Sources of finance

Introduction

The financial manager has to be aware of how they intend to finance operations and which source of finance is the most appropriate for the organisation. When dealing with longer-term finance it is important to consider the available sources and the possible long-term effects to the company.

Short-term Finance

Short-term finance is normally used to finance day-to-day operations. Some examples are:

  • Short term loans
  • Overdrafts – These are very suitable as they can be repaid at any time. However overdraft facilities can be withdrawn at any time from a business or individual.
  • Trade Credit – Helpful to new businesses as payment of current liabilities can be delayed.
  • Lease Finance – Normally cheaper than finding finance to buy the asset.

Short-term finance is used heavily by businesses with seasonal peaks or small businesses looking to make payments of wages to employees, inventory ordering etc.

Long-term Finance

Businesses often require long-term finance which is more expensive and less flexible but enables the funding of major investment projects. The range of sources of long-term finance available is:

  • Debt – Bonds and loans
  • Equity – Ordinary shares, preference shares etc
  • Venture Capital
  • Leasing

Debt Finance

Business may seek to raise finance from financial intermediaries such as banks. Debt finance unlike equity finance is cheaper because interest on payments gains tax relief which means the profit after tax is more than it would be if the business decided to raise the same level of funds using equity.

Businesses may look to raise finance through debt because shareholders are not willing or unable to contribute more capital. Bonds can be redeemable or irredeemable. The forms of bonds are:

  • Floating rate debentures
  • Zero coupon bonds
  • Convertible bonds – The holder can convert these to other securities.

Equity Finance

A business may decide to raise finance through issuing shares to raise capital. Equity shareholders, if we assume they own ordinary shares, will have voting rights this means they have a level of control within the company.

Although equity finance is more expensive due to its high risk to investors, it provides a greater pool of finance to large companies that may trade internationally.

The main types of share capital are:

  • Ordinary shareholders – Ordinary shareholders have voting rights but are on the bottom of the creditors list in the case of liquidation. They gain any surplus funds made by company.
  • Cumulative Preference shareholders – Have little or no voting rights unless the business has not met several dividend payments. They gain a fixed amount per share. If the company fails to pay a dividend the holder is entitled to the missed payment when the next dividend is declared.
  • Non-cumulative Preference shares – If the company fails to pay a dividend the holder is NOT entitled to the missed payment when the next dividend is declared.

Note: When a company issues new shares to existing shareholders at a discounted price (rights issue), it will decrease the present value of the share. The new share price after the issue can be estimated and is known as a Theoretical ex-rights price (TERP).

    Stock Market Listing

In order to have access to a greater pool of finance a company can enter a stock market.

Benefits Drawbacks
Have access to new capital for growth. Giving up some management control of the business may risk takeover.
Allows share option availability to employees as an incentive. Public companies have to meet certain regulatory requirements and accepted standards of corporate governance.

Methods of Listings

Companies looking to enter the stock market can do so in three ways:

  • Initial Public offer (IPO) – Making shares available to the public at large.
  • Placing – Shares only made available to a small number of investors/institutions (usually insurance companies & pension funds). This is cheaper and quicker than IPO and requires less disclosure of information.
  • Introduction – No new issuing of shares because the public already holds 25% or more shares so the company can become listed with existing shareholders. The company enters the stock exchange without raising capital.

Costs involved with Listing

When issuing shares there are a number of costs to the company including:

  1. Underwriting costs
  2. Stock Market listing fee
  3. Fees of public relations, solicitors, auditors etc
  4. Advertising – Newspapers
  5. Printing & distribution charges

What price to set

When determining the share price of an issue, companies have to avoid over/lower-pricing. The P/E ratio can be used as a basis to determine the share price. The following needs to be considered:

  1. Current market conditions
  2. Price of similar quoted companies
  3. Future trading prospects
  4. Desire for quick premium

Right Issues

A rights issue avoids some of the costs involved in raising share capital because shares are being offered to existing shareholders and the discounted share price compensates for the costs avoided.