Notes on Capital and Financing Sources

THE NEED FOR CAPITAL

Definition of Capital

Capital refers to the funds either invested or utilized in a business. It can be defined in two ways:

  1. General Definition: The overall finance required to establish a business and support its ongoing operations.
  2. Essentiality in Business: All businesses, irrespective of their form or structure, necessitate financial resources or capital to operate effectively.

Importance of Capital

Capital is crucial for various reasons, including:

  • Starting up the business: Initial funds are necessary to establish the business.
  • Purchasing fixed assets: Acquiring long-term resources such as machinery or property.
  • Meeting day-to-day expenses: Ensuring operational costs like salaries and rent are covered.
  • Enhancing existing products and developing new ones: Investing in improvements and innovations is vital for competitiveness and growth.
  • Entering new markets, including export markets: Funds are needed to explore and expand into new geographical or demographic markets.
  • Expanding the enterprise: Growth activities including scaling operations require considerable capital investment.

Types of Capital

Start-Up Capital

Start-up capital is the initial investment needed before a business can commence operations.

  • Venture Capital: A specific type of start-up capital provided to companies that demonstrate high growth potential but are perceived as risky by traditional investors. Venture capital is typically supplied by wealthy individuals or large corporations looking for quick gains. It can also be defined as the "sale of shares of an unquoted company with potential for growth." Venture Capitalists are individuals or entities that provide funds to small or medium-sized enterprises with potential growth but face challenges in securing funding from conventional sources.
Investment Capital

Investment capital encompasses the financial resources necessary for purchasing tangible assets of the company, such as machinery and tools.

Working Capital

Working capital refers to the funds required to keep the business operational on a day-to-day basis. This includes payments for wages, raw materials, and maintaining stock. The formula for calculating working capital is:
extWorkingCapital=extCurrentAssets−extCurrentLiabilitiesext{Working Capital} = ext{Current Assets} - ext{Current Liabilities}

SOURCES OF FINANCE

Internal Sources of Finance

  • Retained Earnings: Refers to the portion of net earnings that is retained in the business instead of being distributed as dividends. This capital is utilized for purchasing additional assets or financing operations.
  • Accumulated Depreciation: This is a noncash expense that decreases the taxable income of a corporation, thereby reducing tax payments. The equivalent cash savings can act as a source of funds. Moreover, the accumulated depreciation can be held in a bank account to support replacing depreciating assets.
  • Sale of Assets: A business can sell non-productive assets to generate necessary funds. The cash generated from the sale can be reinvested into the business for fulfilling its financial needs.

External Sources of Finance

  • Loans: Borrowed funds from banks or financial institutions that need to be repaid with interest.
  • Overdrafts: An agreement that allows firms to withdraw more money than is available in their bank accounts, providing short-term liquidity.
  • Share Capital: Funds raised by issuing shares to investors, making them part-owners of the company.
  • Debentures: Long-term securities yielding a fixed interest, secured against the company’s assets.
  • Venture Capital: Funding from investors typically focused on companies with growth potential.
  • Trade Credit: Credit extended by suppliers allowing the business to pay for goods and services at a later date.
  • Hire Purchases: Agreements allowing a business to use an asset while paying for it in installments.
  • Mortgages: Loans secured against property.
  • Government Loans: Financial assistance provided by the government under certain conditions.

DEBT VERSUS EQUITY

Debt Capital

Debt capital represents funds borrowed that must be repaid, with interest. Its advantages include:

  • Businesses maintain ownership since there is no need to surrender shares.
  • Obligations to repay are clearly defined.
  • Major sources include banks, credit unions, and financial institutions.
    However, debt capital must be repaid regardless of business profitability, and it appears as a liability on the balance sheet.

Equity Capital

Equity capital is raised through the issuance of shares, representing ownership in the company. The key characteristics include:

  • No repayment obligation like loans; dividends are only paid if profitable.
  • Major sources include stock sales, personal savings, and funds from friends and family.
    The significant risk is that owners could lose their entire investment if the business fails.

SOURCES OF CAPITAL: ADVANTAGES AND DISADVANTAGES

Equity Capital Advantages

  • No requirement for collateral.
  • No obligation to make regular payments.
  • If the company fails, shareholders do not have to be repaid.

Disadvantages of Equity Capital

  • Requires ceding some control to shareholders.
  • Public companies must comply with transparency, publishing financial accounts.

Debt Capital Advantages

  • Lenders have no equity, preserving ownership control for the business owners.
  • Repayment amounts are known and can be budgeted.
  • Companies do not have to publish detailed accounts.

Disadvantages of Debt Capital

  • Must be repaid regardless of profit or loss.
  • Collateral may be necessary.
  • Lenders may request financial statements for review.

SPECIFIC SOURCES OF FINANCE

Loans

Loans are fixed amounts borrowed from banks or other financial institutions. They specify repayment terms and interest rates, often requiring collateral to secure the loan.

Bank Overdrafts

Bank overdrafts allow businesses to withdraw more than what is present in their accounts, working as a short-term funding solution for immediate cash flow issues. The agreement is based on set limits and repayment expectations.

Debentures

Debentures are long-term secured loans issued to companies. They guarantee fixed interest payments, obligating the company to honor these payments irrespective of its financial situation. Debenture certificates detail the interest to be paid.

Bonds

Similar to debentures, bonds are secured against specific business assets. While bondholders do not have voting rights, they are entitled to fixed returns and may enforce asset sales to ensure repayment in case of default.

SALE OF SHARES

The sale of shares is integral for limited companies to raise capital, categorized into two types:

  1. Ordinary Shares: Higher risk as they are the last to receive payment in insolvency. Shareholders have voting rights and can earn dividends.
  2. Preference Shares: Lower risk with fixed dividends paid before ordinary shares in the event of liquidation. Preference shareholders have preferential rights regarding dividends and asset distribution.

LEASING

For startups and businesses lacking adequate funds, leasing allows them to utilize assets without purchasing them outright. Leasing provides access to necessary equipment while conserving capital that can be used for other investments.

FINANCING STRATEGIES

Short-Term Financing

Short-term financing, typically covering periods of one year or less, is utilized for daily operational needs. Three prevalent sources are:

  • Trade Credit: Payment postponements from suppliers allowing businesses time to generate revenue.
  • Bank Overdrafts: Short-term borrowing against account balances.
  • Factoring of Debt: Selling receivables at a discount to access immediate cash, enabling firms to maintain liquidity.

Long-Term Financing

Long-term financing is intended for funding needs that extend beyond one year, allowing businesses to invest in fixed assets or expansion projects.

  • Sources include share sales, venture capital, debentures, mortgages, and government assistance.

CONSIDERATIONS WHEN CHOOSING SOURCES OF FUNDS

When selecting financial sources, a business must evaluate several factors to aid in decision-making:

  1. Cost to the Firm: Includes interest payments, administration fees, and considerations regarding the most economical financing options.
  2. Use of Funds: It is impractical to finance long-term projects with short-term loans.
  3. Size of the Firm: Larger businesses may have better access to financing sources than small firms due to perceived lower risk.
  4. Financial Stability: Financial institutions will assess a firm’s financial health before lending, impacting interest rates and availability of funds.
  5. Gearing of the Firm: Gearing ratio indicates the relationship between equity and debt capital, influencing financing strategies based on the level of existing debt.
    A company with high levels of debt may prefer raising funds through share issuance rather than increasing borrowings.