Finance plays a critical role in every organization or institution. It serves as the means by which economic decisions are made and enables organizations to run operations successfully. Therefore, the financing decisions of a firm affect their short term and long term success. This chapter explores the objectives of making financial decisions, the criteria used to choose sources of finance, methods of raising finance, and evaluation of such methods to enhance effective financing decisions.
2.1. Objective of Financing Decisions
Financing decision is concerned with the methods of acquiring funds to support various business operations and investments. Financing decision is one of the four functions of finance, which we explored briefly in chapter 1. The other three functions are: working capital decisions, investment decisions, and dividend decisions. Finance managers have the role to decide when, where, and how to acquire business funds – whether through the bank or through shareholders. It is important for the company to maintain a good ratio of equity and debt in their capital structure.
Financing decision often comes from two sources of funds: internal sources which include share capital and retained earnings (from profits); while external sources include borrowings from outside providers such as loans, bonds, debentures, and venture capital.
A firm tends to benefit most when the market value of a company’s share maximizes this not only is a sign of growth for the firm but also maximizes shareholders wealth. On the other hand the use of debt affects the risk and return of a shareholder. It is more risky though it may increase the return on equity funds.
A sound financial structure is said to be one which aims at maximizing shareholders return with minimum risk. In such a scenario the market value of the firm will maximize and hence an optimum capital structure would be achieved.
In summary, the objective of the financing decision is to achieve a balance between debt and equity, which leads to an optimum capital structure. An optimal capital structure occurs when company gets the best mix of debt and equity to maximize the value of the firm and minimize its cost of capital. So, financial managers require sound financing decisions to achieve the following objectives:
- Profit maximization
- Cost minimization and risk reduction
- Maximizing value of the firm
- Long term growth of the firm
- Smooth operations for the business
- Ensuring liquidity and effective cash flow
- Proper asset management and efficient utilization of resources
- Adequate access to capital and funding
2.2. Criteria Used to Choose Sources of Finance
When making its financing decisions, a company considers various factors that determine their choices in terms of sources of finance. Firms have to make a choice between internal and external sources, debt and equity, and/or where to get the funding. To make such decisions, financial managers should be aware of their current financing needs, financial position, availability of funds, cost of financing, leverage position, business risks, security, duration of loan if any, and other factors.
The criteria used can also be defined as the factors to consider when choosing the source of finance. The following factors or criteria must be considered before choosing the best source of finance to use:
- The Amount Required/Capital Requirement: Before choosing a source of finance, the company should first assess its financial requirements to determine the amount of funding required. Some funding sources require a large amount of money to be raised. For instance, share capital is appropriate when raising a large amount of capital. Debentures and venture capital are other sources of finance that are suitable for raising large amounts of capital to meet long term investment needs. On the other hand, short term loans and bank overdrafts are used for small capital requirements, especially when funding working capital or raising money for daily business operations.
- Purpose/Type of Expenditure: Financing decisions are affected by the type of expenditure of the organization. Finance managers should consider the type of expenditure or the purpose for which the funds are raised. Long term sources of finance are better suited to finance capital expenditure projects for example building a new textile factory. On the other hand, Short term sources of finance are more suited to finance operations such as paying suppliers.
- Time/Duration: The matching accounting principle states that assets and liabilities should be matched based on the maturity period of assets. When a company decides to raise funds, they must consider the timelines involved or duration of the funding. For instance, the company can decide to borrow a bank loan that has a duration of 10 years to finance a long term investment project. It is not prudent to borrow a long term debt to acquire an asset that has a short maturity period.
- Cost: The cost of capital is also an important criteria or factor to be considered when choosing an appropriate source of finance. The cost of capital becomes a factor in deciding which financing track to follow: debt, equity, or a combination of the two. For example, the cost of accessing long term loan is the interest charged by the bank. There are also transaction costs and time involved in acquiring the loan. Another cost is the collateral required by the before acquiring a loan. A company that is in its early stage may not have enough assets to be used as collateral for loans, which means that they will choose equity and/or other alternative sources of finance.
- Risk: Every investment involves risks. A company risks losing money and not being able to pay back debts, which calls for equity as an alternative source of capital. Even so, equity capital has its own risks involved such as market risks and loss of share value, which reduces the company’s returns in the long run.
- Control: When a company acquires funds from an external source, it is bound to lose control of some business operations or management. The firm may lose more control in one source of finance than another. For instance, the company loses control of its business and when equity capital and venture capital are involved. However, the company retains much control of its operations when using debt capital. Companies must decide how much control they are willing to lose in order to acquire the right amount of capital.
2.3. 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 acquiring funds 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
Pros and Cons of Venture Capital
The advantages of venture capital are:
- Venture capitalists provide start-up businesses with valuable information, guidance, consultation and advice on various aspects of the business. This can help in improving business outcomes and decisions, including in human resources and financial management.
- They provide additional resources and support on areas such as legal, tax, and personnel.
- Networking and business connections – venture capitalists are resourceful networks for companies because they are often connected in the business community; so they can even be an important source of knowledge, information, technology, and connection with customers in the community.
- Limited liability – business owners are not liable for any losses or liabilities incurred in the business; so they are not liable to refund venture capitalists if the business results are not achieved as planned.
The disadvantages of using venture capital may include:
- Loss of control: the business owner or entrepreneur loses control of the company because venture capitalists demand rights in the company before providing the required funds.
- Expensive: The services and processes leading up to the provision of venture capital are quite costly. Those services may include negotiations in the presence of an attorney as well as due diligence and documentations.
- Loss of Ownership: venture capitalists may demand too much ownership during negotiations, leading to the owner’s loss of majority control. In fact, the start-up founder or founders may become minority owners with less than 50% of ownership.
Finance managers ask the following questions before making the decision to acquire finance through venture capital:
- Are you open to more active input from a venture capital firm?
- Do you appreciate the additional expertise and resources a VC firm could provide?
- Is loss of ownership and control an issue for you?
- Could you gain through a VC firm’s business connections?
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?
Types of shares
There are different types of shares or stock that a company can issue to raise funds. The three major types of shares are ordinary shares, preference shares, and deferred shares.
1. Preference shares
Also known as preferred stock, this is a type of shares which enables the shareholder to receive a fixed rate of dividend. They are the first in line to be paid dividends before any amount is paid to ordinary shareholders. When the company goes bankrupt, preference shareholders are paid first before common stockholders. However, preference shares do not have voting rights like ordinary shares, which means that preferred stockholders do not vote on issues in the company such as election of CEO. Preference shares are in two types: cumulative and non-cumulative preference shares.
- Cumulative preference shares allow shareholders to receive their current dividends from next year’s profits if this year’s profits are not sufficient to pay dividends.
- Non-cumulative preference shares are those that do not allow shareholders to get dividends from next year’s profits even if there is little profit to pay dividends in the current year.
2. Ordinary shares:
These are shares that receive dividends only after the fixed dividends on preference shares have been paid. Ordinary shareholders have no limit on dividends; they can earn higher dividends if profits are large. This type of shares does not give stockholders any dividend if the company experiences a loss or bankruptcy.
3. Deferred Shares:
These shares come last in the order of dividend payment. They only receive their dividends after all other classes of shares have received theirs. Generally these shares are issued to the promoters and to the persons who have helped in the formation of the company.
Pros and Cons of Shares
There are several and advantages and disadvantages of shares as a source of finance. Some of the advantages of using shares as a method of financing include:
- No repayment required. Unlike bank loans and debts which must be repaid in full with some interest on top, a company does not need to repay shares since they are only bought and sold in the stock market. The company may decide to distribute some portion of its profits as dividends to shareholders, but it is not mandatory to do so if the business is not doing well. This creates flexibility for a company to invest its profits on promising projects.
- Lower Risk: Shares involve little risk on the part of the company issuing them. Corporations that use more equity than debt in their capital structure have a lower risk of bankruptcy. Investors are not able to force a company into bankruptcy for failing to pay dividends, but creditors will go for the company’s assets if it is not able to pay its debts.
- Equity Partners: Shares allows a company to bring in equity partners who have interest in the success of the company. These partners could have a great deal of knowledge, connections, and expertise that could benefit the business. Equity partners can also pull more resources into the company for future growth.
Some of the disadvantages associated with the use of shares as a source of capital include the following:
- Dilution of ownership: one of the major disadvantages shares as a method of acquiring capital is that the owner loses control of their company. Shareholders are considered as owners of the company with the right to vote on major decisions of the organization. With every share of stock you sell to investors, you dilute, or reduce, your ownership stake in your small business. So let’s say for example that the original owners of Safaricom lost some control of the company when they issued shares in 2008 at the Nairobi Stock Exchange. If a business owner sells all shares of the firm, it is like selling the entire company.
- High Cost: shares also come at a high cost. This disadvantage emerges from the fact that the company has to pay its shareholders with a high rate of return in order to continue selling shares. Shares tend to lose value and sell at a low price when the company is not performing well.
- Time and Effort: Another great disadvantage of shares is that it takes time and effort to get investors who are willing to buy shares. It typically takes the right connections and a powerful pitch deck to get the equity you need.
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.
Advantages of Debentures
There are certain advantages of issuing debentures:
- Because of the fixed interest on debentures, companies with stable income can secure higher returns on equity capital by trading on equity.
- The rate of interest is usually lower than the expected rate of return on share capital. This is because debenture holders do not bear any risk.
- Debentures do not carry any voting right. Hence management by promoters or existing directors remains unaffected.
Disadvantages of Debentures
- If the earnings of the company are uncertain or unpredictable, issue of debentures may pose serious problems for the company due to the fixed obligation to pay interest and repay the principle
- The company is liable to pay interest even if there is no profit
- If there is default in payment of interest or repayment of the principle, assets can be attached by order of the court
- Trading companies which generally do not have large fixed assets cannot provide adequate security for issue of debentures.
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.
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.
Advantages and Disadvantages of Loans
As a source of capital, loans have certain advantages and disadvantages.
The advantages/cons of loans as a method of financing include the following:
- Keeping control of the company. Unlike shares which give more control and ownership of the organization to shareholders, loans allow the owner(s) to utilize its funds as they wish and still retain control of the company. The bank assesses the creditworthiness and ability of the firm to service the loan, but they do not take ownership or have any interest in the company.
- Temporary Relationship: The firm has a temporary with the bank as a result of taking a loan. The borrower and the lender only engage for as long as the term of the loan is still payable. Once the loan is paid in full, the company ceases making payments to the bank. This is contrary to equity or shares where the company continues to pay dividends to shareholders for as long as the business exists.
- Interest is Tax Deductible: Interest on a loan is deductible for tax purposes. Fixed-rate loans are specifically known for not changing in terms of interest throughout the lifetime of the loan. These benefits reduce costs and make it easy for a company to plan for its finances effectively.
- Advisory Services: Some financial institutions provide advisory services to the business or individual taking a loan.
- Easy Planning: As the repayment of interest and the principal amount is prefixed, one could easily plan their expenses and funds accordingly.
There are also several disadvantages of using loans as a source of capital:
- Difficult process: Perhaps the biggest problem with a bank loan, especially the long-term ones, is that it is difficult and takes time to get loan approval if the business does not have a historical business relationship with the bank. There are procedures and requirements that the company must fulfil before getting a loan. Lenders are careful to lend money to only firms that can repay to minimize defaults.
- High Interest Rate: Another disadvantage of a bank loan is that it carries high interest, which must be paid by the company in addition to the principal amount. This adds financial costs and expenses to the company’s books, leading to reduced profit margins. However, the borrowed funds can generate more returns if they are utilized well.
- Loss of Assets: In extreme cases, the company may have to sell its assets to repay the loan and honor the agreement with the bank. If the business fails, the bank will take possession of the company’s assets.
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.
Types of Leases
There are two types of leases, which are based on how risks and rewards are shared between the lessee and the lessor, the lease period, and number of parties involved.
- Finance Lease: a financial lease is a type of lease in which the lessor transfers all the risks and rewards to the lessee in exchange for lease rentals. This puts the lessee in the same condition as he would have been if he or she had bought the asset. This type of lease non-cancellable until a certain period when the lessor has recovered all his investments.
- Operating Lease: on the other hand, an operating lease is a type of lease in which the lessor does not transfer all rewards and risks to the lessee, which means that the lessee does not take full ownership of the asset. An operating lease lasts for a term that is much less than the economic life of the asset. The lessor does not recover all his investments during this primary period.
Features of a Financial Lease
Based on the above description of a financial lease, the following features can be derived:
- A finance lease is a device that gives the lessee a right to use an asset.
- The lease rental charged by the lessor during the primary period of lease is sufficient to recover his/her investment.
- The lease rental for the secondary period is much smaller. This is often known as peppercorn rental.
- Lessee is responsible for the maintenance of asset.
- No asset-based risk and rewards is taken by lessor.
- Such type of lease is non-cancellable; the investment of the lessor is assured.
Features of an Operating Lease
The features of an operating lease are listed below:
- The lease term is much lower than the economic life of the asset
- The lessee has the right to terminate the lease through a short notice and no penalty is charged for that
- The lessor provides technical knowhow of the leased asset to the lessee.
- Risks and rewards incidental to the ownership of the asset are borne by the lessor.
- Lessor has to depend on leasing of an asset to different lessee for recovery of his/or her investment.
Advantages and Disadvantages of Lease Financing
Lease financing is increasingly becoming a popular way of acquiring assets. It is a cost-effective financing option for any firm that wants to acquire the use of assets at a lower cost. This method of financing has several advantages and disadvantages.
To the lessor, the lease financing:
- Has an assured regular income – the lessor gets lease rentals for the entire period of the lease, which is assured and regular income.
- Preservation of Ownership: the lessor retains ownership of the asset, especially for a finance lease which involves the transfer of risk and rewards without the transfer of ownership to the lessee.
- Tax Benefits: The tax benefit associated with the depreciation of the leased asset remains with the lessor.
- High Profitability: The rate of return from a lease is higher than interest payable on financing the asset; hence leasing is a highly profitable business.
- Potential for Growth: the lessor has a high potential for growth due to the rising demand for leasing as a cost efficient method of financing.
- Full Recovery of Investment: through a finance lease, the lessor can recover all investments on the leased asset through lease rental.
To the Lessee, the following benefits of a lease can be identified:
- Use of capital goods: The lessee gets the chance to use an asset and pay small regular rentals.
- Tax Benefits: the lessee also enjoys a tax advantage because lease rentals are often deducted as business expenses.
- Cheap: Leasing is a cheaper or less expensive source of financing; cheaper than other sources of financing.
- Technical Assistance: for an operating lease, the lessee can get technical assistance from the lessor in respect to the leased asset.
- Inflation Friendly: The lessee pays fixed amounts of lease rentals even if inflation rises.
- Ownership: the lessee may purchase the leased asset at the end of the lease period and take full ownership of the asset.
Disadvantages of Lease Financing
Disadvantages to the Lessor:
- Less profits in case of inflation – the lessor gets constant amounts even when inflation rises
- Double Taxation: sales tax on the leased asset may occur twice – at the time of purchase and the time of leasing.
- Chance of Damage: the asset may be damaged while it is still being used by the lessee during the lease period.
Disadvantages to the Lessee:
- Compulsory payments: the lessee is required to make regular payments of lease rentals even when the asset is not in use.
- Ownership: the lessee does not usually take ownership of the asset at the end of lease agreement unless they purchase it.
- Costly: leasing can be costly to the lessee because it involves the payment of lease rentals and other expenses incidental to the ownership of the asset.
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%.
Summary Table: Types and Methods of Raising Finance
|Long-term Capital||Medium-Term Capital||Short-term Capital|
|Equity Shares||Bank Loans||Factoring|
|Preference Shares||Public Deposits||Trade Credit|
|Debentures||Discounting Bills of Exchange|
|Retained Earnings||Bank Overdraft|
2.4. Choice of Preferred Financial Mix
Financial mix often consists of two important sources of finance: equity and debt. Most companies use bank loans, bonds and debentures as part of their debt capital. On the other hand, equity can be raised through preference shares, venture capital, and private equity funds.
When choosing the right balance between debt and equity, one must consider the risks and benefits involved in each option. Debt is appropriate when the company does not want its ownership to be diluted. Using debt as a method of raising finance also has tax advantages to the business. However, it may lead to bankruptcy if the business does not honour its debt obligations. Equity has less risk of bankruptcy because the company does not need to repay it.
To maximize the value of your business, you should try to find a financial mix that minimizes both the cost of capital and the risk of bankruptcy. Your capital structure can quickly be evaluated by calculating your debt-to-equity ratio. This ratio refers to the proportion of debt in the company’s capital structure as compared to the proportion of equity.
The degree of stability in your business, its ability to provide suitable collateral as security, the interest rate you are charged as well as legal or contractual restrictions on debt are all factors that will influence your optimal debt-to-equity ratio.
For example, a company operating in an unpredictable business environment where a future downturn could impact its ability to repay lenders should have a low debt-to-equity ratio.
Conversely, a company with long-term capital assets, such as buildings or equipment, and predictable cash flows can be more highly leveraged.
The optimal debt-to-equity ratio may vary from one industry to another, but the general consensus is that it should not be above a level of 2.0. This means that debt contributes two-thirds of the company’s financial mix. It also means that the proportion of debt in the capital financing mix of the company is twice that of equity. Most managers suggest that debt should not be more than twice the amount of equity.
While some very large companies in fixed asset-heavy industries (such as mining or manufacturing) may have ratios higher than 2, these are the exception rather than the rule. The less the value of the debt-equity-ratio, the better for the company. It is important to have more equity in the capital structure, but too much of it also dilutes the company’s ownership.