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Sources and Uses of

Short-Term and
Long-Term Funds
Debt and Equity
Financing
Debt Financing can be in the form
of borrowing from banks or other
lending institutions or issuance
debt securities like commercial
papers and bonds. It can also be in
the form of advances from
stockholders to expedite the
process of raising funds.
It creates a contractual
obligation for the borrower to
pay the interest and the
principal. Payments have to be
made on time because unpaid
interest and principal lead to
penalties and more interest.
Benefits of debt financing:

1. Interest expense is tax-


deductible. Unlike cash
dividends for shares of stocks,
interest expense provides a tax
shield.
Benefits of debt financing:

2. Debt financing allows the


company to grow without
diluting the interest of the
controlling stockholders.

3. Creditors generally do not


intervene in the decisions of the
management.
Too much debt can
expose the company to
a bankruptcy risk and
this may disrupt the
operations of the
company.
Equity Financing refers to issuance of
new shares of stocks and retained
earnings plowed back into the
operations of the company. This is
called internally generated funds and
is the safest source of financing for a
company because it does not require
any mandatory payment of dividends.
It also provides the company financial
flexibility.
Disadvantages of Equity financing:

1. Cash dividends are not tax-


deductible.

2. Offering new shares to other


investors may dilute the
ownership stake in terms of
percentage of the existing
stockholders.
Disadvantages of Equity financing:

3. It is the most expensive source


of financing. Because:
a) Most companies opt to have
debt financing.
b) Under Philippine laws, a
company which is in the
process of liquidation cannot
Disadvantages of Equity financing:

distribute anything to the


stockholders unless the
claims of the creditors have
been satisfied first. This
provision in the law implies
that the stockholders are
taking the biggest risk in the
company.
Disadvantages of Equity financing:

c) Unlike loans where interest and


principal payments by
borrowers are more assured,
cash dividends are not
guaranteed.

d) If a company does not perform


well, the stockholders absorb
the losses.
Pecking Order Hypothesis was
developed based on repeated
observations of how companies fund
their financing requirements.
Accordingly, this is how companies
fund their requirements:
1. Internally generated funds.
These are the funds that come
from operating cash flows.
2. Debt. When internally generated
funds have been exhausted,
debt financing is the next
alternative.
3. Equity. The last in the priority
list of financing is equity
financing. This is not surprising
given that it is more difficult to
issue new shares of stocks.
Sources and Uses of Short-Term Funds

Short-term funds are normally used


to finance the day-to-day
operations of the company. It is
used for working capital
requirements such as accounts
receivable and inventories. It can
also be used for bridge financing.
Sources of Short-term
Funds
1. Supplier’s credit. Suppliers of
raw materials and merchandise
are the best sources of short-
term working capital. This is the
reason why a good relationship
has to be nurtured with
suppliers. As much as possible,
honor the credit terms.
2. Advances from stockholders. If
you have enough personal assets
and you control the company,
advancing funds to the company
when there are financial
requirements is an easy way for
the company to raise funds.
3. Credit cooperatives. To borrow
from credit cooperatives, you
have to be a member. Credit
cooperatives can lend as much
as five times of your equity or
contributions.
4. Bank loans. Banks can provide both
short-term and long-term loans.
Government banks, the
Development Bank of the
Philippines (DBP) and Land Bank of
the Philippines (LBP), offer short-
term credit facilities to small and
medium enterprises.
Securing loans from these credit
institutions may take some time as
they have to do credit investigation.
Among the collaterals that can be
acceptable to banks include real
estate, transportation vehicles, and
even inventories. The transaction
costs involved in bank lending
may be high.
5. Lending companies. These are
small lending companies which
cater normally to small and
medium enterprises. The lending
process is much faster as
compared to banks but they charge
higher interests, higher than the
banks but lower compared to a
more informal lending, popularly
known as “5-6”.
6. Informal Lending sources such
as “5-6”. This is a very expensive
source of financing and should
be avoided. It is called such
because for every P5 that you
borrow, you have to return P6.
This 20% interest is just for a
month.
Sources and Uses of Long-Term Funds
Long-term funds are used for long-
term investments or sometimes called
capital investments. This includes
expansion, buying new equipment, or
buying a piece of land which will be
the site of future expansion. They can
also be used to finance permanent
working capital requirements.
Long-term investments
have to be financed by
long-term sources of funds
to minimize default risk or
the risk that you may not be
able to pay maturing
obligations.
Sources of Long-term
Funds
1. Equity investors. They can be
issued common stocks. This is the
most patient source of capital. This
is the safest source of financing.

For SMEs, there are what we call


venture capital companies which
are willing to provide equity
financing to small and medium
enterprises.
In all cases, venture
capitalists conduct a due
diligence which is an
investigation or an audit of
potential investment.
2. Internally generated funds. Based
on the Corporation Code of the
Philippines, retained earning
cannot exceed 100% of the value of
common stocks or sometimes
called paid-in capital. However, if
the board can make a resolution,
setting aside a specific amount of
retained earnings for expansion,
then this is acceptable.
3. Banks. They provide lower interest
rates as compared to other
financial institutions but they have
a lot of requirements.
4. Bond market. Philippine bonds are
now traded through the electronic
platform provided by the Philippine
Dealing System Holdings
Corporation (PDS Group).
To issue bonds, the services of an
investment bank are also needed to
underwrite the issue. The bonds that
will be issued have to be registered
with the Securities and Exchange
Commission and they have to be credit
rated. A high credit rate means that
the bond issuer can afford to charge
lower interest rates which in turn will
minimize its financing cost.
5. Lending Companies. Some of
them also provide long-term
loans ranging from two to five
years. They can process loans
faster but they charge higher
interest rates.
Problems faced by
SMEs in Financing
Reasons for the inability of SMEs to take
advantage of available financing:

1. Limited track record


2. Limited acceptable collateral
3. Inadequate financial statements
4. Lack of business plans
Potential creditors’ reasons for rejecting the
loan applications:

1. Poor credit history


2. Insufficient collateral
3. Insufficient sales, income, and
cash flows
4. Poor business plans
Lack of reliable information
about SMEs makes it
difficult for the potential
fund providers to assess
their credit worthiness.
Duties of the Borrower to Creditors
1. Pay the creditors based on the
payment schedule agreed upon.
2. Provide the collaterals as agreed
upon in the loan negotiation with
proper documentation, if necessary
and if applicable (e.g., annotation of
the Transfer Certificate of Title
(TCT) or Condominium Certificate
of Title (CCT)).
Duties of the Borrower to Creditors
3. Comply with the provisions of the
loan covenant such as maintaining
certain liquidity and leverage
ratios.
4. Notify the creditor if the company
is acquiring another company or
the company is now the subject of
acquisition.
Duties of the Borrower to Creditors

5. Do not default on the loans as


much as possible.
Thanks!
Any questions?