CHAPTER 6

BUSINESS FINANCING
Financial Requirements

All businesses need money to finance a host of different requirements.

1)Permanent Capital
• It is used to finance the start - up costs of an enterprise, or major
developments and expansions in its life - cycle.
• investment in equity is rewarded by dividends from profits, or a
capital gain when shares are sold.
Equity capital usually provides a stake in the ownership of the

business, and therefore the investor accepts some element of risk in

that returns are not automatic, but only made when the small firm has
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2. Working Capital
• It is short-term finance. Most small firms need working capital to bridge the gap

between when they get paid, and when they have to pay their suppliers and their

overhead costs.
• Although short-term finance is normally used to fund the trading of a business, it is

also sometimes needed to purchase assets, which are short-lived such as company

vehicles, which may be changed every 4 or 5 years.

3. Asset Finance
• It is medium to long term finance. The purchase of tangible assets is usually

financed on a longer-term basis, from 3 to 10 years, or more depending on the

useful life of the asset.

• Plant, machinery, equipment, fixtures, and fittings, company vehicles and buildings

may all be financed by medium or long-term loans from a variety of lending bodies.
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 Sources of Financing
Internal Sources (Equity capital)
• Owner’s capital or owner’s equity represents the personal investment of
the owner(s) in a business and it is sometimes called risk capital
because these investors assume the primary risk of losing their funds if
the business fails.
Sources of Equity Capital
1. Personal saving: The first place entrepreneurs should take for startup
money is in their own pockets. As a general rule, entrepreneurs should
provide at least half of the start- up funds in the form of equity capital.
2. Friends and relatives: After emptying their own pockets,
entrepreneurs should turn to friends and relatives who might be
willing to invest in the business. The entrepreneur is expected to
describe the opportunities and threats of the business. 3
3. Partners: An entrepreneur can choose to take on a partner to

expand the capital formation of the proposed business.

4. Public stock sale (going public): In some case, entrepreneurs can

go public by selling share of stock in their corporation to outsiders.

This is an effective method of raising large amounts of capital.

5. Angels: These are private investors (or angles) who are wealthy

individuals, often entrepreneurs, who invest in the startup business

in exchange for equity stake in these businesses.

6. Venture capital companies: Are private, for profit organizations

that purchase equity positions in young business expecting high

return and high growth potential opportunity. 4

External Sources (Debt capital)

• Borrowed capital or debt capital is the external financing that small business

owner has borrowed and must repay with interest. There are different

sources as discussed here below:

I) Commercial banks: Commercial banks are by far the most frequently used

source for short term debt by the entrepreneur. To secure a bank loan, an

entrepreneur typically will have to answer a number of questions, together with

descriptive commentaries.

 What do you plan to do with the money?

 When do you need it?

 How much do you need?

 For how long do you need it?

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Bank Lending Decision
Most bankers refer to the five C’s of credit in making lending decision.
Capital: You must have a stable capital base before a bank will grant a loan
Capacity: The bank must be convinced of the firm’s ability to meet its regular
financial obligations and to repay the bank loan.
Collateral: The collateral includes any assets the owner pledges to the bank as
security for repayment of the loan.
Character: Before approving a loan to a small business, the banker must be
satisfied with the owner’s character. The evaluation of character frequently is
based on intangible factors such as honesty, competence, willingness to negotiate
with the bank.
Conditions: The conditions surrounding a loan request also affect the owner’s
chance of receiving funds. Banks consider the factors relating to the business
operation such as potential growth in the market, competition, location, and loan
purpose. 6
II) Micro Finances: provide financial services mainly to the poor.

III) Trade Credit: It is credit given by suppliers who sell goods on account. This credit is

reflected on the entrepreneur’s balance sheet as account payable and in most cases it must

be paid in 30 to 90 or more days.

IV) Equipment Suppliers: Most equipment vendors encourage business owners to

purchase their equipment by offering to finance the purchase.

V) Account receivable financing: It is a short term financing that involves either the

pledge of receivables as collateral for a loan.

VI) Credit unions: Credit unions are non-profit cooperatives that promote savings and

provide credit to their members. But credit unions do not make loans to just any one; to

qualify for a loan an entrepreneur must be a member.

VII) Bonds: A bond is a long term contract in which the issuer, who is the borrower, agrees

to make principal and interest payments on specific date to the holder of the bond.

VIII) Traditional Sources of Finance: “Idir”, “equib”

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 Lease Financing
• 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 against periodical payments.
• The owner of the asset is known as lessor and the user is called
lessee.
• The periodical payment made by the lessee to the lessor is known
as lease rental.
• Under lease financing, lessee is given the right to use the asset but
the ownership lies with the lessor and at the end of the lease
contract, the asset is returned to the lessor or an option is given to
the lessee either to purchase the asset or to renew the lease
agreement. 8
Types of Lease

Depending upon the transfer of risk and rewards to the lessee, the period of lease

and the number of parties to the transaction, lease financing can be classified into

two categories. Finance lease and operating lease.

1. Finance Lease

It is the lease where the lessor transfers substantially all the risks and rewards of

ownership of assets to the lessee for lease rentals. Finance lease has two phases:

The first one is called primary period. This is non-cancellable period and in this

period, the lessor recovers his total investment through lease rental. The primary

period may last for indefinite period of time.

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The following are features of finance lease:

• 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.

• Lessee is responsible for the maintenance of asset.

• No asset-based risk and rewards are taken by lessor.

• Such type of lease is non-cancellable; the lessor’s

investment is assured.
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2. Operating Lease
• Lease other than finance lease is called operating lease. Here risks and rewards
incidental to the ownership of asset are not transferred by the lessor to the lessee.
• The term of such lease is much less than the economic life of the asset and thus the total
investment of the lessor is not recovered through lease rental during the primary period
of lease.
• In case of operating lease, the lessor usually provides advice to the lessee for repair,
maintenance and technical knowhow of the leased asset and that is why this type of
lease is also known as service lease.
Operating lease has the following features:
• The lease term is much lower than the economic life of the asset.
• The lessee has the right to terminate the lease by giving a short notice and no penalty is
charged for that.
• The lessor provides the technical knowhow of the leased asset to the lessee.
• Risks and rewards incidental to the ownership of asset are borne by the lessor.
• Lessor has to depend on leasing of an asset to different lessee for recovery of his/her
investment. 11
 Crowd Funding
• Crowd funding is a method of raising capital through the collective effort of
friends, family, customers, and individual investors or even from the general
public.
• This approach taps into the collective efforts of a large pool of individuals
primarily online via social media and crowd funding platforms and leverages
their networks for greater reach and exposure.
• Traditionally, if you want to raise capital to start a business or launch a new
product, you would need to pack up your business plan, market research, and
prototypes, and then shop your idea around to a limited pool or wealthy
individuals or institutions.
• With crowd funding, it’s much easier for you to get your opportunity in front of
more interested parties and give them more ways to help grow your business,
from investing thousands in exchange for equity.
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Types of Crowd Funding
The 3 primary types are donation-based, rewards-based, and equity crow funding.

Donation-Based Crowd Funding: Broadly speaking, you can think of any crowd funding

campaign in which there is no financial return to the investors or contributors as donation-

based crowd funding. Common donation based crowd funding initiatives include fund

raising for disaster relief, charities, nonprofits, and medical bills.

Rewards-Based Crowd Funding: involves individuals contributing to your business in

exchange for a “reward,” typically a form of the product or service your company offers.

Even though this method offers backers a reward, it’s still generally considered a subset of

donation-based crowd funding since there is no financial or equity return.

Equity-Based Crowd Funding: Unlike the donation-based and rewards-based methods,

equity-based crowd funding allows contributors to become part-owners of your company

by trading capital for equity shares. As equity owners, your contributors receive a financial

return on their investment and ultimately receive a share of the profits in the form of a

dividend or distribution. 13