RESOURCE NEEDS FOR ENTREPRENEURSHIP NOTES-BBM - University Education and Exams

RESOURCE NEEDS FOR ENTREPRENEURSHIP NOTES

In this lecture we shall discuss the sources of business finance which
include equity finance, debt finance – loan, bills of exchange.
,factoring ,trade debtors ,accrued expenses ,credit card buying (plastic
money) ,debenture finance, invoice discounting (confidential factoring)
,factoring ,sale and lease –back ,sale of an asset, and purchase.

General objectives
By the end of the course the learner should be able to identify the
appropriate sources of funding for entrepreneurship. At the end of this
lecture you should be able to:

Explain the Various sources of finance for entrepreneurship
Discuss the advantages and disadvantages of the various sources of
finance
Identify factors that influence the various sources of finance sought

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

5.1.1 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.

Ordinary share-capital
It that finance contributed by ordinary shareholders of a business. It
is raised through the sale of the company’s ordinary shares- 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 retention
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..
Incase 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.
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
1 Acts as a stabilizer to future dividends (ordinary dividends)
especially when profits perform poorly.
2 No cost are incurred for it’s acquisition
3 It is able to be raised at no notice especially during unforeseen
events e,.g

Abrupt increases in the prices of raw materials
Fire hazards e.t.c

4 Promotes savings promoting investments and growth.
5 Large volumes of retained earnings influence the company’s shares
positively.
6 A good source of finance to those very urgent short-term ventures
whose returns are immediate
7 The 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 mis-invested 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.

Capital reserve
these are reserves which cannot usually be classified as normal trading
profits arising out of the company’s ordinary trading activities – but
are created with say shares are sold at a higher price than the per
value and the excess is profit – such are credited to he capital reserve
account and is used to offset the issuing expenses. It can also be
created from revaluation of assets ( fixed assets)

Quasi equity finance (preference share capital)
This is finance contributed by Quasi – owners or preference
shareholders. It is 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.

Similarities between Ordinary & Preference Shares Capital

Both finances earn a return in the form of dividends

They are a permanent source of finance especially the irredeemable
preference shares
Both receive perpetual dividends ( irredeemable preference shares)
Both form the company share capital
Both are difficult to raise due to prolonged formalities.
Both claim on assets residual and in profits after debt finance has
had it’s claim.
Payment of dividends not a legal obligation
Both finances are not secured
Both are long –term finance to the company.

5.1.2 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 he company’s
resources or assets. Requirements a Company must meet before raising
Debt Finance.

The company must provide a summary of history of the business and its
nature. This is used to assess the risk of the company’s business line.
Details of management – names, ages, qualification and experience of
managers and directors. If these are of questionable integrity, such as
a company may not get debt finance.
To produce five years audited accounts which will reflect t he
company ‘s financial ability to service debt finance.
the purpose of the loan must be;

within the lender’s priority
Within the government areas of priority for development purposes.

Furnish lenders with cash flow forecast and proposed trend of repayment.
Major shareholders of the company must give consent to the loan.

Reasons why Commercial Banks prefer to lend short-term

Majority of deposits with these banks are subject to withdrawal on
demand and short-term notice these cannot be lent long term. The
violation of this principle led to the downfall of a number of financial
institutions in 1986/87 in Kenya.
Commercial banks are subject to sudden credit squeeze imposed by the
central Bank and as such they have to keep their investments in
short-term investments to meet the requirements of the central bank.
Short-term forecasts are usually accurate and also short-term
investments are less risky which is thus preferable to commercial banks.
Short-term investments are usually more profitable to the banks e.g
overdrafts which carry higher rates of interest than long-term loans.
Usually short-term investments are not secured e.g overdrafts and
thus are easier ad more flexible go give.

Limitations of debt finance/ disadvantages of using debt finance to the company.

Interest is a legal obligation and failure to pay it may lead to
company into receivership and consequently liquidation.
Using debt finance entails conditions and restrictions as to its use
and this makes it non-flexible finance which can only be invested in
those ventures approved by the lenders.
Its use on large scale increases the company’s gearing level which
exposes the company to incidences of receivership and thus liquidation.
It is not usually long-term finance and the payment of principal
leaves the company in financial strain and may cause liquidity problems
to the company.
the use of excessive debt finance i.e beyond 67% level puts the
company at the mercy of the lenders because they can come in to control
their interests which dilutes the control of owners and this may lead to
lower share prices. Moreover,
This finance calls for a security i.e it is usually secured against a
collateral security which may be rare or lenders may be rare or lenders
may restrict the use of such asset thus reducing the company’s
operations and thus its profit.
The lenders usually insist that the security be compressively insured
which will compound the cost of this finance as it will entail an
implicit cost to the company.
This finance is available only in big businesses which are known to
lenders and as such small companies will not be able to raise it easily
as they are assumed to be risky and are in most cases unknown to lenders.

Advantages of using Debt Financing.

Most debt financing is short-term and as such it will not burden the
company‘s cost of financing for long i.e cost is short-lived.
Interest on debt is a tax-allowable expense and thus the
effective/real cost of debt will be equal to interest less tax on
interest I,e interest is less by the much of tax on it. ( refer to cost
of finance)
the principal is later reduced in real monetary values by much of
inflation on it I.e the company pays less on long- term loans by virtue
of inflation reducing the real monetary value of the principal and interest.
The use of debt finance does not necessarily entail dilution of
control to existing shareholders are these shareholders may only lose
the control if the company has used 67% of debt finance in its financing
i.e in its total capital employed.
it is usually invested in viable ventures whose return is higher than
its cost, thus it is used with a good investment policy
This finance does not call for a lot of formalities in its use in as
much as it does not involve a lot of floatation costs.

Circumstances under which a company should use short-term debt finance.

Under situations when the company has identified a venture which
calls for finance on short-term notice and will pay back early enough to
facilitate repayment of the loan.
Under situations where the company’s venture promises higher returns
that the cost of debt finances.
Under high debtor’s turnover where the company wants to boost sales
through further investment in stock.
Under boom conditions when the company’s cost of debt is relatively
lower as profits will increase relatively and the company can be able to
service debt finance. This will raise the earning per share of the
company’s shares.

Characteristics of Debt Finance

It is a fixed return finance i.e interest on debt is fixed regarding
less of the profits made by the company.
Interest of debt finance is a legal obligation on the part of company
to pay and failure to pay it may lead the company into receivership in
the extreme.
It is usually given on conditions and restrictions except for overdrafts.
It carries a first claim on profits and assets before other finances.
It does not carry voting rights and as such it does not participate
in the decision making process of the company.
Its use rises the company’s gearing level.
It is always refundable except for irredeemable debentures.
it is usually a secured type of finance
Interest on debt finance is a tax-allowable expense.

Similarities between Debt finance and Ordinary Share Capital

in the case of irredeemable debentures both form a permanent source
of finance to the company
Both carry explicit costs to the company I. e interest on debt
finance and
Dividends on ordinary share capital.
both are raised by financially strong companies
In case or irredeemable debentures both will entail a permanent cost
to the company.
In case the company has used overdrafts then both are not secured
finances.
Both are external sources of finance to the company.
Both have control over the company if the company has used debt
finance of up to 67% of the company’s total financing.

Classifications of debt Finance.

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 repayment of principal and interest, and must identify whether it is
simple or compound interest. For principal, it
has to be paid over some time. This finance usually secured and the
terms of the loan will be restrictive. Usually be invested in an area
acceptable to the bank or lender. Usually this finance should be used to
solve short-term liquidity problems.
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 purpose and is
usually secured but the security should not be sensitive to the
company’s operations. The finance obtained must be investigated while
respecting the matching approach to financing i.e the term and pay back
period must be matched. This type of finance if the most popular of all
debt financing because most of the business will need it both in their
growing stages and also their mature stages of development.
Long-term finance
This is a rare finance and is only raised by financially strong
companies. It will be in business for a period of 7 yeas 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 a long-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.

Reasons why long term loans are difficult to raise on Kenya’s financial
markets/ limitations of using long-term debts.

This finance calls for long-term securities such as land and
buildings which most businesses in Kenya may not have.
There are no long –term savings to back-up these loans due to low
income of average Kenyans and as much most of the savings are short-term
and cannot be made available on long-term basis.
Most business in Kenya are agro-based and these are risky and as such
lenders cannot avail their finance to such businesses of long-term.
The central bank has tended to stimulate the development of money
markets that capital markets which have not been fully developed to avail such finance to meet the
development needs of industry and commercial sectors of the economy.
Long-term loans are not usually profitable because interest and
principal repayment are eroded by the by the impact of inflation and
thus banks may be reluctant to give such.
The size of the businesses in Kenya is small and such businesses are
not going concerns so as to be able to attract this finance on long term
basis.
A number of companies in Kenya are multinational companies which
obtain long-term finances from parent companies abroad and this has
limited the development of capital markets in Kenya as demand by such
companies is low.
there are been a tendency by the financial institutions to avail long
term debt for building purposes and little attention has been paid to
long-term finances for businesses.
This finance is given on conditions and restrictions to avail
long-term debt for building purposes and little attention has been paid
to long-term finances for businesses.
This finance is given on conditions and restrictions which make it
less ideal for profitable ventures as such restriction may reduce
profitability of companies concerned.
Long-term forecasts by commercial banks are inaccurate and filled
with a lot of uncertainties thus the banks are very reluctant to shield
such potential risks and prefer to lend short term which they can
forecast with some degree of accuracy and certainty.

Solutions to the above problems.

The government should diversify the security such that the same asset
acquired acts as its on security and also to allow guarantees as
securities in particular personal guarantees
The government or individual commercial banks should undertake mass
education campaigns to businessmen so as to induce them to save/keep
their money in banks so as to avail such money of long –term lending.
the government should participate in the development of this capital
market by;

Allowing some parastatals to go public i.e. to sell shares to the
public.
Selling or purchasing long-term debt instrument or creating a market
for these and allowing the forces of demand and supply for money to
operate freely in Kenya so as to determine the prices of securities
in the financial market.

The government should introduce insurance schemes to cover agro-based
industries so as to reduce their risk and so as to be open to long-term
finance.
There should be diversification in the economy from over-dependence
on agro-based industries to manufacturing which will create employment
and thus boost the incomes of average Kenyans and thus saving which will
be available for lending.
The government should stabilize the value of the Kenyan currency so
as to attract foreign long-term investors and aim at exporting more as
means of gaining foreign exchange which can be used to stimulate
long-term growth through importation of more capital goods and less
consumer goods.

General Limitations of Debt Financing

The economic life of the asset to be used a security act as an outer
limit to debt financing both the terms of principal and the term.
If the balance of debt outstanding in the company’s capital structure
is high it means t hat the company is highly geared and this cannot
allow lenders to give further finance to such a company as it will be
viewed as risky.
Debt financing may be expensive because it carries both implicit and
explicit costs. These may out-weigh the returns from the investments.
Ordinary shareholders may limit the much a company can use in debt
financing as the level of the gearing is influenced by this finance thus
putting them at risk.
The size of the company may influence its ability to raise debt
finance this size works better for quoted companies and unquoted
companies usually find it difficult to raise such finance.
General economic conditions may limit the availability of debt
finance because in recession it is quite dangerous to use large sums of
debt finance as these may not be serviced under conditions of low
profits and may lead to the company’s receivership in extreme.
The management for the company may also limit the availability of
this finance either by virtue of its nature (if its integrity is
questionable) or if it is conservative in the use of debt.

Advantages of using an Overdraft

it can be used to bail the company out of short-term financial
liquidity problems
Usually it is not secured as the company’s goodwill is all that
matters in obtaining this finance as long as the company is known to
lenders.
It is used without pre-conditions or restrictions which makes it a
flexible source of finance,.
It can be raised fast thus very useful in emergency financing endeavors.
It is not expensive to raise i.e there are no costs paid to obtain it
such as floatation costs. ‘
Its cost and financial constraints are short lived.
it can assist the company to meet its obligations in particular short
term obligations thus sustaining the goodwill from creditors.
Overdraft finance does not increase the company’s gearing level, at
least in the long run.
Overdraft finance is used without consent of shareholders thus it is
flexible as it can be used as and when it is needed.

Disadvantages of using Overdrafts

It is very expensive finance and its lending rate is usually 1-2 %
higher than the usual lending rates.
Its constant use of a sign of bad/poor financial management policy
and this may endanger the company’s ability to raise long-term finance
as longterm lenders view constant use of overdrafts as a sign of lack of
overdrafts as a sign of lack of cash forecasts and budgeting policies on
the part of the economy.
It is not easily available to every business thus it is obtained by
companies know better to the bankers,.
In some cases this finance may be used in a manner flexible to the
management which most cases may not be in the interest of shareholders
it may be used in areas which may not directly benefit shareholders i.e it
It is only available is small quantities and as such may not be
useful for bigger ventures.
The bank may recall this overdraft in part or in whole at any time
and this may inconvenience the Company affected.
Overdraft finance may only be used to finance non-profitable
operations e.g working capital and cannot be used to finance fixed
assets which are the most important ingredients in the company’s
production and profitable
operations. Other Sources of Debt Finance

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

discounted
endorsed
given as securities for loans

The commonest type of bills of exchange. Accommodation type of bills of
exchange is that type where two parties A and B are B is known to
bankers. The two enter into an agreement where A draws a bill on B and B
accepts it an agreement whereby A draws a bill on B and B accepts it and
thereafter A can either discount the same bill or endorse it to another
party to get finance which A will have to
refund later to B. However a bill of exchange is defined as an
unconditional order in writing addressed by one person to another signed
by 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 be valid and to serve as a source of
finance it should be

signed by the drawer
accepted by the drawee
be unconditional
bear appropriate revenue stamp

Advantages of Bills of Exchange as a Source of Finance.

It does not involve a lot of formalities and as such will allow the
drawer to obtain finance faster.
It is highly negotiable making it a liquid investment which the
company can liquidate fast ( if the drawee is of high credit rating)
Since it is unconditional the drawer will use the same finance
obtained on the strength of the bill without preconditions and restrictions.
It does not affect the company’s gearing level.
It is cheap to obtain and to retain – retention cost is discounts
which are usually lower than bank rates.
it does not call for any tangible security because the good will of
the drawee is all that is necessary to use

Disadvantages of Bills of Exchange

It is a very short-term source of finance and as such it may not be profitable as its duration cannot warrant any
profitable ventures i.e finance from the bill cannot be invested in
profit table ventures.
There are possibilities that the bills may be dishonored by the
drawee and drawer may have to settle any liabilities incurred thereon.
It is a foreign bill of exchange this may delay the finance in that
it may require the approval of the central bank before discounting it.
Its negotiability and thus liquidity as an investment will depend
upon the goodwill of the drawee which will be lacking in some cases.
Finance from this bill may be misused (misinvested) by the management
thus may not benefit shareholders.
There are chances of getting a fake bill of exchange which cannot be
discounted nor endorsed which will constitute a fraud to the company.
It may involve some costs in particular discounts which may be high
depending on conditions some of which may be a bit expensive to fulfill
e.g stamp duty.

Factoring
This can be defined as an outright sale of the company’s debtors to a
factor (which is usually a financial institution that specializes in
purchasing of debtors) this factor will pay the selling company up to
80% of the face value of debtors and is left with 20% to care of bad
debts if any, and also his discounts, this type of source of finance is
rare in Kenya mostly because it is an expensive source of finance due to
high discount costs. Savings in this source are in form of costs of
credit management which are transferred to the factor. However, the
factor takes up risks in debts (of default) which previously were
supposed to be borne by the selling company.

Reasons why factoring is not popular in Kenya (disadvantages)

Most transactions in Kenya are strictly on cash basis, due to low
creditability of most of the small firms in Kenya.
It is costly source of finance because the discount rate may even be
higher thank bank rates, thus companies may prefer to use overdraft
finance than factoring.
After selling a debtor, chances are that one might lose such a
customer completely and such this method can be used by monopolies only.
Sale of debtors reduces the company’s liquidity position in a way and
this may not be preferred by companies which depend on trade credit as
their liability rates will not be acceptable to trade creditors.
There is ignorance amongst the business community in Kenya about the
use of this facility as a source of finance.
It is difficult to legally enforce collection of debtors in Kenya and
this may discourage would be factors.
Kenya’s money market is not fully developed and as such the factor
may find it difficult to liquidate these debtors or pass the title in
this asset to another party.
Trade credit is very popular in Kenya and this has made up for factoring.

Advantages of using Factoring

The selling company can obtain ready finance from the factor which
can be used to solve its liquidity problems.
the selling company transfers the risk of bad debts to the factor
company thus reducing its losses
It minimizes the burden of collecting debtors’ i.e debt collection
expenses.
this finance can be raised fast thus does not entail a lot of formalities
It does not carry collateral security thus a flexible source of
finance to raise.
it can be raised by any company regardless of its status as long as
it has good debtors i.e of reputable companies.
it does not affect the company’s gearing level thus no loss of
control to the company by its use.

Trade Debtors
This acts as a source of finance in such as the company holding; such
debtors can discount them with a bank and obtain immediate finance. They
can be used as security for loans in particular overdrafts. The company
can continue to sell on credit and as
such this source can be a semi –permanent source of finance.

Accrued Expenses
Examples of these are;

accrued electricity bills
accrued telephone bills
accrued water bills
accrued rent
Accrued rates.

These are a short-term source of finance and can be big sources if the
company has a number of these outstanding expenses. However, a company
should use these in as much as they cannot affect its future operations
and only pay such on the last date when these are due.

Credit Card buying (plastic money)
These are arrangements whereby a company or an individual enters into an
agreement with a credit card organization to use their card to purchase
a number of goods and services and pay after agreed period of time.
Usually repayment carries interest charges. These cards are used to
obtain such goods and services as:

fuel expenses in particular for tour companies
stationery
Medical expenses for employees and their families.
Vehicle maintenance
Air transport
Purchase of inputs such as oils, spare parts e.t.c.

Reasons why Plastic Money has Developed Fast in Kenya of late

Due to high incidences of frauds by dishonest employees these cards
e.g in tour companies.
They minimize the use of liquid cash thus reduces chances of petty
cash frauds and also solves the company’s liquidity problems and those
of individuals.
Kenyan society has developed fast (in sophistication) and the use of
these cards is a sign of high social and economic status.
There is a lot of awareness amongst Kenya’s elite community as
regards credit facilities and as such have responded to the introduction
of this type of money fast.
There is a lot of risk associated with carrying lots of cash which is
open to theft and as such people prefer to carry finance in card form.
A number of companies and establishments have quickly recognized
these cards as a means of settling bills and some even give discounting
to card holders which has boosted their popularity.
It is a source of finance to individuals who depend on monthly
earnings who settle their bills using the credit cards and later pay at
the end of the month when their liquidity position warrants it.

Disadvantages/ limitations of using credit cards as a source of finance.

It is expensive to obtain (because the bolder has to deposit some
amount of money with credit card
Organizations) and later pay interest on all his expenditure.
It may lead to unwarranted spending which may lead to financial
strain on the part of the holder when it comes to settling his bills.
The majority of Kenyans are unaware of these credit card facilities
in particular the rural Kenyans
who form the majority of Kenyans.
The card is limited only to those establishments which have formal
arrangements with credit cards

Debenture Finance
Debenture has its origin in the latin word Deboe which means “ I owe” 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 with is payable after six months i.e twice a year.

Classification of Debentures

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 on any or all of the
company’s assets not yet attached by other secured creditors. A
debenture holder with a floating charge has a status of a general
creditor, however floating charge debentures are rare and they are sold
by 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 to the first class creditors
but a superior claim over ordinary shareholders. These are rare sources
of finance and are sold by financially strong companies with a good
record of dividend payment to the shareholders.

Classified According to Redemption

Redeemable Debentures – these are bought back by the issuing company.
Like preference shares, these have two redemption periods which are
minimum and maximum redemption periods. This 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 by 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 by financially strong
companies which must have had some good dividend history. These are
unsecured and thus are known as naked perpetual debentures.

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.

However the conversion price of the debenture is given by

Conversion price= nominal value of the debentures No. of shares received
Conversion ratio = Nominal value of debentures Nominal value of
shares to be converted.
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.

Subordinate debentures (naked)
These are issued with a mutuality 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.

Advantages of using debenture finance (to the selling company)

In case the company sells irredeemable debentures these will form a
permanent finance to the company which can be invested in long term
venture or fixed assets.
Their use does not entail dilution of the company’s control as they
carry no voting rights with which to influence the company’s policies.
In case of convertible debentures, once converted into ordinary
shares will be permanent finance to the company and can be used in
finance to the company and can be used in financing of long- term
ventures.
Interest on debentures is tax –allowable expense and as such it will
be less by the much of the tax on interest.

Disadvantages of using debenture finance (to the selling company.)

Interest on debenture is a legal obligation for the company to pay
and failure to pay it may put the company into legal wrangles.
it raises the gearing level of the company which may expose it to
risks of receivership and, in extreme, liquidation
In case of redeemable debentures once redeemed may leave the company
in financial strain.
Since interest is paid twice a year it may be cumbersome to the
company to pay and may pose liquidity problems.
For irredeemable debentures these place a permanent commitment in
terms of cost to the company.
If they are redeemable and reach maximum redemption period before
they are redeemed these may force the company into receivership and
consequently liquidation.
For secured debentures, these may be expensive because they will
carry implicit costs. i.e insurance and maintenance of the security and
later explicit costs . i.e interest on these debentures.

Similarities between Debentures and Preference Shares Capital.

They both carry fixed rate of return.
Both increase the company‘s gearing level.
both can be converted into ordinary shares, if convertible
both carry no voting rights in the company
both may be unsecured if the company sells naked debentures
both claim on profits and assets before ordinary share holders
If they are both redeemable they can force the company into
receivership after the expiry of the maximum redemption period if not
yet redeemed.

Advantages of using Debenture Finance to Ordinary Shareholders.

The use of debenture finance does not dilute the shareholders control
of the company unless they are convertible and are converted.
Under boom conditions ordinary shareholders may benefit from higher dividends due to fixed charges on debentures which is paid under conditions of high profits.
Interest on debentures is tax-allowable expense and as such this may
allow the company to retain more and even pay higher ordinary dividends
to its shareholders.
In case the company issues irredeemable debentures, these will be
invested in long-term ventures with not only have the effect of raising
the shares pieces of the company’s ordinary shares but will also
increase the company’s future ordinary dividends.
After debentures are redeemed, the company will benefit from the
asset/ investment they had financed which will increase the net worth of
shareholders.

Trade Credit
This finance is obtained by companies by which purchase goods on credit
and pay for such goods later. This “kind” and is available to companies
which can pay bills on time as and when they fall due. It the largest
source of finance to sole traders and wholesalers in Kenya. This is
cheap source of finance and it does not entail any explicit cost except
discounts foregone. This finance may be long-term in particular if the
company meets its bills regularly such that after settling a given bill
the same company obtains further credit immediately, thus may become a
continuous source of finance. In order to be a source of finance, credit
received must exceed credit given.

Advantages of using trade credit in Kenya a source of finance (reasons why trade credit is popular in Kenya)

Most businesses in Kenya lack collateral securities which are
necessary to raise other forms of debt finance thus resort to trade credit.
it is cheap source of finance because the only cost involved is
discounts lost I,e no implicit or explicit costs.
most other finances need the borrower to maintain healthy accounts
which small businesses in Kenya may not have thus resort to trade credit.
The fact that small businesses in Kenya are not known to lenders
makes trade credit the best source of finance as they may not qualify
for other finances which require that the borrower be known to the lender.

Disadvantages (limitations) of using Trade Credit.

The debtor company will undergo the opportunity cost of the discount
foregone by the very buying company.
This finance is not reliable because in the event of default on the
buyer’s side the seller cannot give it and this way cut the buyer’s
credit line which may lead a lot of inconveniences and in some cases
stoppages in production or sales of the debtor.
It is usually restricted to working capital items and as such may not
be available for fixed assets which are important for profitability reasons.

Promissory Note
A promissory note is a bill wherein one party promises to pay another
party on a specific date and conditions, a specific sum of money. It is
a short term source of finance to the company, usually up to 3 months.
This type of finance is used when the two parties know each other well.
It acts as a source of finance in as much as it can be discounted or
endorsed. It can also used as security for loans.

Advantages and disadvantages promissory note

Advantages of promissory note

It does not involve a lot of formalities and as such will allow the
drawer to obtain finance faster.
It is highly negotiable making it a liquid investment which the
company can liquidate fast ( if the drawee is of high credit rating)
Since it is unconditional the drawer will use the same finance
obtained on the strength of the bill without preconditions and restrictions.
It does not affect the company’s gearing level.

Disadvantages of promissory note

It is a very short-term source of finance and as such it may not be
profitable as its duration cannot warrant any profitable ventures i.e
finance from the bill cannot be invested in profit table ventures.
There are possibilities that the bills may be dishonored by the
drawee and drawer may have to settle any liabilities incurred thereon.
It is a foreign bill of exchange this may delay the finance in that
it may require the approval of the central bank before discounting it.

Invoice Discounting (confidential factoring)
This is an arrangement where the selling company discounts its invoices
usually with a bank or financial institution and will receive a large
percentage of its invoices in cash in advance. Usually it is expensive
source of finance and should only be used if the
company cannot obtain overdraft finance from commercial banks. The
invoice discounter analyse which invoices to discount and in this case
he will request the selling company to send original invoices to the
customer and a copy to the discounter. The invoice discounter has not
only lien on the debts but also recourse to the borrower in which case
the seller or borrower will have to pay the discounter should any debtor
default to pay his bills on the due date.

Advantages of using invoice discounting as a source of finance

it is useful as a solution to short term liquidity problems
it does not call for a collateral security and as such it is a
flexible of finance to raise.
it is easy to raise as it does not entail a lot of formalities
Normal credit will be extended to customers as the discounting of
invoices does not affect the relationship between the selling company
and its customers.

Disadvantages of using Invoice discounting as a source of finance.

The discounter has resource to the borrower and in case may debtor
fails to honour his obligation then the discounter can turn to the
seller to pay such debt and interest on finance advanced to him.
It may be an expensive source of finance in particular if the
invoices are small and numerous in which case the costs of collecting
these may be too high.
This type of finance is usually available to those companies whose
debtors are highly rated in credit payment point of view thus may be
discriminative if a given company has unknown debtors in which case they
cannot be discounted.

Similarities between invoice discounting and factoring

Both are raised on the account of the company’s debtors or invoices.
both are expensive sources of finance to the company because discount
rates in both case will be higher than the bank rate on borrowed funds
both fall in the family ( group) of short term sources of finance to
the company, thus are aimed at solving the company’s liquidity problems

Differences between invoice discounting and factoring
Invoice discounting

the bank has recourse to the borrower
the borrower keeps the debtor’s ledger
Chances of bad debts are high and this may increase the cost of the
company of using such finance.
invoices act more or less as securities for a short term loan
the discount rate is usually low

Factoring

the factor has no recourse to the borrower
The factor takes over the debtor’s ledger.
The chances of bad debts are minimal and even then these are borne by
the factor.
The invoices are sold outright to the factors and cannot act as
securities for loans.
The discount rate is relatively high.

Advantages of leasing as a source of finance

It may be a long –term source of finance e.g for land leased for a
period of 99 years
In case the lease agreement gives the option to purchase the asset
after the expiry of the lease term then Such a company will have known
which asset it is taking over, and thus make a good investment decision
based on experience.
Lease charges are tax-allowable expenses thus will reduce the
company’s tax liability.
The lessee enjoys the benefits of wear and tear which reduce his tax
liability.
The company does not risk holding assets which may turn to be
technologically obsolete.

Disadvantages of leasing as a source of finance.

This type of finance is available for fixed assets and as such does
not have provision for working capital which is important in generating
sales.
the periodic rental charges may outweigh the cost of the same asset
in the long-term i.e in the long run the leasee may pay more in rental
charges that the cost of this asset.
The lessor may not renew the lease agreement and this may put the
lessee out of business.
It is limited only to those assets which are available from the
lessor’s business thus is not useful in all financial requirements of
the company.
Lease finance entails implicit costs e.g maintenance and insurance of
the same asset leased which may compound the cost of this finance.

Sale and Lease –Back
This is an arrangement whereby a company which owns some assets arranges
to sell the same assets and at the same time agrees with the buyer to
lease the same asset back at an agreed rental charge. This type of
arrangement is possible if the asset back at an
agreed rental charge. This type of arrangement is possible if the asset
is fixed asset whose return must outweigh the cost of the same finance.
Also the parties involved must have had an intimate relationship before
i.e. they should be acquitted to one another.

Advantages of using Sale and Lease Back

The company gets finance in cash and finance in kind which boost its
operations tremendously
Since the lessor and the lessee are known to each other, this finance
may not entail any conditions or restrictions on the part of the lessee.
This arrangement does not involve tedious formalities, thus is
flexible to raise for financing reasons.
The risks of obsolescence shifts from the lessee to he lessor thus
will entail less risk of capital loss the lessee.
It is easily available i.e faster because the two parties are known
to each other.

Disadvantages of using sale and lease back.

The company’s asset will be removed from the balance sheet which will
in essence affect its financial position i.e reflect a bad financial
picture.
The lessee may not enjoy the benefits of wear and tear as such this
will increase his tax liability.
The finance is limited to the cost of the asset leased, and cannot be
versatile.
If it is an operating lease, then it will be used for short-term purpose.
It entails implicit costs such as repairs and maintenance costs of
the asset leased.

Conditions under which sale and lease back is ideal as a source of finance

If the asset is required for seasonal purpose
If the asset is technologically sensitive i.e may soon be
technologically obsolete.
If the asset cannot meet the company’s contemplated expansion programmes
Where the asset has a tendency of depreciating fast
If the asset is not sensitive or central to the company’s operations.

Sale of an asset
For companies with assets which are not very necessary for their
operations, such assets can be sold to raise finance for the company.
These assets should only be sold if the funds from the sale of assets
can be invested in ventures which can generate returns
higher than those the asset sold was generating.

Hire Purchase
This is an agreement whereby a company acquires an asset on hire by
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.
The 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
honour all the terms of the agreement which means that if any term is
violated then the hiree may repossess the asset e.g in Kenya if the
hirer fails to pay any installment before he clears 2/3 of the value of
the assert the hiree may reposes it.

Companies that offer this finance in Kenya are;

National industries 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.

Conditions under which Hire Purchase is an ideal source of finance.

If the asset is so expensive that there is no single source of
finance that can finance it e.g aircrafts.
Under conditions of credit squeeze or restrictive credit control.
If the company cannot obtain securities to cover a loan to finance
this type of asset.
if the asset will meet the company’s future expansion programmes
If the asset is not very sensitive to technology.
If the company is highly geared and cannot borrow to finance such an
asset.

*Advantages of using hire purchase as a source of finance. *

It does not call for securities in acquiring it an as such it is a
flexible source of finance.
this finance is a long-term finance and as such it can be used to
acquire fixed assets which are very essential for the company’s
profitability
It is useful under conditions where the company cannot raise finance
due to the amount involved i,e if it is substantial.

Disadvantages of using hire purchase as a source of finance

it is an expensive source of finance and in most case the interest on
it may outweigh bank rates and at the end of the hire purchase contract
the total installments paid may double the cost of the asset.
it involves a lot of formalities to obtain e.g legal implications and
accounting formalities prior to

Signing Hire Purchase Agreement.

the hiree has a lien over the asset until the final installment is
cleared in which case if the hirer defaults the hiree may repossess the
asset in particular if the hirer has not paid 2/3 of the value of the
asset this will entail a capital loss to the hirer once the asset is
repossessed by the hiree.
It may be difficult to get a guarantor for expensive purchases e.g
huge machinery as their value may be beyond the financial capabilities
of a number of guarantors making it difficult to acquire heavy fixed
assets necessary for the company’s operations.
By not purchasing the asset outright, the hirer foregoes discounts
which will be an opportunity cost as a result of hire purchase.
Hire purchase is limited to those assets which are available with the
hiree and as such may not cover all areas of the company’s financing
needs e,g for working capital.

Institutional Investors
These are body corporates which avail finance for long term use, and
avail their finances though purchase of shares in the stock exchange,
debentures and through mortgage finance to deserving financially strong
companies. Companies that avail this finance include trustee companies,
pension organizations, insurance companies, and investment companies’
e.t.c. these avail finance in
large quantities and usually do this to earn a return on the same
finance or to acquire ownership in those companies so as to safeguard
their investments. Companies which are financially strong will attract
institutional investors.

Advantages of using finance from institutional investors.

it is cheaper to raise this finance because it will be available in
large sums and from a few companies i.e flotation costs will be low.
These institutions using their financial experience can advise the
company in its investment activities so as to utilize such finance more
profitably.
the cost of servicing their finance is low as these will be paid with
a few cheques unlike the case with a company having a large number of
shareholders with will issue many cheques this increasing the cost of
servicing this finance.
These investors will come to the rescue of the company permanent
finance if they purchase ordinary shares and this will be used in long
term ventures.
Being major shareholders they will contribute valuable ideas during
the annual general meetings and such ideas may improve the running of
the company benefiting from such finance.

Disadvantages of raising finance from institutional investors.

They may disrupt the company’s running through the various ideas
they would want the company to implement which may not be in the
interest of other shareholders.
They influence the company’s dividend policy and as such this may be
to the detriment of small shareholders.
In case they decide to sell their shares this will lead over supply
of shares which will lower the price of the company’s shares in the
stock exchange; this may erode the company’s credibility.

Factors affecting the type of finance sought.
Finance to be raised by accompany should be at a cost than the return
expected from the project where such finance has to be invested , for
this reason two types of costs should be considered before raising any
finance:

Explicit costs
These are costs that the company has to pay directly to the lenders for
using their money this could be either interest payable for using debt
finance or dividends payable for using share capital; these two costs
are paid to retain such finance in the business.
Implicit costs
These are costs which are not necessarily paid to lenders directly but
which must be paid to obtain finance these include such costs as;
insurance of the security, its maintenance costs and floatation costs
for raising share capital. These two costs should
be weighed against benefits to be derived from the use of such finance.

Need for finance.

A company may raise finance to finance its working capital needs,
this finance is known as bringing finance such as finance will be
raised form such sources as overdraft and short-term loans.
To acquire a fixed asset this will be raised from long-term sources
of finance
Ordinary share capital
preference shares capital
long term debt financed or sell of debenture
hire purchase finance
lease finance et.c

The company’s gearing level.
The gearing level will influence the company’s ability to raise further
finance in as much as highly geared companies are viewed as highly risky
as they have used more debt finance than equity finance. This exposes it
to chances of receivership and consequently liquidation as creditors can
recall their money at short – notice. This means that high gearing will
not allow the company to raise
debt finance as creditors will be reluctant to lend to a highly geared
company. Also such a company cannot raise equity finance as the demand
for its shares will be low due to such indebtedness.
The size of the company
The size of the company will determine which finance it can raise. This
is so because small companies may not be able to raise difference
finances due to the following reasons;
such companies will find it difficult to have access to different
finances because:

They may be unknown to the lenders and as such their credibility
will be questionable.
Such companies may not have the necessary securities to pledge in
order to raise various finances available in the financial market.
They may be ignorant of the various finances available on the
financial market.

They may not meet the requirements of the stock exchange so as to
float their shares e.g for a company to go public such a company must
have a minimum of shs. 2,000,000 or such £ 100,000 which very few
companies may have.
Lenders also discriminate against small companies in their lending
activities in particular due to ownership of small companies most of
which are sole traders whose life span is equivalent to that of the
owner, this means that they viewed as highly risky areas of investment.
Big companies not only are they able to raise share capital, but also
can sell their debentures even under credit squeeze, which condition
usually makes it difficult for small companies to raise finance.

Repayment Patten
These include the repayment of principal and interest. Ideally a
company’s repayment of principal should be spared over such a period as
can enable the asset and or the project financed to pay back. In case of
interest the company.