MODULE 3: SOURCES OF FUNDS

Finance has long been considered by Small and Medium Enterprises (SMEs) operators as an
important issue. Obtaining financial resources assistance in the amount required and when they
are needed can be more difficult for small scale entrepreneurial ventures than for established
organizations. The critical issue is to ensure that sufficient cash is available for current
operations and growth of the business. The owner must also ensure that money is available to
settle current liabilities when due; these may include inventory, rent, telephone bills,
office supplies etc. Other reasons for sourcing business finance include the following:

i. upgrading facilities to comply with stricter environmental regulations

ii. financing production in cases where there is significant lag between when
costs are incurred and when payments are received;
iii. purchasing of new equipment or facilities;
iv. purchasing of business vehicles; and
v. building up inventory in advance of a busy season.

Irrespective of the reason(s) for which funds are required, it is the sole responsibility of the
business owner to ensure that funding is obtained at the right time, at the right cost and from the
right source. Before raising the required funds, the business owner must estimate the actual
funds needed in order to avoid encountering unnecessary high cost of capital or excess capital.

SOURCES OF FUNDS FOR NEW AND ENTREPRENEURIAL VENTURES

There are several sources of finance for both new and old entrepreneurial ventures. These
sources are:
(i) Personal Savings
(ii) Borrowing from Friends and Relations
(iii) Trade Credit
(iv) Accrual Accounts
(v) Retained Earnings
(vi) Equity Financing
(vii) Bank Loans
(viii) Project Financing
(ix) Venture Capital
(x) Debt Financing
(xi) Commercial Draft
(xii) Banker’s Acceptance
(xiii) Bills Discounting
(xiv) Commercial Paper
(xv) Inventory Financing
(xvi) Bank Overdraft
(xvii) Loans from Corporative Societies
(xviii) Hire Purchase
(xix) Leasing
(xx) Factoring
(xxi) Microfinance Bank
(xxii) Public Offerings
(xxiii) Small Business Investment Organizations

(i) Personal Savings

Personal savings is the most common source of financing for small business enterprises. It has
to do with the personal money which the entrepreneur has been able to set aside for an intended
business venture. This includes cash and any personal assets convertible into cash or to business
use, for example, cash from family/friends which is an informal form of financing falls into this
category. This may also be from past savings, trust accounts or some other form of personal
equity of the business owner. This is the least expensive method of financing and also the
easiest as the decision to lend is made by the same persons wishing to borrow the fund.

(ii) Borrowing from Friends and Relations

Funds can be raised for entrepreneurial ventures through borrowing from friends and relations.
The amount to be raised through this source however, depends on the financial capabilities of
the friends and relations and the relationship that exists between the business owner and his
friends or relations. The repayment period and the interest payable are a function of the
terms of borrowing which are usually determined by the lender.

Trade Credit
Trade credit as a source of fund occurs when a buyer makes an arrangement with the seller to
buy goods on credit and pay later. However, this arrangement depends on the customer’s good
reputation and it often requires a pre-arrangement between the buyer and the seller. Trade
credit is one of the most widely used short term sources of funds and the term normally falls
within the range of thirty to ninety days which can still be extended after the expiration period,
depending on the relationship between the parties involved.

(iv)Accrual Accounts Accrual accounts can also be called account payable. It represents the
continually occurring current liability of a particular business. These include wages, interest,
taxes and other expenses that are payable in arrears. They are due but yet to be paid. Their
repayment period is usually within a period of one year.

(v) Retained Earnings

Funds can also be obtained through undistributed profits. A business owner may decide
to reinvest part of his or her profit back to business for efficient operations of the business. This
is also called plough-back profit and it shows the naira value of ownership rights that result
from the business retention of its past income. In business, retained earnings are usually
considered as an additional fund for financing the future growth of the business. Retained
earnings are helpful as a last resort in business finance. The inability of the business owners in
meeting up with the stringent conditions of the financial institutions usually makes the business
owner come to fall back to their business reserves for funds raising.

(vi) Equity Financing

Equity finance is a form of business finance in which funds borrowed to operate a business
venture are not taken as loan but converted to equity (stake in ownership) which now makes the
lender a part owner of the business venture, risk and profit are shared together. The amount of
equity finance in a particular business may be substantial subject to factors such as the nature of
the business, the total amount of capital required and the interest of the investor. The advantage
of equity financing is that its infusion of capital does not have to be repaid like a loan.
(vii) Bank Loan
A small business entrepreneur can approach bank for a loan. This is a common practice among
established small business enterprises with good reputation doing business with a particular
bank. Banks usually charge their borrowers a prime rate and an additional charge usually called
handling charge.The actual interest rate charged depends on the creditworthiness of the
customers. Banks usually charge a higher interest rate to borrowers whom they perceive as
having a higher risk of default. The bank interest rate also depends on the type of loan involved
whether is fixed or variable. If the loan is fixed rate loan, the interest rate will be the same for
the amount of money over the number of years involved. But if the loan is variable rate loan,
the interest payable will vary periodically over the terms of the loan subject to the fluctuation of
the market interest rates. Bank loan can be given either on short term or long term basis. Short
term bank loan usually covers between one month and less than one year, while long term bank
loan covers a period that is more than year one. Short term loans are used to replenish the
working capital account, such as purchase of inventory, supply of consumables in an
organization, finance of credit sales or taking of advantage of cash/bulk discounts etc. This is
repaid after converting inventory or receivables into cash. The relationship of the borrower
with the bank matters a lot. The reason for this is that banks are more likely to give loans to
business owners they know very well and whom they have their business and personal records.
The amount of money that banks are willing to give per time depends on the nature of
business, the size of business, the repayment period and the creditworthiness of the business
owner.

(viii) Project Financing

Project financing is the funding of a particular project by a financial institution. This can be a
source of funds only when the proceeds from the project are sufficient to repay the capital sum
usually known as the principal which is the amount of money borrowed for the execution of the
project with interest accrued. The project will be used as the security for such loan and the
advance is self–liquidating. In this case, the borrower‘s financial standing or position is less
important because the institution must ascertain the value of the project and ensure that the
value is high enough to settle the amount of money borrowed by the contractor.

(ix) Venture Capital

Venture capital is the money invested by individuals or venture capital firms in small and high
risk business enterprises. Venture capitalists are investors that invest in other people’s
businesses for the sole aim of profit. They receive equity participation i.e. the equity ownership
right of some proportion in the business enterprises they have invested their money in. They
participate substantially in the management of the enterprises in which they have invested,
holding board positions and working in close liaison with the enterprise’s management team.
The venture capital industry may consist of:

(a) wealthy individuals

(b) foreign investors
(c) private investment funds
(d) pension funds or
(e) major corporations.

(x) Debt Financing

These are funds that the business owner borrows and must repay with interest. Borrowed capital
maintains ownership of the business (unlike equity financing, which dilutes ownership) but is
carried as a liability on Balance Sheet. In general, small businesses are required to pay more
interest than large businesses because of perceived higher risks, that is, few percent above
prime rate. Entrepreneurs seeking debt capital can have access to a range of credit options
varying in Complexity, availability and flexibility, both from commercial and government
sponsored lenders.

(xi) Commercial Draft

Commercial draft is a short term financing source credit. It is an unconditional order in writing
made by one party. The drawer addressed to a second party, the drawee ordering the drawee to
pay a specified sum of money to a third party called the payee. Commercial draft may be a
sight or time draft. The type depends on the negotiation terms.

(xii) Banker’s Acceptance

This is credit facility that involves a bank and its customer. It is a time draft payable at a
stipulated date. It is an arrangement between the businessmen who produce goods for sale.
The businessman customer then draws the acceptance credit paper requiring his banker to
accept the responsibility of settling the bills pending when the goods will be sold. By placing its
acceptance on the bill (acceptance credit) the bank has accepted a contingent liability as well as
giving an indication that it will honour the bill upon presentation at maturity in case the
customer defaults. A discount house usually evaluates the creditworthiness and reputation of
the accepting bank. The maturity date is usually less than six months and it is mainly used in
international trade.
(xii) Bills Discounting
Bills discounting is a source of finance where the supplier of goods (creditor) writes a bill of
exchange for the customer for acceptance. Immediate cash may be obtained by the supplier for
his goods after the goods have been dispatched to the customer by discounting the bill with the
bank or discount house after the bill has been accepted by the debtor (customer). Other aspects
of bill discounting involves Government securities such as Treasury Bills and certificates which
can be surrendered before their maturity dates to banks or discount houses for purchase. The
amount paid to the bill owner is less than face value.

(xiii) Commercial Paper

This is an instrument of the money market (commercial Bank) that is usually used by many
organisations to raise short- term funds. Under this source of funds, an issuing house issues it
on behalf of a company. The issuing house only finds investors to buy the commercial paper,
the investors deal directly with the company issuing the note. The issuing house does not even
guarantee the note. The issuing house charges commission for the service through a coupon rate
which is usually stated on the commercial paper. The maturity date of a commercial paper
ranges between 90 and 180 days and it is usually written out to contain details such as the date
of issue, the maturity date, the amount per coupon, etc. The coupon rate and the issuing house
commission make up the cost of commercial paper.

(xiv) Bank Overdraft

Another financial facility is an overdraft facility, which banks give to its business clients. Bank
overdraft is an overdrawn bank current account and a short-term financial facility which
is renegotiated every year depending on the performance of the business. It may be secured or
unsecured depending on the amount of money involved. Bank overdraft is usually covered by
personal guarantee of SME owners and carries a higher interest rate than a normal loan. Often
this interest rate is higher than profit margin percentages, which makes it a very short-term loan
for covering cash flow problems rather than to finance acquisitions or buy stocks. Before banks
grant overdraft, the following factors are considered:
(i) The purpose for which the fund is required;
(ii) The character of the entrepreneur;
(iii) The management and financial position of the business;
(iv) The capacity of the business and
(v) Collateral security (this depends on the amount of money involved).
(xv) Inventory Financing

Inventory financing is the use of inventory or stocks as collateral security for borrowing of
und. The stocks are usually placed under the control of the lender pending when the loan will be
repaid. Note that not all stocks are qualified for such transaction. The marketability, durability
and the price stability of the stocks must be considered before such stocks will be used for
inventory financing.

(xvi) Borrowing from Cooperative Societies

A cooperative society is an association established by group of individuals who pooled their
resources together to engage in a business transaction for profit making but mainly for
the benefit of members. Depending on the financial capability of the cooperative society, it can
provide funds for its members to start business or finance their business transactions.
The amount that can be raised from cooperative society is subject to the financial commitment
of the membershe repayment period is not usually beyond two years since the fund is provided
on short-term sources of finance. The interest charged is also considerable low compared with
Commercial bank interest rates.

(xvii) Hire Purchase

Hire purchase is used when purchasing assets such as plant, equipment, machinery and
vehicles. An initial deposit may be required followed by a series of installment payment with an
attached interest. The interest rate is usually controlled by the prevailing bank rate (e.g. 4
percent above bank lending rate when regulated by government). Under hire purchase,
agreement periods can range between 1 to 3 years depending on life span of the asset. Hire
purchase is quick and easy to arrange, the security for agreement being the asset itself. Upon the
payment of the initial deposit, the customer enjoys immediate use of the asset. The asset legally
belongs to the owner of the asset and if the buyer defaults, the owner of the assets automatically
repossesses his or her asset.
(xviii) Leasing
A lease is an agreement whereby the owner-manager (lessee) undertakes to make
regular monthly payments to the financial institution (lessor) in return for the use of
equipment belonging legally to the latter.The leasing instrument is used by SMEs to finance
equipment (including vehicles) acquisitions. Operating leases function in such a way that
the leasing company retains ownership and risks associated with the equipment (although
insurance is mandatory). The lessor is therefore both the financier and the legal owner of the
equipment. When the tenure of the lease ends, the lessee can decide to elect to purchase the
equipment for a sum which must represent at 10% of the cost of the equipment. In lease
financing, the following points are important and worth noting by any entrepreneur that
wants to enter into lease agreement.
(i) Ownership of the asset does not rest with the business until the asset is sold
at residual value at end of contract.
(ii) Capital allowances may be claimed by leasing institution but not by the business.
(iii) Lease payments are tax deductible that is, passed as expenses in Profit and Loss.
(iv) Leasing does not normally affect borrowing capacity unless financial
legislation requires balance sheets to reflect leasing finance.
(v) Period of repayment matches expected life of asset.
(vi) Immediate use of asset.

(xix) Factoring
Factoring is a financing source that allows a business owner to raise fund based on the value of
his or her invoices yet to be paid. Under factoring arrangement, an entrepreneur can outsource
their sales ledger operations and maximize the use of sophisticated credit rating systems for
their funding. Factoring arrangement can be with or without recourse. It is with recourse if the
factor company collects the amount due from other means upon the default of the debtor and
without recourse, if the factor company bears the consequence upon default of the debtor.

In factoring arrangements, an agreed proportion of the invoice value (about 80%) will be paid
within a pre-arranged time of say 24 hours. In return, the factor issues receipt on behalf the
organization upon collection of the payments. One of the advantages of factoring is that the
business owner will receive the majority of the cash from debtors within 24 hours rather than a
longer time. It also reduces the time and money an organization can spend on debt collection
since the factor will usually run your sales ledger for the organization. On the other hand,
factoring may impose constraints on the way business is being conducted thereby discouraging
the customer for future business transactions with the customers.

(xx) Microfinance Banks

Microfinance bank was established in 2005 by the Central Bank of Nigeria according to the
provisions of Section 28, sub-section (1) (b) of the CBN Act 24 of 1991(as amended) and in
pursuance of the provisions of Sections 56-60(a) of the Banks and other Financial Institutions
Act (BOFIA) 25 of 1991. This was mainly to promote monetary stability and a sound financial
system in the country. The establishment of microfinance banks is meant to expand the
financial infrastructure of the country so as to meet the financial requirements of the Micro,
Small and Medium Enterprises (MSMEs).
Three features distinguish microfinance from other formal financial products. These are:
(i) the smallness of loans advanced and or savings collected,
(ii) the absence of asset-based collateral, and
(iii) simplicity of operations. The goals of microfinance banks include the following:
to provide diversified, affordable and dependable financial services to the active poor,
in a timely and competitive manner, that would enable them to undertake and develop
long-term, sustainable entrepreneurial activities;
(ii) to mobilize savings for intermediation;

(iii) to create employment opportunities and increase the productivity of the active poor in
the
country, thereby increasing their individual household income and uplifting their standard of
living; to enhance organized, systematic and focused participation of the poor in the socio-
economic development and resource allocation process; to provide veritable avenues for the
administration of the micro credit programmes of
government and high net worth individuals on a non-recourse case basis. In particular, this
policy
ensures that state governments shall dedicate an amount of not less than 1% of their annual
budgets for the on-lending activities of microfinance banks in favour of their residents.

(xxi) Public Offerings

Public offering is a financing option that is only available to companies that are well
established. Businesses with sustainable growth potentials in the course of expanding their
businesses might decide to use public offerings by ‘going public’ to raise required funds
for their business operations. However, before a company decides to use public offerings as
financing means, certain factors need to be considered. These factors include; the cost of the
security, other financial obligation of the business, the prospect of the money market, issues
concerning the ownership and control of the business. Public offering usually starts with
selling of equity holding to the public and this is called initial public offering (IPO) in which
stock is registered with the Securities and Exchange Commission (SEC). This is usually
offered to the public through a registered Brokerage firm or an investment Banker and this
gives the organization the opportunity to trade its shares in the floor of the stock exchange
market. To get firms’ shares quoted in the stock exchange market, the firm needs to make
provision for the associated expenses, filling requirements and other equity considerations.
Many Small and Medium Scale Enterprises consider these requirements as stringent conditions
and this affects their readiness to undertake IPO as a financing option. Public offerings usually
result in long term sources of funds which include the following:

(a) ordinary shares

(b) preference shares
(c) debentures

(a) Ordinary Shares: Ordinary shares represent the ownership position in an organization.
Ordinary shares holders are also called shareholders and the risk bearers of the firm. Their rate
of dividend is not fixed rather it depends on the discretion of the management. Ordinary shares
can be issued at par, discount or premium. The rights of shareholders include:

(i) right to participate in the annual general meeting and vote;

(ii) right to appoint a proxy;
(iii) right to have access to the organization’s books; and
(iv) right to contribute to the appointment of members of the board.

(b) Preference Shares: Preference shares as a long term source of funds are certificates of
ownership in organizations that usually have a fixed rate of dividends which must be paid
before ordinary share dividends. It is considered as a hybrid security because it has many
features of both ordinary shares and debentures. The types of preference shares include:
cumulative and non-cumulative preference shares, redeemable and non-redeemable
preference shares, participating and non-participating preference shares. The following features
make preference shares to be in the class of ordinary share
(i) the non-payment of dividends when the company is insolvent;
(ii) dividends are not deductible for tax purposes; and
(iii) some preference shares have no fixed maturity date.

On the other hand, the following features make preference share to be in the class of debenture:

(i) fixed rate of dividends;

(ii) preference shares do not share in the residual earning of the firm; and
(iii) preference shareholders have claims on the income and assets of the business before the
ordinary shareholders in the time of winding up.

(c) Debentures: Debentures are certificates of debts and they are long term sources of funds
that give the holders the opportunity to collect the principal amount at a fixed future date.
Debentures have definite interest rate which is payable at annual basis until the capital sum of
the amount borrowed is fully paid. They are issued in units of hundred and the interest rates
depend on the prevailing interest rate in the money market and financial condition of the firm.
The following are the features of debenture:
(i) debentures are negotiable instruments;
(ii) the interests on debenture are tax-deductible;
(iii) they have a fixed coupon rate;
(iv) debentures are redeemable at specific date;
(v) debenture holders do not participate in the control of the firm; and
(vi) debentures are secured either on floating or fixed assets.

(xxii) Small Business Investment Organizations. These can be government owned or private
owned with debts being government guaranteed. Small business investment organizations can
be regular or specialized, for example, giving loans only to agro-business or manufacturing
firms, business research, product research and development, business start-ups and
minority/vulnerable groups. Unlike traditional venture capital companies, they use private
funds or government funds to provide both for debt and equity financing to small businesses.
Examples of institutions under this category are – Small and Medium Industries Equity
Investment Scheme (SMIEIS), Central Bank of Nigeria (CBN, National Economic
Reconstruction Fund (NERFUND), National Bank for Commerce and Industry (NBCI), Small
Scale Industries Credit Scheme (SSICS).
INTERNAL AND EXTERNAL SOURCES OF FUNDS

Internal financing is the term for a firm using its profits as a source of capital for new
investment, rather than distributing them to firm's owners or other investors and obtaining
capital elsewhere while external financing consists of new money from outside of the firm
brought in for investment. External financing is the phrase used to describe funds that firms
obtain from outside of the firm. It is contrasted to internal financing which consists mainly of
profits retained by the firm for investment. There are many kinds of external financing. The two
main ones are equity issue which is also considered as external financing are accounts payable,
and taxes owed to the government. External financing is generally thought to be more
expensive than internal financing, because the firm often has to pay a transaction cost to obtain
it. Internal financing is generally thought to be less expensive for the firm than external
financing because the firm does not have to incur transaction costs to obtain it, nor does it have
to pay the taxes associated with paying dividends.
Advantages and Disadvantages of internal financing

Advantages of internal sources of finance include the following:

i. capital is immediately available;

ii there is no interest payable on such fund;
iii. there is no control procedures regarding the credit worthiness of the owners; and
iv there is no third party’s influence.

Disadvantages of internally sourced funds

i. It is somehow expensive.
ii. It does not easily increase capital.
iii. It is not as flexible as external financing.
iv. It is not tax-deductible.
v. It is limited in volume because it is subject to the capability of the owner(s) to raise fund
internally.

FORMAL AND INFORMAL SOURCES OF FUNDS

Formal sources of funds represent those institutions that are registered with appropriate
authorities to transact the business of finance with entrepreneurs. Examples of formal sources
of funds include loans from commercial banks, insurance company etc. Formal financial
services are usually provided by financial institutions that are controlled by the government and
subject to banking regulations and supervision. On the other hand, informal sources of funds
are provided outside the structure of government regulations and supervision. Examples of
informal sources of funds include those groups or individuals that are involved in loan
disbursement with little or no formal regulations e.g. Esusu, thrift savings scheme, cooperative
society etc.

Advantages of formal sources of finance

(i) Provides proper guidelines and documentation for loans.
(ii) Business advisory support from the banks that is lending.
(iii) Helps the entrepreneur to stay focused on the business because of interest rates.

Advantages of informal sources of finance

(i) It helps entrepreneurs to have easy access to funding.
(ii) Less documentation is involved in loan process.
(iii) Entrepreneurs do not stand the risk of loss of assets or business to the institution.