CHAPTER: SOURCES OF FUNDS

Dept Capital vs. Equity Capital

Dept Capital is any creditor capital which must be repaid and has a superior position to the
holders of equity securities. Debt Capital includes both short-term and long-term liabilities of
the company. Debt instruments include secured and unsecured creditors without regard to
maturity. Examples of debt instruments include vendor credit (trade payables), short-term
revolving lines of credit, term loans, mortgages, bonds, etc.

Equity Capital is owners capital and has an inferior claim on the earnings and the assets of
the company. Equity owners are the residual claimants and generally require a higher return
to compensate them for higher risk. Examples of equity capital are preferred stock, common
stock and retained earnings.

Debt is a direct obligation to pay something (cash) to someone (an investor or lender). In
exchange for having lent you the money, an investor will expect to be paid interest.
Obviously, this means that you will repay more money than you have borrowed. Therefore,
an important feature of debt financing is the interest rate you will be charged.
Interest Rate and Risk
The interest rate usually reflects the level of risk the investor is undertaking by lending you
money. Investors will charge you lower interest rates if they feel there is a low risk of the
debt's not being repaid. Investors will raise interest rates if they are concerned about your
ability to repay the debt or if you have a history of slow payments to lenders as shown on
your personal or business credit reports.
It is important to realize a new business is likely to be charged a higher interest rate than a
well-established business because the lender will feel a new business represents a greater
risk. Here's an example of how interest rates can affect your loan repayment amount:
Example 1: A ten-year loan for $50,000 at 12 percent interest requires monthly payments of
$717.
Example 2: A ten-year loan for $50,000 at 15 percent interest requires monthly payments of
$807.
A payment difference of $90 each month, over 120 months, makes the loan in Example 2
almost $11,000 more expensive over the life of the loan.
What Do Debt Lenders Look For?

A debt lender will evaluate your loan request by considering answers to several key
questions:

Can you offer reasonable evidence of repayment ability either established

earnings (for an existing business) or income (profit and loss) projections (for a
new business)?

Do you have sufficient management experience to operate the business?

Do you have enough equity in the business? Equity provides what lenders call
a cushion for creditors.

Do you have a reasonable amount of collateral (assets to be acquired,

residential property equity, etc.)?

Three categories of debt funding are personal loans, operations-related financing, and
business loans. Below, these categories are discussed in detail.
Personal loans- Personal loans are often the easiest funds for a small business owner to
obtain. Types of personal loans are:
Personal Bank Loans- A personal bank loan is obtained from a bank and must be paid
back in monthly installments. A personal bank loan can either be secured (collateral is
required) or unsecured (no collateral is required).
Loans from Life Insurance- You may be able to borrow against the cash surrender
value of your life insurance policy. In many cases, insurance companies allow customers
to borrow up to 95 percent of the paid-in value.
Credit Cards- Credit cards are the most common form of short-term credit. Many small
businesses use credit cards to buy supplies and other necessities and to pay for everyday
purchases. Using a credit card will be a more costly form of credit than other types of
personal loans. You should only use this card if your credit limit is high enough to cover
your needs, and if you can repay the balance quickly.
Second Mortgage (Home Equity Credit)- If you have enough equity in your home, you
may be able to qualify for a home equity loan or a line of credit. Including the first
mortgage, you may be able to borrow up to 80 percent for the appraised value of your
home. This type of borrowing may offer tax advantages, but make sure you are able to
repay the loan because you do not want to be in danger of losing your home.
Friends and Relatives- You may be able to talk to friends and relatives about financial
support. If you choose to use this option, treat the transaction in a professional manner.
Pay a fair rate of interest, sign a legal promissory note, and repay the money as agreed.

Operations Related Financing- This category of debt financing depends on the day-to-day
operations of your business. This category includes options for start-up and established
businesses. Types of operations related financing are:
Supplier Credit- The suppliers you do business with can be a source of funds if they
extend favorable credit terms to you. The availability of this form of credit will vary
depending on the industries you and your vendor are in.
Customer Credit- You may be able to create a form of credit by getting your customers
to make a deposit or pay in advance. They may be willing to prepay if you offer a discount
as an incentive.
Leasing- Leasing is a rental arrangement that will give you the use of an asset that
someone else owns. Also the total cost of leasing will be more than purchasing the item
outright, this is a way to reduce the amount of money upfront to get your business
running. Little to no down payment is required, and the company can purchase equipment
at the end of the lease. Payment terms are usually monthly.
Accounts-Receivable Financing- If you have receivables (accounts that have been
billed but not paid), you may be able to use these as collateral for a small business loan.
Lenders that offer accounts-receivable financing will generally offer between 50 and 80
percent of the total invoice amounts outstanding, depending on the type of receivables
and collection method.
Factoring- Factoring allows you to sell your receivables to a financing source called a
factor. You will be paid a percentage of the total value of these accounts, depending on
the type of receivables and collection method. Once you have sold the receivables to the
factor, the factor will collect the accounts and absorb any losses. Payment terms are
dependent on changes with accounts receivable sold.
Asset-Based Financing- You may be able to borrow money on the assets your business
owns. Asset-based financing can be structured as a one-time extension of credit or as a
revolving line of credit requiring a periodic review of the assets pledged as collateral.
These loans are used for rapidly growing or cash strapped companies. The borrower
pledges assets secure a loan that will be used to improve cash flow. Accounts receivable
and inventory are common collateral. Additionally, asset-based loans can be used for
inventory floor plans. Payments are usually monthly, but payment terms are dependent on
changes in inventory and accounts receivable.
Business Loans- This category of debt financing is the most traditional and widely used
among small businesses. Types of business loans are:
Term/Installment Loans- These are installment loans that are paid back at regular
intervals over a specified period of time. These loans are granted for a specific purpose,
such as for working capital or an upgrade in equipment. The term of the loan will depend

on the use of the funds, but it can range from short term to long term. The payment terms
for these loans are either monthly or quarterly and include principal and interest.
Commercial Mortgages- A commercial mortgage is a business loan that involves
business, not residential, real estate. A mortgage is the legal document that insures the
payment of the borrower. The payment terms for these loans are either monthly or
quarterly and include principal and interest.
Demand Notes- This type of financing is a single-payment loan that is intended for
specific short term needs. The contract can call for payment in full within 90 to 180 days,
but the lender can call for the repayment of the note at any time. You may also be asked
to make periodic interest payments during the life of the note.
Lines of Credit- Like a credit card, a line of credit establishes a credit limit and specific
terms for repayment. Lines of credit are easy to access and offer flexibility in managing
cash flow needs. Many small business owners establish a line of credit as a precaution.
Lines of credit are usually linked to short-term assets (accounts receivable, inventory,
etc.). An installment line of credit is when the lender agrees to lend money for a specific
time period, usually one year. Lines can be used to facilitate the purchase of inventory
and equipment, and cover seasonal business fluctuations. A revolving line of credit is
when the borrower has a fixed amount available and when used, the credit line is
reduced. When principal is paid, the credit line is restored.
Letter of Credit- A letter of credit is a document issued by the bank to which the bank
agrees to accept drafts under set conditions. A letter of credit is used for companies
needing to show good faith for a particular purpose. The letter of credit is typically used
for exporters and contractors.
Bridge Loans- A bridge loan is a short-term loan, less than one year, between the end of
one loan and the beginning of another. It must be paid at the end of the period or
consolidated into the next loan.
Permanent Working Capital- Permanent working capital is usually a line of credit that
never reaches a zero balance. The loan extends beyond one year. The loan can be
revolving. Interest is due on a monthly balance.
Government-assisted loans- There are several loan programs in which the government
either directly lends to small business owners or provides a guarantee of loan repayment to
small business lenders.
Advantages of Debt Financing
The biggest advantage of debt financing is that it allows you, the business owner, to retain
control of your company. You are therefore entitled to all company profits and have ultimate
decision-making authority. Since many entrepreneurs start a business for exactly these
reasons, a critical advantage of debt financing is that it provides you with some financial
freedom; your debt is limited to the loan repayment period. After you have repaid the

borrowed money, the lender has no further claim on your business.

Disadvantages of Debt Financing

The biggest disadvantage of debt financing is having to make monthly payments on a loan.
Cash may be scarce and expenses may be higher than estimated during the early years of a
new business. Even so, the lender must be paid on time and there are severe penalties for
late or missed payments, such as additional fees, a poor credit rating and the possibility that
the lender may call the loan due.
Another disadvantage of borrowing funds is the difficulty in obtaining them. In general,
lenders prefer to invest in proven businesses. If your business is new, a lender may charge
you a high interest rate or may refuse to make the loan entirely. In contrast, if you have been
in business for a significant period of time, you may find debt lenders very happy to extend
loans.
Equity Financing
Equity financing involves no direct obligation to repay any funds. It does, however, involve
selling a partial interest in your company. In effect, an equity investor becomes your business
partner and will have a degree of control over how your business is run. For example, the
sale of stock, one type of equity financing arrangement, typically works as follows:
Step 1 -- You determine from your analysis that your business will need more funds than you
can provide.
Step 2 -- You consider financing options and decide that you prefer to sell an interest in your
company rather than borrow money.
Step 3 -- You arrange to offer a sale of stock. This can be much more complicated than it
sounds because you must comply with an array of legal and reporting requirements for the
life of your business. After shares of your stock are purchased, investors own a portion of
your company, which they can keep or sell to others.
What Do Equity Investors Look For?
Equity investors buy part of your company by supplying some of the capital your business
requires. Because they will own a share of your business, equity investors are interested in
the business's long-term success and future profitability.
Equity investors can resell their interest in your company to other investors. If your business
is doing well, they will be able to sell their stake at a higher price than they paid and make a
profit. Legally, equity investors are more exposed to risk than are debt investors. If your
business fails, equity investors stand to lose more money than debt investors, since creditors

are typically paid before owners in the event of business failure. Since equity investors are
taking the greater risk, they expect to earn more on their investment than do debt investors.
Equity Funding Sources
Equity financing may seem less intimidating to a small business owner than debt financing
because of the lack of concern of qualifying for a loan and paying back debt. Equity financing
requires selling a partial interest or ownership in your company. And can involve substantial
transaction costs.
The types of equity partners to be considered include informal investors, limited stock
offering, venture capital, and initial public offering (IPO). Following, there is a detailed
discussion of each type.
Informal Investors- Informal investors can include family, friends, colleagues, suppliers, or
private (angel) investors. Private (angel) investors are difficult to find and require a very
detailed business plan. You can find investors by contacting the investor directly or by
contacting accountants, bankers, stockholders, venture capitalists, or investment clubs.
Limited Stock Offering- Limited stock offering provides an opportunity for your company to
raise significant amounts of equity from outside investors without the high cost and burden of
a public stock offering. A limited stock offering is still subject to some state and federal
regulations. You must make sure your offering complies with all provisions that exempt it from
the public offering registration process.
Venture Capital- Venture capitalists are the most risk-oriented investors. Most venture
capital firms have specific investment preferences that involve business style, size of
investment, rapid growth, and high return. To a venture capitalist, the most important factors
are the management team and the ability to recover investment with substantial return in 5-7
years. Venture capital funds are typically available to less than one half of one percent of all
new businesses.
Initial Public Offering (IPO)- An IPO involves offering your stock to the public. It is very
expensive as it requires extensive registration procedures. Most small businesses will not
consider IPO for the afore-mentioned reasons. However, a profitable and well-managed
business with great market appeal may consider IPO as an option.
Advantages of Equity Financing
No debt payments
Increases the net worth of the business
With equity financing, you do not repay the money invested by others (unless a payoff
agreement is made at the time of investment). This can be important when cash is at a
premium. Also, your ideas for making your business successful may carry more weight with a
potential equity investor than with a debt investor. Since it is in an equity investor's best

interest for your business to grow and expand, he or she will be more likely to consider sound
business ideas than will a debt investor, who is more concerned with the security of the deal
proposed.
Many people who are interested in starting or expanding a business have more ideas than
money; this can be an important factor in favor of equity financing. In addition, equity
investors, with their genuine interest in your success, can be a good source of advice and
contacts for your business.
Disadvantages of Equity Financing
No longer the full owner of the business because financial contributors expect a
share
Must relinquish some control
The biggest drawback of equity financing is that you give up some control over your
business. You may or may not find this acceptable. Remember, when you accept equity
partners, you are selling part of your business. It may be very difficult to retain
control in the future.
Also, you may find your equity investors do not always agree with your plans for the
business. However, since they own part of your business, you will have to consider their point
of view, even if you do not agree with their choices.
Finally, equity financing tends to be very complicated and invariably will require the advice of
attorneys and accountants. A great deal of paperwork must be prepared and filed. For
example, public companies must comply with specific legal regulations that govern their ways
of doing business.
__________________________________________________________________________
POSSIBLE SOURCES OF FINANCING
Most new small businesses start out by borrowing money rather than by selling stock. If your
business does well, you may at some point combine both types of financing as your needs
change. Because knowing how, when and where to borrow is so important to the success of
your business, you should be aware of the variety of possible funding sources. These fall into
two basic categories: private sources, such as your local bank, and public sources, such as
the federal government.
Private Sources
Private sources of financing are either personal sources (savings or loans from friends and
relatives) or external sources (debt lenders, equity lenders and arrangements that combine
debt and equity).

Savings
Personal funds are the most likely, and the most typically used, source of funds for a new
business. Most lenders require that a reasonable percentage of your own funds be invested
in your business, as an indication that you will work hard to make the business a success.
You will find most investors unwilling to consider your request for funding if you have not
contributed cash. This can present a problem, though. Most entrepreneurs do not have the
personal resources to provide all of their initial financing. They are not alone. Almost all
business owners must borrow money from outside sources.
It is helpful if you, as an owner, provide some of the funds from your own savings. You may
also want to consider such personal sources as the cash value of a life insurance policy, a
home equity loan or even a credit card. Combining personal savings with external sources of
debt and equity will permit you to benefit from the effects of leverage, i.e., using other
people's money to earn a profit for yourself.
One of the biggest advantages of using personal savings to fund your business is your easy
access to those funds. There are no loan applications to complete, no lenders to visit, no
paperwork to prepare and no interest payments to make. If available, personal savings are a
valuable source of capital for your business.
Finally, a big advantage of having your own start-up capital is that it ensures that you retain
ultimate control of and responsibility for your business.
Friends and Relatives
Friends and relatives are often an important source of capital for your business. Since they
know you well, the terms of repayment are likely to be more flexible than those of strangers.
Keep it formal. It's a good idea to prepare a formal agreement when a friend or relative is
willing to invest money in your business. This will make the relationship professional and will
help to avoid future misunderstandings about how much was borrowed or when it should be
repaid.
The investment can take the form of a direct loan or an equity investment. Review the
previous section on debt versus equity financing to determine which arrangement will be best
in your particular circumstances.
Based on their personal relationship and their impression of your business judgment, friends
and relatives may be willing to invest in your business even when others may not. Beware,
however. Because they know you well, they may wish to be more involved in the day-to-day
operations of the business than you would like. Friends or relatives may feel their investment
entitles them to a routine say in how the business is run, even though you intend to repay the
loan.

Banks
Banks are financial institutions that accept deposits and make loans. They fall into several
categories, such as savings and loans, thrift institutions and commercial banks. Knowing the
category in which they include themselves can tell you a lot about the kinds of loans these
banks are interested in making. Savings banks are more experienced in dealing with
consumer loans, such as home mortgages and automobile loans. Commercial banks have
more experience and interest in business loans. This doesn't mean that you can't go to a
savings bank for a business loan. It may be a good choice. Just be sure to consider that
bank's primary focus and level of experience with your type of request. Probably the most
important point to keep in mind when dealing with a bank is that bankers don't like risk. Their
primary concern is always the safety of their funds.
How do they operate? Banks may be one of the first sources that come to mind when you
begin searching for additional business capital. Certainly, they will meet your most basic
condition: they have money available to lend. However, it may be difficult for a new business
to borrow from a bank since lenders usually prefer to lend to established businesses. Keep in
mind, the first responsibility of a bank is to protect its depositors. As a result, bankers tend to
be very cautious about lending money.
Banks come in all shapes and sizes and there are some real differences among them. Small
community banks with two or three branches may operate quite differently from large
commercial banks with hundreds of loan offices. You will want to carefully review the
differences among banks before you select a particular one. Each type offers certain
advantages. A commercial bank may be more experienced and familiar with a business loan
request, but a community bank may know you personally and have more confidence in your
ability to repay your debt.
Where can you get more information? Chances are you're already familiar with several banks
in your area. It's extremely helpful to approach a bank with which you already have a savings
or checking account or a personal loan. For banks outside your area, you may want to
consult a banking directory, such as Rand McNally's Bankers Directory or Polk's World Bank
Directory. Most libraries have copies. Directories list the name, location, assets, liabilities and
officers of banks.
Credit Unions
Credit unions are financial institutions developed by the members or employees of a
company, labor union or other group. Their overall goal is service to their members, as
opposed to profit making. As a result, their interest rates and other terms may be more
favorable than those offered by a bank. Credit unions are regulated by the National Credit
Union Administration.
What are the advantages of a credit union? The company for which you or another family
member works may have a credit union. If you decide to start your business while you are

still working for a large company, you may be able to borrow some of the capital you will
need from the credit union. As your business becomes more profitable and better able to
support you financially, you may decide to concentrate all your energies and time on your
business.
Credit union interest rates are often lower than the rates charged by other lenders. The
amount you will be able to borrow from a credit union may not be large, but this source of
funds may be helpful in making initial purchases for your business. Also, a loan application
through a credit union may be more likely to be approved as you may be known to the
individual evaluating your loan request.
Where can you get more information? If you're employed, ask the human resources
department of the company where you work about your eligibility to join a credit union. There
are directories available at your local library listing all of the credit unions in the United
States.

Sources of Funds
A. Internal Sources
a. Spontaneous Liabilities accounts payable and accured expenses.
b. Retained Earnings Profit after taxes not paid out on dividends.
B. External Sources
c. Debt Sources (Including bank debt, bonds, mortgages & leases).
short-term sources
long-term sources
d. Equity Sources (including preferred & common stock)
Funds Classified By Maturity
A. Short-term Funds less than one year in maturity and usually debt instruments. Included
in this category are accrued expenses, accrued taxes, short term bank notes, balloon
notes due within one year, revolving lines of credit and trade accounts payable.
B. Medium-term Funds funds due from one to 5 years, including term loans, debentures,
capital leases, etc.
C. Long-term Funds funds with a maturity of greater than 5 years. Long-term loans,
mortgages, bonds, common and preferred stock as well as retained earnings are sources
of long-term funds.

Primary Financing vs. Secondary Financing

Primary financing is raising new capital to finance the expansion of assets. Both debt or
equity funds can be utilized as the source to finance the use of funds created by the increase
in assets.

Secondary financing is re-financing of existing debt or equity. Renewing maturing debt, debt
consolidation, stock repurchase, debt for stock and stock for debt are all secondary financing
since no new funds are injected into the firm.
Meaning and nature of short-term financing:
Short Term financing is that from of financing which embraces borrowing or lending of
funds for a short period of time. It refers to the finance obtained on short term basis, usually
one year or less in duration. Short term finance is secured for financing the current assets,
for example, inventories. Short term finance is also known as working capital which is the
excess of current assets over current liabilities. Current liabilities become due within one year
and indicate the amount of short-term credit being utilized by the business.
Practically all enterprises use the short-term credit as sources of finance. We find in
the balance sheets of almost all the companies some kinds of current liabilities which are the
indicator of the uses of short term finance in business. It has been found in the developed
countries that even the largest business establishment makes use of short term finance.
The size of business has an important bearing on the use of short term finance. There
is variation in the use of short term finance between the large and small sized business
establishments. In practically all types of business, there is lesser use of short term credit
among larger concerns. The small concerns make more use of short term financing on
account of lower average credit standing and impermanent nature of business.
Sources of Short Term and Long-term Financing.
1. Trade Creditors
2. Customers Advances
3. Commercial Banks
4. Finance Companies
5. Commercial Paper House
6. Personal Loan Companies
7. Governmental Institutions
8. Factors or Brokers
9. Co-operative credit society
10. Loan Mortgage Banks
11. Money Lender
12. Accruals
13. Miscellaneous Sources

1. Trade Creditors: Trade creditors are probably the most important single source of
short term credit. Trade creditors are those business establishments which sell good
to others on credit. That is, they do not require payment on the spot; rather they are to
be paid after some days from the date of sale.
Trade credit: Trade credit is a kind of business credit which is extended by the seller
of goods to the buyer of the same at all levels of production and distribution process
down to the retailer. Before the goods and services have reached the ultimate users or
consumers, they pass through many hands starting from the producers down to the
retailer. Trade credit is used by various agencies operating in the trade channel
between the producer and the retailer. For example, the producer may extend credit to
the wholesaler, who may also facilitate the retailers trade by extending credit to him.
Such credits extended by the wholesaler to the retailer or producer to the wholesaler
are known as trade credit.
Trade credit has been defined as the short-term credit by a supplier to a buyer in
connection with purchase of goods for ultimate resale. This definition makes it clear
that trade credit is a different type of credit than the consumer credit and installment
sale credit. Trade credit is a credit extended for the purchase of goods with the
ultimate purpose of resale. The credit accepted for the purchase of goods which are
consumed by the purchaser is not trade creditit becomes consumer credit. So a
credit, in order to be designated as trade credit, must be extended in connection with
the purchase of goods which must be resold.
Advantages /Reasons for use Trade Credit:
1. It increases profit
2. Convenience of Informality
3. Flexibility
4. Less Risk
5. Less Costly
6. The only Source
7. Existence of Business
One of the most important reasons for the use of trade credit is its cheapness. Trade credit,
in most cases, is cheaper than other sources of credit, obtaining funds form finance
companies or banks gives rise to many complications. The lender may impose restrictions on
the action of the management. The rate of interest to be paid on the funds is also determined
in advance. In trade credit no specific rate of interest is to be paid.
Trade credit is also used as a matter of convenience. It is convenient to obtain,
because the purchaser receives the goods from the seller when the latter sends the goods
on receipt of the order form the former. The purchaser is to make payment on a stipulated
date. But obtaining finance from the financial institutions is not so easy. Many formalities are
to be performed to obtain funds from such institutions.
Trade credit has also got widespread use because of the fact that it is less risky than
other sources of funds. If the credit can not be repaid by the end of the credit period, the

trade creditors usually dont proceed to liquidate the firm. If the default is only for a few weeks
or a month and does not occur frequently, the creditor may not even be heard from.
When other sources of obtaining funds are closed to a business organization trade
credit may be obtained easily. This is especially true of small concerns. Such enterprises do
not usually possess a good credit standing and thats why, they can not approach big lending
intuitions for loans.
The banks, insurance companies and other finance companies hesitate to lend funds
to the business enterprises that are small in size and financially weak. They fear that these
enterprises would not be able to repay the debt on maturity. As such, the small business
concerns rely mostly on trade credit.
Disadvantages of Trade Credit:
1. Cost of Trade Credit
2. Frequent Maturity
3. Insolvency
Cost of Trade Credit:
To a business man, the cost of trade credit is that additional cost which he may pay if
he does not take the cash discount offered by the creditor for prompt payment. The cost of
trade credit is found to occur when the firm forgoes the cash discount and pay its bill on the
final due date of the net period. If no cash discount is offered, there is not cost for the use of
credit during the net period.
2. Customers Advances: Customers often finance the seller through advance payment
for the goods. The prices of the goods to be purchased are paid in advance, i.e.
before the receipt of the goods. This practice is prevalent where the seller does not
wish to sell goods without prepayment and the buyer also can not purchase goods
form other sources. The seller might require advance it the quantity of goods ordered
is so large that he cannot afford to tie up more fund in raw materials or in good-inprocess. Special type machine manufactures often demand advance payment in order
to protect them from the loss caused by cancellation of contract at a time when the
machine has been built up or is in work in process.
3. Commercial Banks: The commercial banks of a country generally supply funds to the
business concerns on a short-term basis, either with security or without security if the
customer is financially established. The banks, collecting scattered savings of the
people, invest a portion of the deposits in the business for a short period of time.
4. Finance Companies: Finance companies usually lend money to business. They are
specialized financial institutions and their primary function is to advance funds to the
business
5. Personal Loan Companies or Microfinance Institutions: These companies make
small loans to individual generally for consumption purposes. The small business
undertakings can procure fund form such companies or institutions.
6. Governmental Institutions: There are some governmental and semi-governmental
corporations which are authorized to advance short term funds to business concerns.
Their importance is of course not so much less than other sources.

7. Factors or Brokers: In one basic respect, factoring is different from other forms of
financing. In other forms funds are granted to one individual largely on the basis of his
property. Factoring is based on a different philosophy. In considering a companys
request for funds we are more interested in the men behind the company their ability,
their hopes and aspirations for the future.
A factor company can be a useful source of funds if you are already in business and
have made sales to customers. Factor companies purchase your accounts receivable
at a discount, thereby freeing cash for you sooner than if you had to collect the money
yourself. You transfer title of your accounts receivable to the factor company in
exchange for a cash payment.
How do they operate? Factor companies provide two types of financing alternatives:
recourse factoring and nonrecourse factoring.
In recourse factoring, you retain part of the risk for ultimately collecting the debts owed
to you. The factor company assists you by speeding up the process. For example, the
factor company purchases your receivables and advances you cash while the
accounts are being collected. However, if your customers do not pay, you will be held
responsible for repayment to the factor company.
In nonrecourse factoring, you sell all rights and obligations concerning your accounts
receivable. The factor company purchases your receivables and collects the debts
owed. If a customer does not pay, you will be under no obligation to the factor
company. Factor companies can be a useful source of funds for a new or existing
business. They are not appropriate as a means of seed capital to start a business
because they require that you have accounts receivable to sell.
8. Leasing Companies
A leasing company is a business that rents various types of equipment to businesses
and individuals. By renting rather than buying the equipment your business will need,
you will be able to avoid many capital expenditures associated with the purchase of
equipment.
How do they operate? Many leasing companies require a down payment or several
months' prepaid rent. Some, however, may allow you to lease equipment without
requiring any prepayment. This depends upon the relative size or worth of the asset
leased. The small amount of cash needed to secure the use of equipment for your
business makes leasing very attractive to many business owners. However, since you
do not actually own the equipment, the leasing company may repossess it if you miss
a payment.
An advantage provided by leasing is that you will need little or no cash to secure
equipment and you will be able to upgrade your equipment more easily than if you

purchased it. If your industry experiences rapid changes in technology, leasing may
help you to avoid the expense of purchasing quickly outdated equipment.
Obviously, you will not be able to meet all of the financing needs of your business by
leasing. You will still need additional funds for ongoing expenses, such as employee
salaries. Leasing, however, can allow you to hold on to the cash you may otherwise
have spent on equipment, and this cash savings can be used in other, less easily
financed, areas.
9. Miscellaneous Sources: There are many more sources from which can secure funds
for short period. They arefriend and relatives, public deposits, loan from officer and
the company directors and foreign exchange banks
Advantages of Short-Term Financing:
1. Easier to Obtain
2. Lower cost
3. Flexibility
4. No Sharing of control
5. Availability
6. Tax Savings
7. Convenience
8. Extension of credit
1. Easier to Obtain: Short term credit can be more easily obtained than long term
credit. A firm which poor credit standing may be unable to obtain long term funds but it
can procure, at least some trade credit from sellers who are anxious to increase their
sales. The short-term creditors, by granting loans, assume less risk than long term
creditors because there is less chance of substantial change in the financial
soundness of the creditor within a few weeks or months time.
2. Lower cost: Short term credit may be obtained with lower cost than the long term
finance because of priority of creditors in general. Because of the prior position given
creditors in the matter of claim to income and to assets in dissolution they generally
will accept a relatively low interest.
3. Flexibility: Due to seasonal nature of business many firms have a temporary demand
for short-term funds to carry heavier inventories. Most enterprises are in constant
need of short term funds. Short-term financing is flexible in the sense that the firm is
able to secure funds as they are needed and repay then as soon as the need
vanishes. Funds may be needed to meet the daily, weekly or monthly requirements.
Such funds can be advantageously supplied by short term credit. It long term credit is
secured to finance the daily or weekly or seasonal variations, it would become
inflexible because long term funds cannot be repaid as soon as the need for funds
vanishes.
4. No Sharing of control: Obtaining funds form short term creditors prevents the
inclusion of more owners through the procurement of owners funds. This results in
maintaining the position of control by the existing owners. Because the creditors have
no voice in the operations of the business.

5. Availability: In many cases, particularly for small enterprises short term credit is the
only source available. It may not be possible for a small firm to obtain long term funds
because of poor credit standing. Long-term credit is not generally granted without
adequate margin of protection which the small firms may not be able to provide with.
The small business has then recourse to short term funds.
6. Tax Savings: The cost of short term funds are deductible for income tax purposes
while the dividend paid to the owners is not deductible. Thus a substantial tax-savings
may result form the use of short-term funds.
7. Convenience: Short Term credit can be more conveniently secured than the other
types of funds. It is more convenient to pay labour weekly or employees monthly than
every day
8. Extension of credit: Many enterprises purchase equipments, supplies and good by
ordering from a supplier with the intent of paying after delivery has been made. If
subsequently the bills are met promptly, the firm acquires a good credit standing. Then
, if any emergency arises for the purchase of any goods the firm
Disadvantages of Short-Term Financing:
1. Frequent Maturity
2. High Cost
1. Frequent Maturity: Short-Term credit is disadvantageous in the sense that it matures
frequently. The principal must be repaid when due, otherwise the creditors may close
the business. The use of such credit is also a risk to the owners investment from the
inability to meet the creditors claims when due. There may be danger of either
meeting the principal payment at maturity of the loan or meeting the principal payment
at maturity of the loan or meeting any periodic interest payment or both. The sorter the
credits the greater the potential risk to the owners because of the problem of prompter
repayment.
2. High Cost: The rate of interest paid on sort-term is usually higher than that on longterm credit is usually higher than that on long-term credit. The rate of interest usually
depends on the risk involved, size of loan, collateral protection, etc. The lenders may
demand a high interest if the credit involves large amount and the potential credit risk
is also high or the debtor may not give suitable security. A high interest may also be
demanded when the firm can not procure funds form other sources on suitable terms
and conditions.
Purpose/Goals of Short-Term Financing:
1. Lowering of cost (Low cost financing)
2. Raising Funds according to necessity.
3. Facilitating prosecution of business with others money
4. Secure additional fund
FINANCIAL MANAGEMENT DECISIONS
Three types of Financial Management Decisions

1) Financing decision
Long-term financing decision. How much to raise? Debt or equity?
How much to retain and how much to payout as dividend?
2) Capital budgeting(investment) decision
Whether or not to invest in the project under consideration, i.e., examining
feasibility of the investment project
3) Working capital management
Short-term financing decision
How do we manage the day-to-day finances of the firm?
I.e., management of cash, account receivables, inventory, and shortterm borrowing