Sources of finance to a limited company and advantages and limitations of them
There are many sources of finance, which would all provide the business with a quick source of money, which will have to be paid back. But the amount the company needs can limit them to a range of sources of finance and methods of repayment e.g. interest. The sources of finance can be split up into three types; long term, medium term and short term. Long term finance is mainly for companies who need a large sum of money, which would be difficult to be paid back, this would be used to provide start-up capital to finance the business for its whole lifespan, finance the purchase of assets with a longer life, such as buildings and provide expansion capital for large projects, such as building a new factory or taking over another business. The repayment as it is so much would be paid over a number of years rather than straight away. Medium term finance is again for high sums of money needed but not as high as long term, these usually would be used to finance the purchase of assets with a two to five year life, such as vehicles and computers, to replace an overdraft which is difficult to clear and is proving expensive and to finance a change in strategy, such as to switch marketing focus from Britain to the whole of Europe etc. But the repayment would be faster than long term, such as in a couple of years etc. Short-term finance is when a company needs money quickly for immediate things, which are temporary; the repayments are much quicker than the others. They would be used to bridge temporary finance gaps, to get through periods when cash flow is poor and to cover temporary needs for extra funds due to unexpected problems or opportunities.
There are possible sources of finance, which available to a Limited company.
Sources of Short-term Finance
There are a number of sources of short-term finance which are listed below:
1. Trade credit
2. Bank credit
- Loans and advances
- Cash credit
- Discounting of bills
3. Customers' advances
4. Instalment credit
5. Loans from co-operatives
1. Trade Credit
Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods, components, etc.
2. Bank Credit
Commercial banks grant short-term finance to business firms which is known as bank credit.
When a certain amount is advanced by a bank repayable after a specified period, it is known as bank loan.
(ii) Cash Credit
It is an arrangement whereby banks allow the borrower to withdraw money upto a specified limit. This limit is known as cash credit limit. Initially this limit is granted for one year. This limit can be extended after review for another year. However, if the borrower still desires to continue the limit, it must be enewed after three years.
When a bank allows its depositors or account holders to withdraw money in excess of the balance in his account upto a specified limit, it is known as overdraft facility. This limit is granted purely on the basis of credit-worthiness of the borrower .
(iv) Discounting of Bill
Banks also advance money by discounting bills of exchange, promissory notes and hundies. When these documents are presented before the bank for discounting, banks credit the amount to cutomer's account after deducting discount.
3. Customers' Advances
Sometimes businessmen insist on their customers to make some advance payment. It is generally asked when the value of order is quite large or things ordered are very costly. Customers' advance represents a part of the payment towards price on the product (s) which will be delivered at a later date.
4. Instalment credit
Instalment credit is now-a-days a popular source of finance for consumer goods like television, refrigerators as well as for industrial goods.
5. Loans from Co-operative Banks
Co-operative banks are a good source to procure short-term finance. Such banks have been established at local, district and state levels. District Cooperative Banks are the federation of primary credit societies.
Merits and Demerits of Short-term Finance
Short-term loans help business concerns to meet their temporary requirements of money. They do not create a heavy burden of interest on the organisation. But sometimes organisations keep away from such loans because of uncertainty and other reasons. Let us examine the merits and demerits of short-term finance.
Merits of short-term finance
a) Economical : Finance for short-term purposes can be arranged at a short notice and does not involve any cost of raising. The amount of interest payable is also affordable. It is, thus, relatively more economical to raise short-term finance.
b) Flexibility : Loans to meet short-term financial need can be raised as and when required. These can be paid back if not required. This provides flexibility.
c) No interference in management : The lenders of short-term finance cannot interfere with the management of the borrowing concern. The management retain their freedom in decision making.
d) May also serve long-term purposes : Generally business firms keep on renewing short-term credit, e.g., cash credit is granted for one year but it can be extended upto 3 years with annual review.
After three years it can be renewed. Thus, sources of short-term finance may sometimes provide funds for long-term purposes.
Demerits of short-term finance
Short-term finance suffers from a few demerits which are listed below:
a) Fixed Burden : Like all borrowings interest has to be paid on short-term loans irrespective of profit or loss earned by the organisation. That is why business firms use short-term finance only for temporary purposes.
b) Charge on assets : Generally short-term finance is raised on the basis of security of moveable assets. In such a case the borrowing concern cannot raise further loans against the security of these assets nor can these be sold until the loan is cleared (repaid).
c) Difficulty of raising finance : When business firms suffer intermittent losses of huge amount or market demand is declining or industry is in recession, it loses its creditworthiness. In such circumstances they find it difficult to borrow from banks or other sources of short-term finance.
d) Uncertainty : In cases of crisis business firms always face the uncertainty of securing funds from sources of short-term finance. If the amount of finance required is large, it is also more uncertain to get the finance.
e) Legal formalities : Sometimes certain legal formalities are to be complied with for raising finance from short-term sources. If shares are to be deposited as security, then transfer deed must be prepared.
Medium term finance
Bank term loan - This is possibly the simplest form of loans available to businesses. The average bank manager dealing with a medium sized firm and responsible to head office for the performance of the branch uses a set of well-defined criteria when making a loan. A bank loan is for a fixed amount at a fixed rate of interest. There is likely to be a demand for regular payments.
The advantages of a bank term loan is that financial planning is made easier as repayments are made in regular instalments and the interest rate are often fixed, but the disadvantages are the smaller the business the higher rates paid due to presenting a higher risk of things going wrong.
Long term Finance
Sale of Shares - This is the issuing of shares of the business to other investors who want to buy into the company.
The main advantage of issuing shares is that the shareholders have limited liability if the business fails. Personal possessions are not at risk and their liability is limited to the actual capital invested. Also the capital is raised by issuing shares (which are a proportion of what the company is worth) to investors, who are encouraged to buy by the promise of receiving dividends or profits on their shares. Also shares can be sold as preference shares which offer a fixed return as profits change from year to year, according to how well the company has done.
The disadvantages of selling shares are the administrative costs of issuing shares are high. Also it is difficult to estimate the market price of shares, though this problem can be avoided if tender issues them, where investors state how much they are willing to pay for them. Also the price of the shares can go up or down and shareholders may have to sell at a lower price than they bought it. Also the shares of an Ltd will have to be sold privately, which costs money and investors would might not want to invest due to the lack of hassle from buying into a Plc.
Reinvested Profits - This is the money that the business makes being re-invested into the business to aid its plans.
The advantage of this is capital can be raised by the company reinvesting or ploughing back the profits made at the end of the year, after expenses and dividends to shareholders have been paid.
The disadvantage of this is profits may be scare or non-existent, especially in times of recession.
Mortgage Loans - This is a loan where the lender insists on some asset of the business being tied to the repayment of the loan. In the event of bankruptcy or liquidation that lender will then have priority on the money from the sale of that asset for the repayment of the loan. The asset is always land or property.
The advantage of this is capital is often supplied by pension or insurance funds for a loan over 25 - 30 years for buildings or land, with the asset as security.
The disadvantage of this the loans are usually only given when large sums are required.
Venture Capital Loans - Venture capital is risk capital, usually in the forms of loan and shares as a package, to provide a significant investment in a medium or large business.
The advantages of this are capital is supplied by venture capital firms who accept a certain degree of risk being inevitable. Also most venture capitalists also provide help in the form of back up management and financial expertise. Also the governments Enterprise Investment Scheme offers incentives to private investors willing to invest in unquoted companies.
The disadvantages are that most venture capitalists are only interested in loans for more than Â£50000 and some only consider ventures where more than Â£250000 is involved, as the administration costs are not worthwhile on smaller projects. Also they charge a negotiation fee for arranging the finance and they generally expect a non - controlling equity stake of 20 - 40% in the firm's capital, as a return of their investment.
Debenture Loans - A debenture is a long-term loan, which does not have to be repaid until an agreed date. Debenture holders are entitled to a fixed rate of the return year and have priority over all the shareholders.
The advantage of this is that individuals can supply capital to a company in the form of a long-term loan called debentures, which have to be repaid on an agreed date. These payments take priority over payments to all other shareholders.
The disadvantage is that the company has to offer some security for the loan, which can be sold if the company cannot meet the payments. In the case of a fixed debenture this is a specific asset such as a building or land.
(Source - Advantages/Disadvantages - Understanding Industry by Ian MarcousÃÂ© pg 85-86, Definitions - Business Studies Pg 297 - 301 - Susan Hammond & A-Z Business Studies pg 148, 167 - David Lines, Ian MarcousÃÂ© & Barry Martin)
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