SOURCES OF COMPANY FINANCE

SOURCES OF COMPANY FINANCE NOTES

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 by real owners of the
business i.e. ordinary shareholders.
2) Quasi equity- This is finance provided by quasi-owners of the
business i.e. preference shareholders.
3) debt finance- This is finance provided by 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 by 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 by the ordinary shareholders of a
business. This is raised through the sale of the company’s ordinary
shares. It is finance contributed by real owners of the company. This
finance is only raised by 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. Ordinary shares carry rights and usually each share is equal
to one vote exercised in

Annual General Meetings.
Ordinary shares are quoted at the stock exchange where they are sold and
bought by 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 by retention of
earnings.

*Rights to Ordinary Shareholders

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

Features of Ordinary share Capital

It is a permanent finance to the company which can be refunded only
during liquidation.
It is the largest source of finance to the Ltd Company.
This finance has a residual claim on profits and assets during
liquidation.
Ordinary share capital is entitled to voting powers, each share
usually being equal to one vote.
This finance carries a varied return i.e. its dividends will vary
with the profits made.
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.
It is the only finance which will grow with time as a result of
retention.
This finance cannot force the company into liquidation i.e. it does
not increase its gearing; on the contrary, it decreases the gearing.
It can be raised by limited companies only.

Advantages of using Ordinary Share Capital by a company

Being a permanent finance the company will invest it in long term
ventures without inconveniencies of paying it back.
Dividend payment (to ordinary shareholders) is not a legal
obligation to the company, thus no threat to liquidity of the company.
This type of finance contributes valuable ideas towards the running
of the company during the Annual General Meeting.
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.
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

The cost of ordinary share capital (ordinary dividend is paid in
perpetuity).
This finance may disorganize a company’s policy in case
shareholders’ votes are cast against the company’s present
operations and policies.
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.
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.
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 by 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

Both finances earn a return in form of dividends
If the preference shares are irredeemable then both will be
permanent sources of finance to the company.
In case the preference share capital is irredeemable both will
receive dividends in perpetuity.
Both form the company’s share capital/ share finance
Both are difficult to raise due to a lot of formalities the company
must go through to raise this finance.
Both claim on assets and in profits after debt finance has had its
claim.
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.
Both finances are not secured i.e. no security is attached to such
finance.
Both finances are raised strictly by limited companies.
Both finances are long-term finances to the company.

Differences between Ordinary and Preference Share capital

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

What is 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

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.
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.

Long-term finance

This is a rare finance and is only raised by 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:-

Discounted
Endorsed
Given as securities for loans

A bill of exchange us 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 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 by the drawer;
Accepted by 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

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 by 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
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 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. 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 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. They 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.
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 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 whereby a company acquires an asset 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. 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 hiree 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.