Methods of Raising Finance

A company or business person can choose various methods of acquiring funds to finance their business operations and investments. The major methods of raising finance in the corporate world include: venture capital, shares, debentures, bonds, debts/loans, lease financing, trade credits, and retained earnings.

1) Venture Capital

Venture capital (VC) refers to an investment fund provided by investors to businesses in their early stages, where the investor gets some stake (ownership rights) in the business. Usually, an entrepreneur comes up with a promising business idea but may lack the financial resources to put their ideas into action. Venture capitalists come in to provide the required capital and management support to the new business. Venture capital firms usually invest in start-ups that have the potential to grow substantially and generate good returns in the future. Apart from supplying funds, venture capitalists also provide advice on various issues including management, marketing, product development, and staffing. Thus, venture capitalists (VCs) are usually involved in business aspects of the companies they sponsor.

The major difference between venture capital and shares is that venture capital is a private equity investment that cannot be traded in public exchanges such as the Nairobi Stock Exchange. Institutional and individual investors usually invest in private equity through limited partnership agreements, which allow investors to invest in a variety of venture capital projects while preserving limited liability.

2) Shares

Shares refer to interests or stake held by individuals or corporations in a company, which allows them to share the profits or losses of the firm. They represent the ownership of a company. The company issues shares, also known as stock, in exchange for money. Those who buy shares of stock are known as shareholders, and they represent ownership of the firm. Thus, a person who buys and owns 100% of a company’s shares is said to own the entire company.

Investors purchase shares to become part owners of the company, and get share of profits through dividends. Shareholders expect to receive a rate of return in two forms: dividends and/or capital gain. Dividends are direct payments made to shareholders from the company’s profits while capital gains refer to the increase in value of stock or shares when it is sold.

The company then uses the money raised to invest in various projects, which are expected to generate returns for the shareholders. The funds raised through shares is known as equity capital. When making financing decision regarding shares, finance managers ask the following:

  • How and when does the company get money from the sale of its stock?
  • What rate of return does the company promise to pay when it sells stock?
  • Who makes decisions in a company owned by a large number of shareholders?

3) Debentures

A debenture is a type of long-term debt issued by a company to the public to raise capital for various investments. It is usually used when the company has a solid financial position and does not want to dilute its ownership through the issuance of shares. Let’s say it is a long-term financial instrument issued by a company to meet their financial requirements, where investors are compensated with a fixed interest income. It is like a company is borrowing a long-term loan from the public or from investors. The holders of debentures are creditors to the company.

Companies generally have powers to borrow and raise loans by issuing debentures as securities of specified face value. The rate of interest payable is fixed at the time of issue, and they are recovered by a charge on the property or assets of the company, which provide the necessary security for payment. Debentures are mostly issued to finance the long-term requirements of business.

4) Bonds

Another source of financial capital is a bond. A bond is a financial contract: a borrower agrees to repay the amount that was borrowed and also a rate of interest over a period of time in the future. A corporate bond is issued by firms, but bonds are also issued by various levels of government.

A large company, for example, might issue bonds for $10 million; the firm promises to make interest payments at an annual rate of 8%, or $800,000 per year and then, after 10 years, will repay the $10 million it originally borrowed. When a firm issues bonds, the total amount that is borrowed is divided up. A firm seeks to borrow $50 million by issuing bonds, might actually issue 10,000 bonds of $5,000 each. Anyone who owns a bond and receives the interest payments is called a bondholder.

The difference between bonds and debentures is that bonds are backed by collateral or physical assets as security, while debentures are not backed by collaterals.

5) Loans

An organization or business can also acquire finance by borrowing money from a financial institution such as a bank. Loans can be long-term or short-term debts depending on the firm’s financial needs. Short-term loans usually last for 1 year and are used to finance the company’s daily operations. On the other hand, long term debts are payable beyond 1 year and are used to finance the firm’s investment projects.

Loans are similar to bonds in that they both involve borrowing funds which should be repaid with interest. However, loans are borrowed from banks and other financial institutions, while bonds are borrowed from bondholders in the money market. Individuals and companies borrow money from a bank using the same procedure, but firms borrow a larger amount of money with an agreement to repay at an agreed upon rate of interest over a given period of time.

6) Leasing

Another important method of financing a business is leasing. Lease financing is one of the important sources of medium-and long-term financing where the owner of an asset gives another person, the right to use that asset in exchange for periodical payments. The owner of the asset is known as lessor and the user is called lessee. The periodic payments are lease rentals. During the lease period, the lessee gets the right to use the asset, but its ownership remains with the lessor. At the end of the contract, the lessor and the lessee may agree to transfer the asset back to the lessor; extend the lease agreement; or the lessee may buy the asset and take full ownership.

It is an alternative way of obtaining the use of assets if the company does not have enough money to buy the asset completely. In most cases, companies lease space for manufacturing, warehousing, and business operations. A lease can be used in relation to real estate – land and buildings; but nowadays even capital equipment are leased.

7) Factoring

Factoring is a method of acquiring short term capital. It is a type of financing in which a company sells its outstanding debt dues or accounts receivables to a third party to meet short-term financial obligations. In most cases, customers may buy goods from a company on debt (debtors). The amount that customers owe the company on credit remain outstanding until the end of the credit period. However, the company may run short of funds before all the dues have been collected from debtors.

Such debts may be transferred to a third party, which is usually a bank, in exchange for cash. The bank charges the company a specified amount of fees for the transfer of credit. It helps companies to secure finance against debtors’ balances before the debts are due for realisation, and incidentally also helps in saving the effort of collecting the book debts.

The advantages of factoring include: saving time and effort of collecting debts; minimizing risks of bad debts; increasing liquidity; and meeting immediate financial obligations.

The disadvantage of this method of financing is that customers who are in genuine difficulty do not get the facility of delaying payment which they might have otherwise got from the company. This may affect the relationship between the company and its customers negatively.

8) Discounting Bills of Exchange

A discounting bill of exchange is another important source of capital, which is used to raise short-term finance. When goods are sold on credit, bills of exchange are generally drawn for acceptance by the buyers of goods. The bills so drawn are payable after 3 or 6 months depending on the prevailing practice among traders. Instead of holding the bills till the date of maturity, companies generally prefer to discount them with commercial banks on payment of a charge known as bank discount.

In other words, this method of financing occurs when a bank buys a trade bill (bill of exchange) from the company (payee) before it reaches its maturity date. A trade bill is a document that allows a customer to take possession of goods and services and pay for them at a later date. The company can sell the bill of exchange to a bank, which pays the bill and charges service fees. The bank then recovers the said amount after the maturity of the bill. This allows the company to access money to meet its financial obligations as they fall due.

If any bill is dishonored on maturity, the bank returns it to the company which then becomes liable to pay the amount to the bank. The cost of raising finance by this method is the discount charged by the bank.

9) Trade Credits

Another source of short-term financing for a corporation is trade credit. This method of financing allows a company to take possession of goods from suppliers on credit.

Just as companies sell goods on credit, they also buy raw materials, components, stores and spare parts on credit from different suppliers. Hence, outstanding amounts payable to trade creditors as well as bills payable relating to credit purchases are regarded as sources of finance.

Generally suppliers grant credit for a period of 3 to 6 months, and thus provide short-term finance to the company. Availability of this type of finance is closely connected with the volume of business. When the production and sale of goods increase, there is automatic increase in the volume of purchases, and more of trade credit is available. On the other hand, if sales decline there is a corresponding decline in purchases of materials, and consequent decline in trade credit as a source of finance.

Thus, creditors, balances (account payable) and bills payable help companies to finance current assets, i.e., stock of materials and finished goods as well as book debts. However, trade credit also involves loss of cash discount which could be earned if payments were made within 7 to 10 days from the date of purchase. This loss is regarded as the cost of trade credit.

10) Bank Overdraft

Cash credit and bank overdraft are other important methods of raising finance. Bank overdraft is a short term source of capital which allows a company to overdraw money from its bank account above what it has in the bank. Cash credit refers to an arrangement on a continuing basis whereby the commercial bank allows money to be drawn as advance from time to time within a specified limit known as cash credit limit. Bank overdraft and cash credit are granted against securities such as stock, government bonds, or a promissory note.

The rate of interest charged on cash credit and overdraft is relatively much higher than the rate of interest on bank deposits. But this method of financing has the flexibility of allowing funds to be drawn for short-term purposes according to changing needs which depend on business conditions.

11) Public Deposits

Another important source of finance is public deposit, which refers to funds raised through deposits made by shareholders, employees and the general public. Members of the general public are invited to deposit their savings with the company, which the company invests in various projects. Thus, public deposits can be a raised by companies to meet their short-term and medium –term financial needs. It is a simple method of raising finance for which the company has only to advertise in the newspapers giving particulars about its financial position as prescribed by the Companies Act.

The advantage of public deposits is that they allow the company to access money for short term and medium term financial obligations. The disadvantage is that a company is not allowed to raise unlimited amounts of money through public deposits.

12) Retained Earnings/Profits

Retained earnings are also known as retained profits, reinvestment or ploughed back profit. It is an internal source of finance which allows a company to use some of its profits for capital investments. After distributing some of the profits to shareholders as dividend, another proportion is transferred to reserves and used by the company as additional capital.

The main advantage is that there is no legal formality involved, nor does the company have to depend on external investors to raise capital. Another advantage is that it does not involve difficult or lengthy procedures to acquire finance. The third advantage of retained profits as a method of financing is that it promotes organic growth in the company since the company does not need to borrow external funds.

However, this method of raising finance has some disadvantages. One of the disadvantages is that only the on-going profitable companies can make use of this source of finance. Start-up companies do not have an ongoing source of profit to reinvest. Furthermore, the amount of money raised through this method is limited because the company can only transfer a certain percentage of profits to reserves, such as 10%.

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