Financing Financial Resources and Decisions

A financial resource is what a business uses to acquire and place all the other resources in
place in order to generate wealth for the business. There are three types of financial resources
that each business requires. The first one is the fixed capital financing and involves the
acquisition of fixed resources such as plant and equipment, computers, and land and building.
Resources invested in the acquisition of these fixed assets are frozen because the funds cannot be
utilized in any other way. A lot of funds are required to fund the acquisition of these assets and
repayments of the resources consumed take a long period of time. owever, it is expected that
the fixed assets will increase efficiency in the operation of the firm and consequently increase the
profitability !"hu, #uxiang and "hengwei, $%&'. The increased revenue will place an
organization in a position where the necessary repayments can be made on time. #orking capital
is another form of financing that is required by business and it is used to fund the short term
liabilities such as the paying of salaries and wages, bill settlement, stocking of the inventory and
the accommodation of credit sales. (t is important to maintain certain levels of working capital in
order to caution the firm cash flow differentials. These differentials are brought about by
fluctuations in sales, unexpected changes in demand of a firm)s product and occurrence of an
unpredicted event. *ust as fixed capital, the providers of working capital expects that the funds
provided will be used to generate more cash flow in order to assure the repayment of the funds
upon expiry of a certain period. The third important financial resource is the growth capital
financing.
The need of growth capital financing does not arise from ordinary operations of the
business or from occurrence of unplanned events but arises when a company decides to expand
its business operations or decides to venture in a new line of business. +or instance, when social
networking sites began to gain popularity, growth and expansion opportunity for companies in
the business of manufacturing electronics and communication devices emerged. These
companies were forced to expand their business by producing portable devices that would enable
customers to have access to their favorite networking sites on a real time basis. A new need arose
for these companies to acquire the necessary raw materials, build the required assemble plants
and the hiring of professionals with the right manufacturing and marketing knowledge.
The amount of funds requires to fund these types of financing needs are quite high and a
business cannot manage to fund them by themselves. ,usinesses can access funds from various
external sources whereby the choice of a specific source will depend on the specific
characteristic of the business and the kind of financing being sought. -quity and .ebt financing
are the two main sources of funds for businesses. -ach has its own advantages and disadvantages
and it is up to the management to determine which is most appropriate for their business.
Equity Financing
This is that type of financing where investors are willing to put their funds in a certain
business. (t is also referred to as risk capital since the investors) bear all the risk of losing their
investment if the business collapses !.ong, irshleifer and Teoh, $/0/'. The main advantage of
this method of financing is that it does not require the regular payments of interest to the
providers of the funds and any payment to the investors is done only when the business makes a
profit. Additionally, the risk of the businesses is shared by the equity owners and does not lie
entirely with the management of the business. The process of issuing equity is however time
consuming and sometime expensive. (t also brings with it some compliance issues which a
business has to conform to. The huge disadvantage however is the involvement of the equity
holders in decision making of the business. This causes a firm to have a low reaction time and
the management of the agency conflict may come between other important business activities.
Sources of Equity Finance
1ersonal savings is the first source of equity financing for most businesses. This is
because these businesses start as small enterprises and do not have collateral or a proven track
record to seek other finance sources. This source of equity financing is the least expensive and is
easy to acquire with no conditions imposed on manner in which is will be spent. The faster the
business uses other expensive means of financing the sooner the owner of the business will have
to surrender some ownership to outsiders. +or a newly established business, the repayment s of
outside debt will create a cash flow problem for the business which will in turn reduce the
chances of the business becoming successful. 1ersonal financing is also used as a means of
attracting other investors to invest in your business. (nvesting a huge amount on personal saving
instills confidence in the minds of investors since an entrepreneur is willing to risk his savings
for the sake of the company. Additionally, investing personal saving in a business implies that the
entrepreneur is willing to provide all the management abilities necessary to manage the funds.
This is because he or she stands to loose if the business is managed poorly !.ong, irshleifer
and Teoh, $/2&'.
This form of financing is most appropriate for start up form of businesses where it is
difficult to access other forms of financing. -ntrepreneurs also need to keep cost at a minimum to
improve the cash flow of the business in order to increase the chances of survival. +inally,
personal financing attracts new sources of financing through the risking of owners fund which
instills confidence to potential investors.
Friends and Family Members
An entrepreneur should use this source of equity financing after the exhaustion of
personal saving. .ue to the relations that exist between the owner and family members, they are
likely to invest in the business without interfering too much on the management of the business.
They are also not likely to require collateral and the presentation of information that is expensive
to collect. owever, while sourcing equity from friends and family the following are some
guidelines that should be observed in the sourcing process and help an entrepreneur to make a
decision on whether to borrow from family and friends or not. The financing arrangement should
always remain formal and in business terms. This means that no matter how close the
relationship, formal means of lending such as the creation of a contract must be applied to
significantly reduce the risk !"hu, #uxiang and "hengwei, $%%'. Additionally if the amount to
be borrowed exceeds 30455 it should attract an interest rate equal to the market rate or otherwise
it may be considered a gift. All the details involving the transaction such as the amount to lend,
the payment plan, solutions incase the business fails and the repayment period should be agreed
before any money changes hands preferably through a written contract. This will wipe out any
misunderstandings and wrong expectations on the side of the borrower and the receiver. The
probability of conflict will also be eliminated. An entrepreneur should also not receive an
amount he cannot afford to lose no matter how available the funds are. This ensures that the
entrepreneur remains in his risk class. +amily and friends only provide finances that support the
business in the short term. (f the business owner is looking for a long term solution, this is not a
viable source of financing. +inally, a lending agreement involving a business owner and family
members or friends must have an exit strategy if the existing relationship heads south and
threatens the survival of the business. This source of equity financing is a cheap and there exist
little or no limitations on how the funds should be utilized. owever, these agreements need to
be afforded a business treatment in order to increase commitment and reduce the degree of risk.
Angels
Angel investors are private wealthy investors who put their money in a start up or a
growing business in exchange for ownership and control in the business. These kinds of investors
provide their assistance not only for their economic benefits but also provide assistance inform of
expertise in an area where they are knowledgeable to advance their personal interests. This type
of financing is appropriate for businesses that have exhausted personal saving and the
borrowings from family and friends. 6ome of these businesses may fail to attract the attention of
venture capital companies and angel investors help in breaching the gap !+ehr, .avid and
7aamaa, 89%'. An example of how angel investors help entrepreneurs to take their businesses to
the next level is Amazon.com. *eff ,ozos, an entrepreneur behind Amazon.com was able to
attract a total of :8.% million from angel investors before landing :& million from venture capital
firms. Angel investors help bring small business to the limelight and catch the attention of
venture capital firms and corporate firms. Angel investors are an example of growth capital
source.
Partners
(n order to increase the business capital base, entrepreneurs can agree to pull together the
necessary resources with another business that shares the same vision and ob;ectives. This
enables the combined business to take up expansion and growth strategies that neither firm could
have managed on its own. ,efore reaching such an agreement with other business owners,
entrepreneurs should analyze the impact of the agreement on their control of the business and the
sharing of profits. -very time entrepreneurs surrender a certain ownership of their business
through whichever means, there is always a risk of losing control over the business operations.
As the owner of the business, the issuing of equity to other parties significantly dilutes the
ownership and risk of losing control over the future path of the business and the decision making
process increases. This method of equity financing is most appropriate when a business owner
has exhausted personal savings and borrowing from family and friends !+ehr, .avid and
7aamaa, 8$2'. A business owner may also opt for a partnership as opposed to angel investors
when the business stands to gain in terms of management capabilities. The use of partners is a
way of seeking growth capital where the combination of resources makes it possible for the new
firm to seek new growth strategies through large capital base and better management capabilities.
Corporate Venture Capital
An enterprise may benefit from direct in;ection of financial resources by large corporate
organizations. This is refereed to as corporate venture capital where large organization provides
capital to small and upcoming business. <urrently over $55 corporations provide corporate
venture capital globally which translates to a fifth of all venture capital received by businesses.
=ther than financial assistance, small businesses also stand to gain through the established
relationship through provision of expertise on how to do business and the provision of
distribution channels that would have otherwise been inaccessible. =ther benefits include the
introduction to large and long term customers, suppliers and the provision of marketing know
how. Additionally, an upcoming firm will have an increased level of credibility through the
association with a highly credible organization that provides venture capital. This form of
financing is highly appropriate when a fairly mature company is looking for ways to grow into
new territory. This is an example of a source of growth capital.
Venture Capital Companies
These are profit organizations that are privately owned that bring together financial
resources that are then used to purchase ownership rights of new businesses. These businesses
have a high growth potential and profit making potential of between $55> and 055> in a span
of five years !,enson, .avid and Rosemarie, 92&'. =ther institutions that engage in other areas
of business have set a side a department that specializes in providing capital to companies with a
high growth potential. 6uch institutions include universities, collages and even the central
intelligence agencies. ?enture capital companies provide about 2> of the total amount invested
in small businesses and they have played a role in the success of huge companies such as Apple,
ome .eport, 7oogle, 6tarbucks, and @icrosoft. ?enture capital companies only invest in
companies in the expansion phase and the early development stage. This implies that investors
who wish to obtain the assistance of these companies must establish their status through their
personal saving, borrowing and from friends and family. The ma;or factors considered by venture
capital organizations in making their investment decisions includeA B competitive position of the
company, existence of exit strategy, the growth potential, and the competence of management.
#hen it comes to the ownership, the owners of the business must consider carefully the
implications of venture company)s funds because these companies rarely assume a passive
position in the business of their interest. This implies that once a venture capital provides capital,
the company will be heavily involved in the management of the business. The venture companies
are heavily involved in the recruitment processes, implementation of various advertising
strategies and even the installation of new management. (n general, the entrepreneur must be
willing to give up control of his firm and in some cases leave the firm entirely due to lack of the
necessary management abilities !,enson, .avid and Rosemarie, 9&&'. ?enture capital provides a
business with fixed capital, net working capital, and growth resources because they acquire a
ma;ority shareholding in the high potential growth company.
Public Stock Sale
Cnder this method of equity financing, businesses sells the company stock to public
investors. Through an initial public offering, a company is able to sell its stock to the public for
the first time. This way a company is able to raise large sums of money but it can be expensive,
time consuming and full of registration and compliance nightmares !<arpentier and 6uret, 9/'.
=nce a company shares are sold to the public, the responsibilities and duties of the company
increases significantly due to the entry of new elements in the decision making process. The
main elements to be considered include the stock price and the interest of shareholders. owever,
this source of financing is limited for only large companies mainly because the requirements that
are to fulfilled before the selling of shares to the public eliminates small and emerging
companies. ,efore a company can sell its shares to the public, it should have a good track record
of earnings, must be in existence for a number of years, and a well experienced management and
board of directors. Through an (1= a company en;oys a number of advantages with the first one
being the improved image and credibility of the company through the publication of the exercise
in the media. =ther advantages includes the attracting and retaining of the best employees
through stock ownership compensation packages, ability to acquire other companies through the
use of stock hence eliminating the cash flow problem and the opening of other avenues of
financing. These advantages comes at a cost is in the form of dilution in ownership, loss of
privacy and control of the business and the cost of complying with the various reporting
requirements !<arpentier and 6uret, 0&'. +unds raised through an (1= are normally directed
towards growth and expansion plans or the acquisition of a fixed asset.
Rigt issue
This is a form of equity financing that is available to company that are publicly traded. A
cash strapped public traded company can issue additional shares at an offer price to existing
shareholders. Cnder right issue agreement, existing shareholders have the right to purchase a
maximum number of shares, at a specific price and at a specific price !"hu, #uxiang and
"hengwei, $%%'. The shareholders can exercise the rights in full or partially and at times the
rights may be transferrable to other parties where the shareholders sell the new shares privately.
The right issue is normally a ratio in relation to the total number of shares owned. +or instance, a
ratio of 8A 9 means that a shareholder has the right to purchase one share for every four shares
held. The offer price is normally slightly lower than the market price in order to make it
attractive to shareholders. This form of financing is an attractive form of equity financing since it
raises capital without diluting the ownership of the company. This form of financing is most
appropriate for close ended companies that are required by shareholders or by law to distribute
all the profit and capital gains from the previous years to the owners of the company. +unds
raised from a right issue are used to fund new investment pro;ects that are as a result of growth
and expansion of the company.
Debt Financing
.ebt is that type of financing that is made available to the business owner by a lender
which must be repaid after a certain period and with interest. This type of financing does not
involve the allocation of ownership to the lender and the business owner remains in full control
of the business operations. owever, the amount of debt must be represented in the financial
statement as a liability together with the regular payment of interest !ADca, Eenay, and 6attar,
4%'. The rate of interest mostly depends on the credibility of the borrower in terms of payment.
7enerally, small businesses are charged a higher rate of interest as the risk of non repayment is
considered to be high. 6mall companies therefore have an equity financing cost that is lower than
the cost of debt finance while large companies have a lower cost of debt financing than cost of
equity. There are a number of areas from which a company can finance the debt source of
finance.
!oan from Commercial "ank
This is the largest source of debt financing which is estimated to stand at /9> of all total
debt financing available to companies. This source of financing is only available to established
businesses and is rarely provided to start up businesses. This is because for a business to qualify
for a commercial loan, it must show a proven track record of successful operations before
allocation a certain amount of loan to a business !ADca, Eenay and 6attar, 44'. The bank will
therefore analyze the business financial statements with the aim of predicting the future ability of
the business to service the loan. ,ank loans can be acquired as a way of fixed capital or growth
capital or for net working capital purposes. Through short term loans, businesses is able to source
funds for working capital requirements and sometime fund the acquisition of a fixed asset with
repayments due within 8% months. These funds are used by the business to replenish the
inventory, take advantage of trade discounts and support credit sales. There are a few types of
short term loans.
The first type is a commercial loan which is provided by a bank to aid the business in
acquiring certain equipment or any other form fixed asset. This type of loan is repaid on a lump
sum basis after a period of three to six months. There are two types of commercial loansA B
unsecured and secured commercial loans. Cnder a secured loan commercial agreement, the
borrower)s promise of repayment is represented by the provision of collateral and even though
the risk of losing is low on the side of the bank, such loans are costly to administer and maintain.
The other type of commercial loan is unsecured loan where the borrower need not to provide any
collateral mainly because the borrower has proven his financial ability to repay the loan to the
satisfaction of the bank over a period of time. +or these two types of commercial loans, the
borrower is expected to pay the whole loan amount at the expiry of the period. (n such short term
loans the interest is pre paid implying that the amount received by the borrower is net of the
interest amount.
A business owner can establish a line of credit with a bank where the business is allowed
to borrow a maximum amount of over certain period of time. This kind of loan is used to fund
the working capital requirements to meet the day to day responsibilities of the business. The
credit line limit is usually between 95> and 05> of the existing working capital requirements of
the business. *ust like the commercial loans, the line of credit can be secured or unsecured. A
business usually pays a transaction fee of one to two percent of the total line of credit in addition
to the interest on the amount received. +loor planning is another way of short term financing
which is normally employed for large money items which are easily identifiable from other
inventories. A bank finances the acquisition of a large money item and maintains it as collateral.
The businesses entity repays the amount offered by the bank upon selling the item together with
the interest. The longer the item remains in the inventory, the more expensive the short term loan
becomes through monthly bank interest. +loor planning is a way of financing the working capital
requirements of a business.
#ntermediate and !ong $erm !oans
,anks are also highly involved in breaching the gap that a firm might be experiencing in
growth and fixed capital requirements. These loans normally have a repayment period of more
than one year and require a business enterprise to provide collateral. 6mall businesses normally
experience a huge challenge due to the lack of enough collateral and the high rates of interest the
bank charges as the probability of default is higher for small businesses. =ne of the common
long term loans offered by a bank is the installment loan. Cnder this type of loan the bank
finances the acquisition of a fixed asset to levels of about /5> to 25> of the total cost of the
asset and in return the business pays an interest on the amount provided. The loan amortization
schedule of the machine coincides with the economic life of the asset thereby providing the
business with enough time to repay the loan. Another type of long term financing is through the
use of a term loan where a bank lends to borrower on a long term basis without the need for
collateral. A proven history of the borrower ability to repay is used as collateral but the bank
imposes some covenants on the borrower. These may include the setting of a maximum amount
to be paid out as salaries, maximum amount to be borrowed from other banks and the ensuring
that some financial ratios do not go below or above certain levels.
Asset "ased !ending
These are financial lenders who are mainly small commercial banks or specialty lenders
who provide debt financing to businesses through the pledging of idle assets of the business. The
first way of debt financing through asset based lending is through discounting account
receivables. Cnder this agreement, business owners provide account receivables as collateral and
return receive a certain level of debt financing which is equal to the approved receivables
!+iordelisi, +ranco and 6tefano, &&4'. The loan amount differs from the face value of the
accounts receivable because the lending company makes a risk allowance for those receivable
that will be written off as bad debts. (n most cases firms will secure a loan amount that is
between 00> and &5> of the total accounts receivables.
#n%entory Financing
(n this arrangement, a business is able to secure a loan while using finished goods, work
in progress or raw materials as collateral. (n case the borrower defaults on the loan the lender can
sell the inventory to recover the loan. .ue to the fact that inventory is not a highly liquid asset,
lenders are only willing to provide a loan that is equivalent only to a certain portion of the
inventory !+iordelisi, +ranco and 6tefano, &4&'. Fenders are only willing to lend if the inventory
is accompanied by other asset security such as accounts receivables. Asset based financing is
most appropriate for those small companies that do not have a proven track record that
guarantees the debt financing from banks. This form of financing also enables business to
acquire only the amount of capital that they are to consume in running the day to day operations.
Vendor Financing
This is that type of financing that business attain when they acquire goods on credit from
suppliers and vendors !,oyer, @artin and Garine, %$2'. This is considered a form of debt
financing because the businesses do not need to pay for the acquired good in advance and only
pay for the purchased good after the sale. They do not have to employ their own capital for the
transaction. This is a cheap source of financing which a small emerging business can utilize
when banks refuse to offer a loan due to the associated level of risk. ,argaining of lenient terms
of payment such the extension of the credit period to $5 days is one way through which a small
business can take advantage of this source of financing. This kind of agreement implies that the
business owner is receiving a short term loan which is interest free from the supplier which is
equivalent to the value of goods purchased !,oyer, @artin and Garine, %95'.
Conclusion
-quity and debt are the two ma;or means of financing business operations. -ach of the
two sources can be financed by various components of each source which are determined by
specific circumstances of a business. +or instance small companies are more likely to use
personal savings and borrowing from friends and family together with vendor financing and
asset based lending. Farge organizations on the other hand will issue new shares either through
an (1= of through a rights issue and seek short term and long term loans from commercial banks.
The choice of which source to use is determined by the benefits a firm stand to gain in
consideration of the cost associated with that source of financing.
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