CHAPTER
SIX
BUSINESS
FINANCING
6.1 INTRODUCTION
Sourcing money may be done for a variety of reasons.
Traditional areas of need may be for capital asset acquisition- new
machinery or the construction of a new building.
The development of new products can be costly but capital may be
required. Such developments are financed internally, whereas capital for
the acquisition of machinery may come from external sources.
In this day and age of light liquidity, many organizations have to look for
short term capital in the way of loans, working capital etc., in order to
provide a cash flow cushion
6.2 Financial Requirements
All businesses need money to finance a host of different
requirements. In looking at the types and adequacy of funds available, it
is important to match the use of the funds with appropriate funding
methods.
1. Permanent Capital
The permanent capital base of a small firm usually comes from equity
(the value of a company’s shares/shares of a company) investment
in shares in a limited company or share company, or personal loans to
form partners or to invest in sole proprietorship.
It is used to finance the start - up costs of an enterprise, or major
developments and expansions in its life - cycle. It may be required
for a significant innovation, such as a new product development.
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.
6.3 Sources of Financing
6.3.1 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. However, if the venture
succeeds, they also share in the benefit.
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. 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.
They provide start -up capital, development funds or expansion
funds.
Comparison of Angles and Venture Capitalist
Angels Venture Capitalists (VCs)
• Individuals who wish to assist • Finance, small scale new
others in their business venture, technology and any risky idea.
• Usually found through networks, • Funds are more specialized
• Reasonable expectations on versus homogeneous
equity position and ROI, • High expectations of equity
• Often passive, but realistic position and ROI,
perspective about business
venture,
Exit strategy is important,
6.3.2 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 :
I) Commercial Banks: Commercial banks are by far the most frequently used
source for short term debt by the entrepreneur.
In most cases, commercial banks give short term loans (repayable within one
year or less) and medium term loan (maturing in above one year but less than
five years), long term loans (maturing in more than five years).
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?
☞How will you repay the loan?
Bank Lending Decision:-The small business owner needs to be aware
of the criteria bankers use in evaluating the credit worthiness of loan
applications. Most bankers refer to the five C’s of credit in making
lending decision. The five C’s are capital, capacity, collateral, character,
and conditions.
1. Capital: A small business must have a stable capital base before a
bank will grant a loan.
2. Capacity: The bank must be convinced of the firm’s ability to meet its
regular financial obligations and to repay the bank loan.
3. Collateral: The collateral includes any assets the owner pledges to
the bank as security for repayment of the loan.
4. 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.
5. 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. Another important
condition influencing the banker’s decision is the shape of the overall
economy including interest rate levels, inflation rate, and demand for
money.
The higher a small business scores on these five Cs, the greater its
chance will be of receiving a loan. In the Ethiopian context,
collateral is very critical.
II) Micro Finances: provide financial services mainly to
the poor ,micro and small enterprises(detail to be
discussed later in part 6.7)
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. Bonds have
always been a popular source of debt financing for large
companies in the western world.
VIII) Traditional Sources of Finance: “Idir”, “equib”.
6.4 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.
6.4.1 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.
i. Finance lease, and
ii. 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.
In other words, it puts the lessee in the same condition as he/she would
have been if he/she had purchased the asset.
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. The lease rental for the secondary
period is much smaller than that of primary period.
Following features can be derived for 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.
• 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 are taken by
lessor.
• Such type of lease is non-cancellable; the lessor’s
investment is assured.
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.
Advantages and Disadvantages of Lease Financing
At present leasing activity shows an increasing trend. Leasing appears
to be a cost-effective alternative for using an asset. However, it has
certain advantages as well as disadvantages.
The advantages of lease financing from the point of view of lessor are
summarized below:
☞Assured Regular Income: Lessor gets lease rental by leasing an
asset during the period of lease which is an assured and regular
income.
☞Preservation of Ownership: In case of finance lease, the lessor
transfers all the risk and rewards incidental to ownership to the lessee
without the transfer of ownership of asset. Hence the ownership lies
with the lessor.
☞Benefit of Tax: As ownership lies with the lessor, tax benefit is
enjoyed by the lessor by way of depreciation in respect of leased asset.
☞High Profitability: The business of leasing is highly profitable since
the rate of return based on lease rental, is much higher than the
interest payable on financing the asset.
☞High Potentiality of Growth: The demand for leasing is steadily
increasing because it is one of the cost efficient forms of financing. Economic
growth can be maintained even during the period of depression. Thus, the
growth potentiality of leasing is much higher as compared to other forms of
business.
☞Recovery of Investment: In case of finance lease, the lessor can recover
the total investment through lease rentals.
Lessor suffers from certain limitations which are discussed below:
Unprofitable in Case of Inflation: Lessor gets fixed amount of lease rental
every year and they cannot increase this even if the cost of asset goes up.
Double Taxation: Sales tax may be charged twice. First at the time of
purchase of asset and second at the time of leasing the asset.
Greater Chance of Damage of Asset: As ownership is not transferred, the
lessee uses the asset carelessly and there is a great chance that asset
cannot be useable after the expiry of primary period of lease.
Reading Assignment (Page 143 -
145)
6.5 Traditional Financing in
Ethiopian (Equib/Edir, Etc.)
6.6 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.
6.6.1 How is Crowd Funding Different?
Crowd funding is essentially the opposite of the mainstream approach
to business finance. 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.
These funding sources included banks, angel investors, and venture
capital firms, really limiting your options to a few key players.
6.6.2 The Benefits of Crowd funding
From tapping into a wider investor pool to enjoying more flexible fund
raising options, there are a number of benefits to crowd funding over
traditional methods. Here are just a few of the many possible
advantages:
Reach: By using a crowd funding platform like Fundable, you have
access to thousands of accredited investors who can see, interact with,
and share your fund raising campaign.
Presentation: By creating a crowd funding campaign, you go through
the invaluable process of looking at your business from the top level its
history, traction, offerings, addressable market, value proposition, and
more and boiling it down into a polished, easily digestible package.
PR & Marketing: From launch to close, you can share and promote
your campaign through social media, email newsletters, and other online
marketing tactics. As you and other media outlets cover the progress of
your fund raise, you can double down by steering traffic to your website
and other company resources.
Validation of Concept: Presenting your concept or business to the
masses affords an excellent opportunity to validate and refine your
offering. As potential investors begin to express interest and ask
questions, you’ll quickly see if there’s something missing that would
make them more likely to buy in.
Efficiency: One of the best things about online crowd funding is its
ability to centralize and streamline your fund raising efforts. By building a
single, comprehensive profile to which you can funnel all your prospects
and potential investors, you eliminate the need to pursue each of them
individually. So instead of duplicating efforts by printing documents,
compiling binders, and manually updating each one when there’s an
update, you can present everything online in a much more accessible
format, leaving you with more time to run your business instead of
fundraising.
6.6.3 Types of Crowd Funding
Just like there are many different kinds of capital round raises for
businesses in all stages of growth, there are a variety of crowd funding
types. Which crowd funding method you select depends on the type of
product or service you offer and your goals for growth.
The 3 primary types are donation-based, rewards-based, and equity
crow funding.
i. 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.
ii. Rewards-Based Crowd Funding
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.
iii. 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.
6.7 Micro Finances
6.7.1 What is Micro Finance?
Microfinance is a term used to describe financial services, such as
loans, savings, insurance and fund transfers to entrepreneurs, small
businesses and individuals who lack access to banking services with
high collateral requirements.
Essentially, it is providing loans, credit, access to savings accounts –
even insurance policies and money transfers to small business owners,
entrepreneurs (many of whom live in the developing world), and those
who would otherwise not have access to these resources.
6.7.2 Importance of MFIs
Microfinance is important because it provides resources and access to
capital to the financially underserved, such as those who are unable to
get checking accounts, lines of credit, or loans from traditional banks.
Without microfinance, these groups may have to resort to using loans or
payday advances with extremely high interest rates or even borrow money
from family and friends.
Microfinance helps them invest in their businesses, and as a result, invest in
themselves.
While microfinance can certainly benefit those stateside, it can also serve as
an important resource for those in the developing world.
While some have lauded microfinance as a way to
end the cycle of poverty, decrease
unemployment, increase earning power, and aid
the financially marginalized,
some experts say that it may not work as well as
it should, even going so far as to say
it’s lost its mission.
Others argue that microfinance simply makes
poverty worse since many borrowers use
microloans to pay for basic necessities , or
their businesses fail, which only plunges them
further into debt.
6.7.3 Micro Finances in Ethiopia
Micro-finance in Ethiopia has its origin in traditional informal method used
to accumulate saving and access credit by people who lacked access to
formal financial institutions.
Ethiopia has also more 38 MFIs (in 2018) and practice is one of the
success stories in Africa even though there are certain limitations.
The history of formal establishment of Ethiopia Micro finance institution
is limited to about less than twenty years (since 2000).
The first groups of few MFIs were established in early 1997 following the
issuance of Proclamation No. 40/1996 in July 1996.
The objective of the MFIs is basically poverty alleviation through the
provision of sustainable financial services to the poor who actually do
not have access to the financial support services of other formal
financial institutions.
The microfinance industry is growing in terms of number and size.
The MFIs in Ethiopia have been able to serve the productive poor
people mainly with savings, credit, money transfer, micro-insurance
and other related services.
Governmental and other developmental organizations have played a
vital role for impressive performance the microfinance sector in the
country.
The known micro finance institutions in different regions of
Ethiopia with more than 90% market share are
Amhara Credit and Savings Ins. (ACSI) S.C.
Dedebit Credit and Savings Ins. (DECSI) S.C.
Oromiya Credit and Savings Ins. S.C (OCSCO).
Omo Credit and Savings Ins. S.C.
Addis Credit and Savings Institution S.C.(ADCSI)
6.7.3.1 Types of Activities Carried Out by Ethiopian MFIs
According to Article 3(2) of the aforementioned proclamation, MFIs are
allowed to carry out the following activities:
☞Accepting both voluntary and compulsory savings as well as
demand and time deposits,
☞Extending credit to rural and urban farmers and people
engaged in other similar activities as well as micro and small
scale rural and urban entrepreneurs,
☞Drawing and accepting drafts payable within Ethiopia Micro-
insurance business as prescribed by NBE,
☞Purchasing such income generating financial instruments as
treasury bill and other income generating activities,
☞Acquiring, maintaining and transferring any movable and
immovable property including premises for carrying out its
business,
☞Supporting income generating projects of urban and rural
micro and small scale operators,
☞Rendering managerial, marketing, technical and administrative
advice to customers and assisting them to obtain services in
those fields,
☞managing funds for micro and small scale business,
☞Providing money transfer services,
☞Providing financial leasing services.
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