Unit 2: Sources of Finance - Subjective Questions

Sources of finance are the various means through which a business obtains funds to establish, operate, or expand its activities.

They may be classified as follows:

• According to period:
  • Long-term finance: Funds available for more than five years, such as ordinary shares, preference shares, and debentures.
  • Medium-term finance: Funds generally available for one to five years, such as term loans and lease finance.
  • Short-term finance: Funds repayable within one year, such as trade credit and bank overdrafts.
• According to ownership:
  • Owned funds: Capital belonging to shareholders, including ordinary and preference share capital.
  • Borrowed funds: Loans and debt raised from external parties, including debentures and bank loans.
• According to origin:
  • Internal sources: Funds generated within the business, such as retained earnings.
  • External sources: Funds obtained from investors, lenders, banks, or suppliers.

Major long-term sources of finance include:

• Ordinary shares: Represent ownership capital and usually carry voting rights. Dividends depend on profits.
• Preference shares: Carry a preferential right to a fixed dividend and repayment of capital before ordinary shareholders.
• Debentures: Long-term debt instruments carrying a fixed rate of interest.
• Long-term bank loans: Borrowings repayable over several years, usually through installments.
• Retained earnings: Profits reinvested in the business rather than distributed as dividends.
• Lease finance: Enables a company to use an asset in return for periodic lease payments.

These sources are generally used to purchase fixed assets, fund expansion, acquire businesses, and finance long-term projects.

Short-term finance is generally repayable within one year and is mainly used to finance working capital requirements.

Principal sources include:

• Trade credit: Suppliers allow the company to purchase goods now and pay later.
• Bank overdraft: The business withdraws more than the balance held in its bank account, up to an agreed limit.
• Short-term bank loan: A fixed amount borrowed for a specified short period.
• Commercial paper: Unsecured short-term securities issued by financially strong companies.
• Factoring: Receivables are sold to a factor to obtain immediate cash.
• Accrued expenses: Expenses such as wages and taxes are used as temporary finance until their payment dates.

These sources help finance inventory, receivables, wages, and seasonal fluctuations in cash flow.

Ordinary shares are units of ownership in a company. Ordinary shareholders are the residual owners of the business.

Rights of ordinary shareholders:

• The right to vote at general meetings.
• The right to elect directors.
• The right to receive dividends when declared.
• The right to share in surplus assets after all prior claims are settled on liquidation.
• The right to receive company information and financial statements.

Risks:

• Dividends are not fixed or guaranteed.
• Share prices may fall.
• Ordinary shareholders rank last in liquidation.
• Additional share issues may dilute control and earnings per share.

Their potential return is relatively high because dividends and capital gains can increase when the company performs well.

Advantages:

• Ordinary share capital is generally permanent and has no compulsory redemption date.
• Dividends are discretionary and may be reduced or omitted when profits are low.
• The absence of compulsory interest payments lowers financial distress risk.
• A larger equity base can improve borrowing capacity.
• No business assets normally have to be offered as security.

Disadvantages:

• New shares may dilute the ownership and voting power of existing shareholders.
• Shareholders generally expect a higher return than lenders because they bear greater risk.
• Dividends are usually not deductible when calculating taxable profit.
• A public issue can involve substantial legal, underwriting, and administrative costs.
• A greater number of shares may dilute earnings per share.

Thus, ordinary shares strengthen financial stability but may be expensive and affect control.

Preference shares are shares that give their holders preferential rights over ordinary shareholders, particularly regarding dividends and repayment of capital.

Principal characteristics include:

• A dividend normally stated as a fixed percentage of nominal value.
• Priority over ordinary shares in the payment of dividends.
• Priority over ordinary shareholders in the repayment of capital on liquidation.
• Limited or no voting rights under normal circumstances.
• Dividends that are normally paid from distributable profits rather than being a legal obligation like interest.
• Possible special features, such as cumulative, participating, convertible, redeemable, or non-redeemable terms.

Preference shares therefore combine certain features of equity with features commonly associated with debt.

• Cumulative preference shares: Unpaid dividends accumulate as arrears and must normally be settled before ordinary dividends are paid.
• Non-cumulative preference shares: A dividend omitted for a particular year is lost and does not accumulate.
• Participating preference shares: Holders receive the fixed preference dividend and may also participate in additional profits under stated conditions.
• Convertible preference shares: Holders may convert their shares into ordinary shares according to predetermined terms.
• Redeemable preference shares: The company repays the share capital on a specified date or under agreed redemption conditions.

The categories are not always mutually exclusive. For example, preference shares may be both cumulative and redeemable.

Ordinary shares are more suitable for investors seeking ownership and growth, whereas preference shares appeal to investors seeking a more stable return.

A debenture is a long-term debt instrument issued by a company as evidence of money borrowed from investors.

Its main features are:

• Fixed interest: Debenture holders usually receive interest at a predetermined rate.
• Contractual payment: Interest must generally be paid regardless of whether dividends are declared.
• Creditor status: Holders are creditors rather than owners of the company.
• No normal voting rights: Debenture holders do not ordinarily participate in company management.
• Security: Debentures may be secured against company assets or may be unsecured.
• Priority: Debenture holders rank before shareholders in interest payments and liquidation.
• Redemption terms: A debenture may be repayable on a fixed date or may have no predetermined redemption date.

Debentures allow a company to raise finance without diluting shareholder control.

Redeemable debentures are repaid by the company on a specified date, in installments, or when stated conditions are met. Because repayment is required, the company must plan for the future cash outflow. Their cost can be estimated by considering interest, issue proceeds, redemption value, and time to maturity.

Irredeemable debentures, also called perpetual debentures, have no fixed repayment date. Interest may continue indefinitely, although repayment may occur on liquidation or if the company exercises a contractual repayment option.

Key differences are:

• Maturity: Redeemable debentures have a defined maturity; irredeemable debentures do not.
• Cash-flow planning: Redeemable debt creates a future principal repayment obligation.
• Valuation: Redeemable debt is valued using interest and redemption cash flows; irredeemable debt resembles a perpetuity.
• Refinancing risk: Redeemable debt may need replacement at maturity, while perpetual debt avoids a fixed refinancing date.

Debt may increase shareholder returns through financial leverage when operating returns exceed the cost of borrowing. However, excessive debt raises default and insolvency risk. Equity provides greater financial flexibility but can dilute control and is often more costly.

Advantages of debt finance:

• Existing shareholders retain their voting control.
• Interest is commonly deductible for tax purposes, producing a tax shield.
• Debt is often cheaper than equity because lenders face lower risk.
• The lender's return is fixed, so shareholders retain profits above the interest cost.
• Repayment ends the lender's financial claim under the agreement.

Limitations of debt finance:

• Interest and principal payments are contractual obligations.
• Debt increases financial gearing and the risk of insolvency.
• Loan covenants may restrict dividends, further borrowing, or investment decisions.
• Security over assets may be required.
• Poor cash flow could cause default even when the company reports an accounting profit.

Debt is therefore attractive when cash flows are stable, but it can be dangerous when earnings are uncertain.

Advantages:

• Ordinary equity normally has no compulsory repayment date.
• Dividend payments can be reduced or omitted if necessary.
• It lowers the probability of default because there is no compulsory interest.
• It may improve the company's creditworthiness and ability to borrow.
• It is suitable for risky projects with uncertain or delayed cash flows.

Limitations:

• New shares can dilute existing ownership, voting control, and earnings per share.
• Equity investors normally demand a high return for bearing residual risk.
• Dividends do not usually provide a corporate tax deduction.
• Share issues may involve substantial flotation and regulatory costs.
• Managers may face greater scrutiny from a wider shareholder base.

Equity is financially flexible but may be expensive and may alter corporate control.

A finance manager should consider:

• Cost of finance: Compare the required shareholder return with the after-tax cost of debt.
• Cash-flow stability: Stable cash flows can support fixed interest and principal payments more safely.
• Existing gearing: Highly geared companies may be unable to assume additional debt without excessive risk.
• Control: Equity issues may dilute the voting power of existing owners.
• Taxation: Interest may create a tax shield, while dividends generally do not.
• Asset security: Lenders may require assets as collateral.
• Financial flexibility: The company should preserve borrowing capacity for future needs.
• Market conditions: Interest rates, share prices, and investor sentiment affect the attractiveness of each source.
• Business risk: Firms with volatile operating income should generally use debt cautiously.
• Maturity matching: The financing period should correspond to the life of the asset or project.

The objective is to obtain finance at a reasonable cost without creating unacceptable financial risk.

The matching principle states that the maturity of a source of finance should broadly correspond to the economic life of the asset being financed.

• Permanent fixed assets, such as buildings and machinery, should normally be financed through long-term funds such as shares, debentures, or long-term loans.
• Permanent working capital, which remains invested in operations continuously, should also generally use long-term finance.
• Temporary or seasonal working capital may be financed through short-term sources such as overdrafts and trade credit.

This principle reduces the risk that finance will have to be repaid before the asset generates sufficient cash. Financing long-term assets entirely with short-term debt creates refinancing and interest-rate risk. Conversely, financing temporary needs with long-term funds may be unnecessarily expensive and leave idle cash after the need disappears.

Trade credit is convenient for routine purchases, factoring accelerates cash collection, and commercial paper can provide relatively low-cost funding to strong corporate borrowers.

Trade credit arises when a supplier provides goods or services and permits the buyer to pay at a later date. Terms such as payment within 30 days create a short period of interest-free finance.

Advantages:

• It is convenient and usually arises automatically from ordinary purchases.
• Formal security may not be required.
• Finance can grow with the level of purchases.
• It helps bridge the period between acquiring inventory and collecting cash from customers.

Potential costs and risks:

• A company may lose an early-payment discount.
• Suppliers may include financing costs in their prices.
• Late payment can damage supplier relationships and credit standing.
• Suppliers may suspend deliveries or impose penalties.
• Excessive reliance may conceal weak cash-flow management.

The true cost should include any discount sacrificed, not merely explicit interest charges.

An overdraft provides flexibility for changing working capital needs, while a short-term loan provides greater certainty for a specific requirement.

1. Debt-to-equity ratio

The ratio is:

Therefore, the company has $0.60 of debt for every $1 of equity, or a debt-to-equity ratio of 60%.

2. Interest coverage ratio

The ratio is:

Interpretation:

• A 60% debt-to-equity ratio shows that equity exceeds debt, although the significance depends on the industry and stability of cash flows.
• Interest is covered three times by operating profit.
• A decline of more than two-thirds in operating profit would leave interest inadequately covered.
• The figures should be compared with prior years, competitors, loan covenants, and expected cash flows before concluding whether debt is excessive.

The company should use a combination of long-term and short-term finance based on the matching principle.

New factory:

• The factory is a long-term asset and should be financed with ordinary shares, preference shares, debentures, or a long-term loan.
• Equity would be suitable if cash flows are uncertain or existing gearing is already high.
• Debt may be suitable if cash flows are stable and the company can benefit from lower after-tax financing costs without creating excessive default risk.
• A mixture of debt and equity may balance cost, control, and risk.

Seasonal inventory:

• Temporary inventory needs can be financed with an overdraft, trade credit, short-term loan, or commercial paper if the company is sufficiently creditworthy.
• The finance can be repaid when inventory is sold and customer cash is collected.

The final choice should consider borrowing capacity, security, interest rates, shareholder control, repayment ability, market conditions, and the predictability of operating cash flows.