Sources of Funds and Capital Structure - Coursework Example

Student: Lecturer: Course: Date: Sources of funds and capital structure Businesses will always be in need of money to finance both long-term and short-term needs of the business. Sources of funds maybe internal or external, internal sources are the “safest and most preferred but maybe inadequate such that external funding maybe required” (Dlabay and Burrow 92). Below are examples of short term and long term financing under respective headings. Short term financing Short term financing is a kind of financing whereby the business has to repay or return the money within one year. Of course there are several factors that influence choice of funding for a business such as the cost, the implication on capital structure and repayment period. A business may choose to finance using debt sources or equity. McLaney contends that debt financing is costly but businesses have to use it at some point since capital might not always be sufficient for the business 45. Sources of short term funding for business include but not limited to the following sources: Debt Bank overdraft This type of funding facility is extended to a business which does not have money enough in its accounts or in cash to finance a short term need. It is usually a relatively small amount depending on the needs of the business and its credit rating. The fund is expected to be repaid back to the bank within a stipulated short time of mainly 30 days. The interest on the money starts accumulating immediately the account has been overdrawn. Many businesses especially in the small and medium sized segment rely on this funding to take care of huge orders or pay their expenses when profitability in a month fall below expected levels (McLaney 56). Short term loans Businesses can also take up short term loans from the banks to finance short term projects within their financial year. The loan is different from an overdraft in that it is usually backed with some more collateral and lasts for an average of one year. Banks can extend this time depending on repayment ability of the business although the common limit is three years. Short term loans will mostly be secured by a collateral in form of asset incase of defaulting on the loan by the business (McLaney 60). Short term Leasing A business can buy an asset or land for production purposes. The business can also lease the land or equipment from a leasing firm or another business. The difference between the two is that, in the latter you don’t own the asset but can use it for your production purposes after you have hired it. In the former you buy the asset and use it as your own. Buying an expensive asset can be a costly affair to a business which is cash constrained, leasing therefore becomes a preferred option to acquire the equipment and keep sufficient workflow capital to run the business without reducing available funds (Redman, Tanner and Manakyan 172). Trade credit This is an arrangement whereby a business gets goods from a supplier to pay at a later date usually within one month or three months depending on the demand behaviors of the industry. This is a common method of doing business for businesses limited in terms of working capital. Small and medium sized businesses rely on good relation between them and suppliers to ensure they get such benefits as this which are vital for their survival and growth. It is also common for big businesses to pay for huge orders and request for supply in small portions until the order is over (Dlabay and Burrow 74). This is another form of short term funding for businesses since they can use the money for short tem needs but still have enough stock to sell to other customers. Credit cards A credit card enables one to buy things for credit and repay the money later to the credit card company. The money is limited to a certain extent depending on many factors such as credit rating. It is the same with businesses, they can use the credit cards to pay for goods and pay 30 days later as required by most credit card companies (Dlabay and Burrow 80). Non-debt financing Profits This is a common way of financing short term business needs especially for small start ups that put back most of what they make to run the businesses. This method is a relatively cheap way of funding short term needs since no interest is repayable, but it should be checked well since reliance on profit to fund short term needs may have an impact on long term growth of the business if a certain percentage of profits is not kept a side to finance long term growth like acquisition of capital equipments (Dlabay and Burrow 87). Owners funding Businesses owners may decide to put money into a business when it is facing liquidity issues until it has recovered to return their money. This is common in small business or big businesses owned wholly by individuals. This funding is also cheap since the owner can not charge the interest on the business (Dlabay and Burrow 99). Sale of assets A business may choose to sell some assets within its possession which are not important in its activities such as old vehicles or equipment to raise money for short term needs. This practice is also common for long term financing where business may sell priced assets such as land to fund long-term projects as opposed to the intentions in short term financing (McLaney 131). Long-term sources of funds for businesses Long term funding is mostly used by businesses to acquire equipment, land, and licenses in cases where the licenses are expensive but lucrative and last a long time such as mining licenses. However long time financing is not only limited to the above but maybe used for other purposes for as long as they are long term objectives of the business. This financing is split into two main types; capital financing and debt financing which are explained below under respective sub headings (Dlabay and Burrow 145). Capital financing Stock markets In this market, companies sell their shares to raise money to grow from their current positions. Stock markets are regulated by governments or mandated authorities to ensure fair play. Only registered companies can have their shares listed in the stock market to raise money mostly through the initial public offer and subsequent offers. With this type of funding the company does not have to repay the money in interest form or in principle, however the company must gave up a certain percentage of ownership as agreed in the share capital structure. The shareholders who buy a stake into the company by giving it requested fund will have a share of the company’s profits in form of dividends and liabilities to the agreed extents (Wang and Zhu). McLaney outlines three types of shares in equity funding structures: 112 Ordinary shares- this are the most common shares on offer in stock markets, they carry the greatest risk incase the business does not perform as expected. They are also not guaranteed of dividends. All the same the holders of this share have a voting right. Preference share- this carry a lesser risk as compared to ordinary shares, they receive a fixed rate of return and receive their dividends before the ordinary shares. Deferred shares- these are held mostly by the founders of a company and only receive their dividends after the ordinary shareholders have received theirs. Debt financing Bank loans Long term bank loans are a good way of financing long term business projects such as buying production plants or acquiring land for expansion. Seitz and Ellison warn that Loans are an “expensive source of funding” since the interest may be very high to the company and might affect the businesses cash flow. The good thing with loans is that they do not buy into the ownership of the business and are only entitled to the agreed interest. 214 Long term loans to a business come in different forms depending on what is the intended purpose of the loan. Some examples include Debentures in the form of corporate bonds which are basically debt advanced by an individual to a business based on the creditworthiness of the business but not on assets as collaterals. Mortgages which is a debt backed by collateral in form of real estate property. Long term Leasing of assets Leasing is a practice whereby a leasing company buys an equipment or land and leases it to another company for use within a specified period of time for production purposes. This practice is not only used as a short term financing method it can also be used for long term purposes since some leased item might be so expensive or scarce in the case of land (Redman, Tanner and Manakyan 170). Retained earnings During better financial times a company may make quite high profits from its business operations. Some profit maybe retained after the company has paid dividends to its shareholders. The profits are refereed to as retained earnings which are a cheap and safe way of financing the business even in the long run since no interest is charged on the money (Dlabay and Burrow 102). Works Cited Dlabay, R Les and L James Burrow. Business Finance. Cengage Learning, 2007. McLaney, Eddie. Business Finance: Theory and Practice. Prentice Hall/Financial Times, 2009. Redman, Arnold, John Tanner and Herman Manakyan. "Corporate real estate financing methods: A statistical study of corporations’ choices." ournal of Corporate Real Estate 4.2 (2002): 169-186. Seitz, nEIL and Mitch Ellison. Capital Budgeting and Long-Term Financing Decisions. Thomson/South-Western, 2005. Wang, Zhengwei and Wuxiang Zhu. "Equity Financing Constraints and Corporate Capital Structure: A Mode." China Finance Review International 3.4 (2013). Read More