Ch-2 (Sources of Finance) PDF

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Business Finance Chapter : Two Sources of Finance Prepared by: Anindita Tasneem Department of Finance University of Dhaka

1. Describe the sources of financing. To start a business and run daily activities, it is very much essential to make correct decision about financing. Required fund can be collected from various sources. At first all available sources have to be listed and then appropriate sources have to be chosen for raising required fund. Not only to raise fund is important, but also to use fund properly, effectively and profitably is important for a business. Firms usually raise their funds from two sources: a. Internal Source b. External Source

2. Describe the internal sources of financing. Internal Sources: The fund raised by owners / promoter’s capital or other personal earnings and cash is called internal funding or internal financing. Following are some examples of internal financing: 1. Promoter’s initial capital: The most common source of internal financing is promoter’s initial capital. Promoters invest capital at the start of the business. This shareholders capital is the long term fund because there is no obligation to repay the debt of the shareholders. In most cases the owners do not withdraw their capital from the firm.

2. Retained earnings: The part of net income of a firm which is set apart for any other purpose is known as retained earnings. This is an important source of internal financing. This is mainly used for the expansion of the firm. What will be the ratio of the “dividends paid” and the “retained earnings” depends on the financial condition of the firm. If the company is financially stable, it has good profit scenario. It can give dividend to the shareholders and the residual can be retained for further expansion. It can also retain all the earnings if it is financially unstable. Retained earnings can be allocated in different forms or in different sectors which are stated below: i.

General Reserve: The funds created as reserve by separating an amount of net income for nondetermined purpose, is called General reserve. It pertain the highest amount of retained earnings. It is used generally for the expansion of firms, welfare of shareholders and for facing any future financial crisis of the firm.

ii.

Dividend Equalization Fund: Most of the firms try to give dividend to their shareholders every year. But for the inconsistency in profit earning, they fail to do so. Sometimes, their profit is too low to give dividend that year. Again, some years earn a good profit that they use all of them as dividend. To prevent this inconsistency, firm tries to set aside an amount of profit if the profit is very high in a certain year. If one year the firm bears loss it can equalize the dividend amount through this fund. This dividend equalization fund can be used as a source of internal financing until they are used in dividend distribution.

iii.

Sinking fund: Sometimes, firms take a big loan either from banks or buy issuing bonds and debentures with a high interest rate. When the payment period occurs, firms have to undergo a lot of pressure of loan and interest payment. For this reason, the firm forms sinking fund with a part of retained earnings. This fund can be used as an internal source of financing until the payment period occurs.

iv.

Workmen’s compensation and welfare fund: This fund is created from a part of retained earnings for compensating the workmen in case they meet any accident. This fund is used as a source of internal financing until this is used for any compensation.

v.

Credit balance of profit and loss account: After declaring dividend, transferring a part to general reserve or any other reserve (by preparing profit and loss appropriation account), the rest amount of net income is carried to the balance sheet. It is also an important source of internal financing.

3. Provident fund of officers and employees: Many government and non-government firms arrange provident fund facility for their employees. This fund is created from a part of their salaries and an amount given by the government. Employee and the government deposit equal amount each month for the provident fund. While retirement, the employee gets a large amount form the provident fund. Before the payment, the total fund can be invested and a large amount of interest can be earned. That’s why before repaying the employees their part of provident fund, this large amount with interest is used as a source of internal financing. 4. Sale of surplus fixed assets: Sometimes, businesses collect their fund by selling their surplus assets which have lost their effectiveness. 5. Over use of fixed asset: The fixed assets the firm holds have limited time. The cost of fixed asset is called depreciation expense. It is showed equally in the profit loss account and the accumulated depreciation account each year. This accumulated depreciation account can be used as an internal source of financing. Besides, if the fixed asset is usable after its expiry date, the firm can use the amount, kept for purchasing a new asset, as an internal source of financing.

3. Describe the external sources of financing. External Sources: Internal sources are not always enough to fulfill the firm’s need. Then the firm tries to collect the necessary funds from external sources. The portion of the necessary funds, which is collected from the external sources, is called external financing. We can categorize the external sources under two major headings. They are: 1. Institutional Sources 2. Non-institutional Sources

1. Institutional Sources: The major institutional sources of external financing are: i.

Commercial Banks: The most popular and reliable external institutional source is commercial banks. It deposits the money of its customers and gives loan with a higher interest rate. For starting a business, expanding product line, modernizing plants and fulfilling the need of working capital firms take loan from banks. It generally gives two kinds of loan. 1. Secured loans: 1. Short-term loans: For 1 year or less. Some examples: a. Cash credit b. Cash credit hypothecation c. Warehouse receipt loan 2. Intermediate-term loans: For 1 to 5 years 3. Long-term loans: For more than 5 years b) Unsecured loans: These loans generally short-term loans. Some examples: 1. Line of credit 2. Revolving credit 3. Single payment loan 4. Overdraft

ii.

Investment Banks: 1. Financial institution that provides large amounts of long-term fixed capital, primarily for established firms. Investment banks generally take an equity stake in the borrower firm to exercise some influence on its direction and operations. They also act (often jointly) as financial intermediaries by underwriting the sale of new securities and providing the facilities of bridge financing. 2. Investment banks purchase the newly issued share of public limited companies and sell them to the capital market. By purchasing the share of public limited companies they reduce the problem of capital shortage. Thus, they expand the investment base of a country. 3. They are important source of financing at the foundation of the firm. Because when firm forms it tries to sell shares into capital market, it can be somehow unsuccessful for its lack of popularity among investors. At that time, investment bank purchases all shares and sell them to the capital market. Thus, they bear all the risk of selling the shares of a new firm.

4. Investment banks also provide loans to the firms by purchasing their debentures and bonds. 5. It participates in stock exchange activities and directly purchase and sell shares on behalf of investors. 6. It participates in joint venture projects 7. It creates mutual fund and sells unit certificate to collect fund. Thus, they finance public limited companies. 8. It gives advice to investors.

iii.

Insurance Companies: The insurance companies collects premium from the premium-holders. Though they collect much premium they have to repay the insurance claims in rare cases. So, they hold a large amount of money for a long time. These companies invest these funds by giving loans to other established firms.  Advantage- It gives large amount of long–term loans.  Disadvantage- It gives loans at a high interest rate and only gives loan to strong and well-established firm.

iv.

Development financing institutions: This type of institutions are formed and operated for development of specific sectors. Bangladesh Development Bank Limited (BDBL) works for the development of the industrial sector of our country which:  Provides funds for the establishment of new industries and for the expansion and modernization of old industries.  Gives long-term loans in both domestic and foreign currencies  Performs as underwriter and provides the facility of bridge financing.  Provides working capital  Provides guarantee against loans borrowed from other sources.

v.

Leasing companies: 1. Performs a strong role providing intermediate term loans. 2. Allows firms to use their fixed assets for industrialization 3. Example: Industrial Development Leasing Company (IDLC), United Leasing Company (ULC)

vi.

Owner’s capital from capital market: When private limited company turns into public limited company it invites common people to purchase their share. Common people purchase these shares from capital market and become shareholders or owners of the company. The fund raised from these shareholders is called owners capital. There are two types of owner’s capital: a. Common stock b. Preferred stock

vii.

Specialized financial institutions: It gives loan where there are any specific needs: 1. 2. 3. 4.

Bangladesh House Building Finance Corporation (BHBFC) Bangladesh Krishi Bank (BKB) Rajshahi Krishi Unnayan Bank (RAKUB) Bangladesh Small and Cottage Industrial Corporation (BSCIC)

2. Non-Institutional Sources: Besides the institutional sources we can also collect funds from non-institutional sources. They are: i.

Trade Credit: Many purchaser now purchase on credit and repay the debt on a given credit period. Until he has to pay the amount to the debtor, he can use the amount as short-term source of financing. The duration of trade credit can be 15 days to 3/ 4 months.

ii.

Mortgage: Firms can take loan against their real property secured under a mortgage agreement. Land, buildings, plant, machine etc can be used as securities while borrowing this kind of loan.

iii.

Debenture and bonds: Strong and powerful companies (Blue Chip Companies) can collect necessary funds by issuing bonds and debentures to general public. The difference between shares and debentures is that firm has to pay a fixed amount of interest against the loan taken by issuing bonds and debentures.

iv.

Friends and relatives: Small firms can manage it necessary funds by taking loan from friend and relatives. These type of loans are generally of small amount and short-term.

v.

Money lenders: Small firms also collect their funds from moneylenders. These sources have no legal authorization and the firm has to pay interest at a very high rate against these loans.

4. Describe the owner’s equity capital and debt capital. The term capital denotes the long-term funds of a firm. All items on the right-hand side of the firm’s balance sheet, excluding current liabilities, are sources of capital. The sources of capital can be categorized into two sections according to their ownership. They are: a. Owner’s capital/ Equity capital b. Debt capital These two types of capitals are described below: 1. Owner’s capital/ Equity capital: Owner’s capital or equity capital is the aggregate of promoter’s initial capital, capital collected by issuing shares and the reserves created from retained earnings. After repaying all the claims of the creditors, the residual of firm’s total capital is recognized as equity capital. A firm can obtain equity either internally, by retaining earnings rather than paying them out as dividends to its stockholders, or externally, by selling common or preferred stock. 2. Debt capital: The part of firm’s total capital which is raised as loans from creditors is called debt capital. Debt capital includes all long-term borrowing incurred by a firm, including bonds, debentures and trade credits. If we exclude the owner’s capital from the total capital the residual is called the debt capital.

5. What are the differences between owner’s and creditors? No . 1.

Features

Owners/Owner’s capital

Creditors/ Debt capital

Definition

2.

Risk Level

All long-term borrowing incurred by a firm, including bonds and debentures. Creditors have to bear less risk. They get a fixed amount of interest on the fund supplied by them.

3.

Maturity

4.

Bindings in payment

5.

Claim on income

6.

Claim on assets

The long-term funds provided by the firm’s owners, the stockholders. Owners have to bear more risks. Only if the firms earn profit, they can earn dividend. If there is no profit there is no chance to have dividend. Unlike debt, equity capital is a permanent form of financing for the firm. It does not “mature” so repayment is not required. Equity is liquidated only during bankruptcy proceedings. Firms are not legally bound to pay dividend and repay share values to the shareholders Their claims on income cannot be paid until the claims of all creditors (including both interest and scheduled principal payments) have been satisfied. The equity holders’ claims on assets also are secondary to the claims of creditors. If the firm fails, its assets are sold, and the proceeds are distributed in this order: employees and customers, the government, creditors, and (finally) equity holders. Because equity holders are the last to receive any distribution of assets, they expect greater returns from dividends and/or increases in stock price.

Generally, firms take loan for a certain period and they have to repay them after the period ends

Firms are legally bound to pay interests and repay the loans borrowed from the creditors After satisfying these claims, the firm’s board of directors decides whether to distribute dividends to the owners. The debt holders’ claims on assets also are senior to the claims of creditors. If the firm fails, its assets are sold, and the proceeds are distributed in this order: employees and customers, the government, creditors, and (finally) equity holders. Because debt holders are the first to receive any distribution of assets, they have chances to receive less return than dividends received by the stockholders.

7.

Cost of capital

The costs of equity financing are generally higher than debt costs. One reason is that the suppliers of equity capital take more risk because of their subordinate claims on income and assets.

The costs of debt financing are generally lower than equity costs. One reason is that the suppliers of debt capital take less risk because of their seniority to claims on income and assets.

8.

Certainty/ uncertainty in extra payment

If the firms earns large amount of profit in a certain year, owners have the chances to earn more dividends in that year

If the firms earns large amount of profit in a certain year, creditors don’t have any chances to earn more interest in that year. Because, the rate of interest paid to them is fixed.

9.

In case of bankruptcy equity holders are the last to receive any distribution of incomes and assets Common stock, Retained Examples (instruments) earnings Control Unlike creditors, holders of equity capital are owners of the firm. Holders of common stock have voting rights that permit them to select the firm’s directors and to vote on special issues. They can also have influence on the decisions taken by the management. Tax Treatment Dividend payments to a firm’s stockholders are not taxdeductible. Further causing it to be higher than the cost of debt financing.

10. 11.

12.

Bankruptcy

In case of bankruptcy debt holders are the first to receive any distribution of incomes and assets Bonds, Debentures, Mortgage In contrast, creditors have no voting right to choose directors and no right to participate in management. They may receive voting privileges only when the firm has violated its stated contractual obligations to them.

Interest payments to debt holders are treated as tax-deductible expenses by the issuing firm. The tax deductibility of interest lowers the cost of debt financing....