This 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 charge against the company’s resources or assets.

Classification of Debt Finance

1. Short term finance
This ranges from 1 month up to 4 years and is given to customers known to the bank or to lenders. The agreement of this loan will mention both the repayments of principal and interest, and for interest it must identify whether it is simple or compound interest. For principal, it has to be paid over some time. This finance is usually secured and the terms of the loan will be restrictive e.g. to be invested in an area acceptable to the bank or lender. Usually, this finance should be used to solve short-term liquidity problems.

2. Medium-term finance
This finance will be in the business for a period ranging between 4-7 years. This term is relative and will depend upon the nature of the business. This type of loan is used for investment purposes and is usually secured but the security should not be sensitive to the company’s operations. The finance obtained must be invested while respecting the matching approach to financing i.e. the term and payback period must be matched. This type of finance is the most popular of all debt financing because most of the businesses will need it both in their growing stages and also in their mature stages of development.

3. Long-term finance
This is a rare finance and is only raised financially strong companies. It will be in the business for a period of 7 years and above. This finance is used to purchase fixed assets in particular during the early stages of a company’s development. It is always secured with along term fixed asset, usually land or buildings. Its investment, however, must obey the matching approach. In all, the companies needing such finance do not have to be known to the lenders.

Other forms of Debt Finance

Overdrafts
These are very short-term sources of finance to the company and are usually used to finance the company’s working capital or solve its liquidity problems. This finance is usually not secured and is more costly than long-term loans as much as its interest is 1- 2% higher than bank rates. Interest on overdrafts is computed on a daily basis although it may be paid monthly. Overdrafts are usually given to very well known customers of the bank although over-reliance on overdrafts is a sign of poor financial management policies and as such they should not be used often.

Bills of Exchange
As a source of finance, bills of exchange can be:-

  1. Discounted
  2. Endorsed
  3. Given as securities for loans

A bill of exchange us defined as an unconditional order in writing addressed one person to another signed the person giving it, requiring the person to whom it is addressed to pay on demand at a fixed or determinable future date a certain sum of money to the order of the person or to bearer. Most of the bills mature between 90-120 days although they could be sight bills i.e. payable on sight or issuance i.e. payable in the future. In order for a bill to be valid and to serve as a source of finance it should be:-

  • Signed the drawer;
  • Accepted the drawee;
  • Be unconditional;
  • Bear appropriate revenue stamp.

Debenture finance
It is a document that is evidence of a debt which is long-term in nature, and confirms that the company has borrowed a specific sum of money from the bearer or person named in the debenture certificate. Most debentures are irredeemable thus forming a permanent source of finance to the company. If these are redeemable then these will be long-term loans which range between 10-15 years. They can be endorsed, negotiated, discounted or used as securities for loans. They carry a fixed rate of interest which is payable after six
months i.e. twice a year.

Classification of debentures

1.Classification according to security

  • Secured debentures- these are secured against the company’s assets or have a fixed charge against the company’s assets. In the event of the company’s liquidation such debentures will claim from that particular asset. They could be secured against a floating charge in which case the holder can claim on any or all of the company’s assets not yet attached other secured creditors. A debenture holder with a floating charge has a status of a general creditor. However, the floating charge debentures are rare and they are sold financially strong companies.
  • Unsecured (naked) debentures- these carry no security whatsoever and such they rank as general creditors. They carry a residual claim to the first class creditors but a superior claim over ordinary shareholders. These are rare sources of finance and are sold financially strong companies with a good record of dividend payment to the shareholders.

2.Classified according to redemption.

  • Redeemable debentures- these are bought back the issuing company. Like preference shares, these have two redemption periods. This is usually between 10-15 years, i.e. the company has the option to redeem these after 10 years but before expiry of 15 years. In most cases redeemable debentures are secured against specific assets e.g. land or buildings (mortgage debentures). Their interest is a legal obligation on the part of the issuing company.
  • Irredeemable debentures (perpetual debentures)- these can never be bought back the issuing company except in the event of liquidation and as such they form a permanent source of finance to the company. These debentures are rare and are only sold financially strong companies which must have had some good dividend history. They are unsecured and thus are known as naked perpetual debentures.

3.Classified according to convertibility

  • Convertible Debentures- These are the type of debentures which can be converted into ordinary share capital and this conversion is optional as follows:
    At the option of the company i.e. at the company’s option.
    At the option of both parties i.e. debenture holder and the company.
    At the option of the holder.
    In all, convertible debentures are never secured.
  • Non-convertible debentures- These cannot be converted into any shares be it ordinary or preference shares and are usually secured.

4.Subordinate debentures (naked)
These are issued with a maturity period of 10 years and above, and usually they carry no security and depend upon the goodwill of the company. They are so called subordinate because they rank last in claims after all classes of creditors except trade creditors. Nevertheless their claims are superior to those of shareholders both preference and ordinary shares.

Hire Purchase
This is an arrangement wherea company acquires an asset paying an initial installment usually 40% of the cost of the asset and repays the other part of the cost of the asset over a period of time. This source is more expensive than bank loans. Companies that use this source of finance need guarantors as it does not call for collateral securities to raise. The company hiring the asset will be required to honor all the terms of the arrangement which means that if any term is violated then the hire may repossess the asset. This finance is kind and the hirer will not get a good title to the asset until he clears the final installment and an optional charge in some cases. Companies that offer this finance in Kenya are:- National Industrial E.A. Ltd., Diamond Trust(K) Ltd., Kenya Finance Corporation, Credit Finance Co. Ltd. They avail hire purchase facilities for such assets as: Plant and machineries, vehicles, tractors, heavy transport machines, aircrafts, agricultural equipments.

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