When a company seeks to raise finance it must ensure that it has a suitable mix of long, medium and short term sources available, however, the availability of finance is often determined by factors such as ‘age’ of the company.
You are required to:
i) Critically assess the differences in finance sources and availability between an established company and a relatively new company
Talk about sources of finance for well established private companies and young limited companies
Discuss all the possible advantages and disadvantages for each source and in relation to each type of company
Attempt a debate as to which types company has it easier to source finance and why this might be
ii) When lending to smaller or newer companies what considerations would lenders examine before deciding whether to lend to the company or not
Consider the issues involved with determining which companies a lender would lend to
Consider the factors that might influence their decisions
Discuss and debate how important each of these factors are in relation to a lender deciding whether or not to lend money
iii) Previously companies with high gearing have been considered to be risky to lend to, debate why this was considered the case and why companies may not always be risky to lend to
Discuss what high gearing means and what the implications are
Debate the advantages and disadvantages of having debt as a form of finance
Use your academic references to gather opinions, DO NOT STATE WHAT YOU THINK
i) Your assignment should show extensive evidence of research
ii) 15% of the marks available are for quality of English (10%), and proper referencing according to the Harvard method (5%);
iii) This assignment carries 50 % of the total module weighting
iv) Please note that the marking grid gives guidance as to the content of the assignment whereas the Assessment Criteria tells you what you should be aiming for in terms of the level
(15 marks) (Total 100 marks)
Finance Sources for new and Established Companies
Dlabay and Burrow (2008, p.32) points out that financial capital is a paramount component for business formation, operation, and expansion. Its level of activity, the size of the venture, influences the type and availability of each source of finance for a private limited company and the type of industry the company operates. On the other hand, the source and availability of funding for a new limited company depend on the purpose, time, the amount required, and its size. The sources of finance for the two types of business are classified as either internal or external (Dlabay & Burrow 2008, p. 60). Internal sources of funding are raised from within the organization while external sources arise from avenues outside the business.
Internal sources of finance for private limited companies majorly ascend from the fact that it has been in operation for a period. These sources include retained profits, the sale of stock and fixed assets and debt collection as well as venture fund (Koh 2013, p.163). External sources comprise term loans and overdrafts, inventory financing, the issue of new shares and debentures, factoring, mortgages, major and minor recapitalization and Initial Public offers (IPOs). For young public companies, internal sources largely depend on the owners’ equity, which is sourced from the promoters of the business or equity shares issued to the public. Sanford and Peirson (2007, p.231) further explain that more sources of financial capital expand as the business grows. These sources include owners’ equity, issuance of ordinary shares to existing members, rights issue, reinvested profit, and sale of stock. The companies also receive external finance in the form of trade credit, invoice factoring, and debt financing and leasing as well as government grants.
Various sources of funds present finance businesses with diverse advantages (Vine 2000, p. 53). Internal sources provide the private companies with long-term financial capital that are not subject to repayment or interest rates such as retained earnings. Additionally, the sale of assets enables the company to dispose of obsolete and worn out assets. The collection of debt has no additional costs, as it is part of the normal business operations. New companies draw the advantage of obtaining non-interest and non-payable source of finance that is necessary for long-term growth. Sale of stock enables the company to reduce the cost associated with holding them as well as providing a quick way of raising capital.
In his book, Vine (2000, p. 70) continues to clarify that external sources provide private companies with a pool of resources both human and capital. Share issue accrues no interest nor does it require repayment. Other sources such as mortgages provide a flexible and cheap way of obtaining assets by spreading the cost over a longer period. Term loans also cover an extended repayment period, which makes it possible for the company to budget. Young companies profit external sources by having finances that otherwise would not have at their disposal. Leasing allows a company to acquire assets without immediate cash and allows a company to avoid tying significant amounts in assets in the short term. Bank overdrafts offer means to cover the period between money coming and money going out. In fact, it is cheaper than a bank loan if used in the short run. Government grants do not need repayment giving a company an opportunity to invest in other areas (Svensson, 2008, p.101)
In his opinion, Marsh (2012, p. 95) argues that well-established companies stand a better chance of sourcing finances. One of the reasons discussed is the perception of steady income, which stems from the implication that when a company grows enough, it commands a larger market share.
The established company is assumed to have steady cash flows and thus do not experience the same economic swings that affect a growing firm. The steady cash flow means that established company’s funds promise reliable returns. Therefore, the company is likely to generate money. This perception makes it easier for these companies to access more funding from financial institutions as compared to emerging companies. Marsh (2012, p. 179) further explains that funds to companies that are established reward more dividends. When a company is making a profit, it distributes the returns to investors or ploughs it back in the company. Besides, established companies do not require liquid cash to run which translates to a higher share of more profits as dividends. This aspect gives investors more confidence to invest more and attract new investors.
Issues involved in lending to new and smaller companies
It is the interest of every lender to recover the full amount lent out together with the accrued interest (Doukas & Walter, 2013, p.798). Therefore, there is a need to analyze the organization with which to get into a contract. The major issues involved in undertaking this process irrespective of the type or size of the organization are clearly explained by the 5Cs of lending (Bekaert 2010, p.274). The first C stands for character, which is based on credit history. Lenders also use a credit score to determine a company’s borrowing risk. The second C stands for capacity, which determines the comfort with which a company can handle its payments. Healthy history of profitability makes a good indicator of a company’s ability to repay debts. Collateral makes the third C, which represents anything a company owns that a lender can confiscate to recover funds in case of default. The fourth C is capital that a borrower puts towards a particular investment. The notion here is that large investments lessen the probability of default. Finally, prevailing conditions constitute the last C, which ranges from economical to environmental to how the lender intends to use the funds. By considering these issues, a lender can decide which company to advance funds.
Once a lender decides the company to lend, other factors come into play that may influence the decision to lend the funds. The factors may range from internal operations to external factors that affect a company (Agarwal 2013, p.57). Among these factors include the size of the firm, cash flow records and prevailing economic conditions among others.
The size of the firm has a great impact on the decision of the lender. Brancati (2014, p.455) proposes that lenders favor large companies as compared to small firms. The reasons put across include that small businesses are thought to be more affected by economic swings, have a higher risk of failure and lenders find it hard to assess the creditworthiness of these firms. Agarwal (2013, p. 148) also argue that small businesses possess less collateral to pledge for loans compared to large advanced firms. Inadequate collateral may force individual investors to use their real estate as collateral, which adversely affects credit worthiness. Therefore, the size an entity is important as it implies that a business has sufficient security to cover its loans.
Agarwal (2013, p. 258) clarifies that cash flow statements play a vital role for a lender to decide on lending or not. The cycle of cash flow from inventory purchase to the collection of debts is an essential for obtaining short-term finances. A consistent cash flow helps the lender to determine whether daily operations of a company generate enough returns to repay the debt. Cash flows also provide information on the primary sources of funds and expenditures. These figures are important for the lender to determine the company’s market demand, business cycles, management competencies, and effects of any changes on the business over time.
Lenders also consider prevailing economic conditions such as economic recessions (Agarwal, 2013, p. 381). As lenders try to be more risk averse, they may decline advancing loans during times of economic slowdown than they would have made during prosperous times. On the contrary, lenders might decide to lend more to large institutions, as they are less risk averse during times of economic drags. These firms take this approach to make use of the fact small businesses are more risk averse during such times and decide not to undertake projects leaving a gap for the large firms to fill. An attempt by large firms to invest at such times presents lenders an opportunity to generate income from high-interest rates.
Issues related to high gearing and Debt in companies
Accountingexplanation.com (2011) defines gearing, also known as leverage, as the ratio that measures the percentage of investments in any business venture that is financed by long-term borrowing. Gearing focuses on the proportion of investment provided by debt relative to the funds provided by shareholders. Allen (2003, p.97) explains that a high leverage implies that a company has more risks since payment of debt, and accrued interest is not optional same as dividends. Gearing focuses on the long-term financial position of the business as well as its liquidity.
Monteiro (2003, p. 473) expounds that the main implications of gearing are that a company is vulnerable to downturns during low business cycles. A high level of gearing discourages investors by viewing the business as a high risky venture to invest. Also, low profits made by the company imply that it may struggle to pay interests that make it more vulnerable to liquidation. Allen (2003, p.217) however debates that a high level of gearing is not that bad at all for a firm. Continuous borrowing may allow the firm to undertake projects with higher returns and to allow the company to expand which in turn reduces the gearing ratio in the future. Gearing also provides an easier and faster way of financing business projects compared to other sources such as issuing shares. Therefore, a high gearing may imply high risks, but it may also translate to high returns.
According to Finnerty and Emery (2001, p.316), debt refers to the funds a company obtains from external sources and that a company is liable to pay both the principal and resulting interest. Debt provides a fast source of capital for start-up businesses as well providing finance to run daily operations for established firms. Banks are the most common sources of debt although private companies, government, or relatives can also provide debt. Like any other source of finance, debt has a share of its advantages and disadvantages.
Maintaining ownership is one of the benefits of debt (Finnerty & Emery 2001, p. 418). The lender is only obliged to provide funds for the business but has no obligation to interfere with the management of the firm. The manager chooses how to operate the business since their obligation is to pay the debt and the accrued interest on time. Additionally, a tax deduction that results from debt is another advantage that makes debt more attractive as a source of funds. This situation occurs because, in most cases, the principal and resulting interest are categorized as expenses thus can be deducted from the business income tax. Another advantage of debt is the lower interest rate (Peirson 2002, p.549). This arises from the fact that a business can analyze the interest rate charged by various providers. This analysis enables a firm to source funds from providers with lower rates.
Finnerty and Emery (2001, p.573) however clarify despite its advantages; debt is faced by various disadvantages. First, the business is obliged to pay its debt and the accumulated interest even it fails. If the business is forced into bankruptcy, lenders present the priority to be paid before any equity investors. Second, the business still faces high-interest rate irrespective of its ability to compare existing rates. This situation occurs when a business has a low credit rating, poor history with the banks and the fact that interest rates vary with economic conditions. Third is that more borrowing has a negative impact on credit rating. Although borrowing is an attractive source of funds, the more a business borrows, the higher the risk to the lender. This continuous borrowing may translate to higher interest rates a company will pay relative to others within the same industry but with lesser leverage. Finally, debt requires a business to present collateral inform of tangible assets to cover the debt in case of default. Sanford and Peirson (2007, p. 193) adds that this form of security forces a business to maintain a record of assets that otherwise would be disposed and provide cash.
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