The concerning case study is based on a prospectus entrepreneur, John Caird. The case study will give its reader a clear concept about the different sources of finance. It will also help to identify the appropriate sources of finance in some specific categories. This case study will also help those who are prospective in business. Here, one will find the use and effect of some practical finance sources like bonds, stocks, trade credit, bank loan, leasing, etc. Therefore, general people are also most welcomed to read the case study. It’ll help them in gaining knowledge of the use of finance in a business.
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Introduction
There are different types of businesses in the world. Different businesses have different characteristics and specialties, but every business is same in one place, and that is businesses basically need finance. The aim of this chapter is informing John about the different forms of businesses that are available as well as giving an idea about different sources of finance available in the business. This chapter is divided into three tasks. We are proceeding below with Task A-
1.1.1 Businesses and Legal Procedures
It has mentioned earlier that there are different types of businesses in the world. Among them three are the most common legal forms of business. John can choose any of the three forms of business. For John’s convenience we have briefly discussed different possible businesses below:
Sole Proprietorships: “A sole proprietorship is a business owned by one person who operates it for his or her own profit.”
Sole Proprietorship is the simplest form of business organization. About 75 percent of all business firms are sole proprietorships. As a sole proprietor one has full control over his business and he can take any decision without consulting and taking permission from other. The procedure to open this business is very simple. There is no such legal restriction to set up this business. Also, to set up a sole proprietorship business it doesn’t require submitting accounts or records in companies’ house. So, if John thinks to open a sole proprietorship business he should have a trade license only.
Partnerships: “A partnership consists of two or more owners doing business together for profit.”
Partnership is the most common form of business organization. Typically small business organizations are carried on by this form of business. Actually, a partnership business is much more flexible and easy to operate with tax advantages. Partnerships are governed by statute law, common law and private agreement (the partnership agreement). The establishment of partnership business is simple and inexpensive. Profits and losses in a partnership business equally distributes among the partners. “Partnership Act 1980” developed to solve the distribution process of loss and profit among the partners. So, the most important consideration in this type of business is the partnership agreement.
So, if John wants to form a partnership business, he needs to find partners first. And, the partnership agreement should be the only important fact for him.
Corporations: “A corporation is an artificial being created by law, and it often called a legal entity.”
Only about 15 percents of all businesses are incorporated. The corporation is the dominant form of business organization in case of receipts and profits; according to this, nearly 90 percent of business receipts and 80 percents of net profits. Corporations are structured with ownership of shares of stock which are variable and transferable. In theory, corporations are separate legal entities from the owners. Corporations provide limited liability for the owners. This means that the owners cannot be sued for the debts of the corporation unless they personally guaranteed the debts. The potential loss for the business owner is limited to the capital they invested. The control and operation of a corporation are in the hands of the shareholders who tend to operate with a board of directors.
Corporation business has some formalities. If John wants to form a corporation, he must file an IRS tax return and pay taxes on profits as it’s a legal entity. And to be incorporated, John should fill Articles of Incorporation. After all, John should have stock holders.
In the above, we have discussed three basic legal forms of businesses. Still there are some other options for John. But, John should choose one the business form from the above as these are the basic legal forms available for him.
Now, we will proceed to Task B –
1.1.2 Categories of Finance Terms
Financial planning is an important part of any business organization’s operations because it provides the guideline, and controls the firm’s procedures to achieve its objectives.
In the given case study, John also has financial planning as we have seen that he has estimated finance needs. But, the thing is John doesn’t have enough finance knowledge to classify his finance needs in terms of finance.
Types of Finance Sources
Financial sources may be external or internal, but they may also be short, medium or long term in type:
Short Term: Finance the business for up to 1 year.
Medium Term: Finance the business for up to 5 years
Long term: Finance the business for more than 5 years.
Classification according to Types of Finance Sources
In the following boxed paragraphs we will help John to classify his financial needs in short, mid and long term sources of finance.
Requirement 1: Building & Fixtures
Finance Type: Long term
Explanation: Business requires fixed assets like land, Building, furniture etc. Finance required to buy these assets is for a long period, because such assets can be used for a long period and are not for resale. So, in the given case study, John’s requirement for building & fixtures is a type of long term sources of finance. Share, debentures, bank loans are some common form of long term sources of finance.
Requirement 2: Office Vehicle
Finance Type: Medium Term
Explanation: We have learnt it earlier that financing a business for a period of more than a year but less than 5 years is called medium term financing. Actually this type of finance is attained for extension and transformation of existing organisation. In the given case study, John needs this type of finance for the purchase of assets like office vehicle, and as it is bit bigger to pay in short period of time, he needs mid-term financial sources.
Requirement 3: Security System
Finance Type: Short/Medium Term
Explanation: Already we have learnt about medium term sources of finance. In the given case study John needs security system. Security system can be either medium or short term sources of finance. It varies under the situation and the way one wants to pay.
Requirement 4: Payroll Expense (year 1)
Finance Type: Short Term
Explanation: In the given case study, John also plans about payroll expense. It’s a type of short term sources of finance. Because, things like raw materials, workers wage, water and power charges should be paid regularly. Thus there is a continuous requirement of liquid cash needs to be available for covering these operating cost. And in the given case it has mentioned that it is for one year. For financing such requirements short-term finance is needed. Trade credit, cash credit, overdrafts are some common forms of short term sources of finance.
Requirement 5: Marketing Expenses
Finance Type: Short/Mid Term (can be varied)
Explanation: John’s fifth requirement is marketing expenses. Businesses essentially need marketing to expand its sale. These expenses can be covered from either mid or short terms of finance sources. It varies under situation and the cost that one wants to spend.
Requirement 6: Office Stationary
Finance Type: Short Term
Explanation: Office stationary, the sixth requirement of John. Things like office stationary are a temporary need of any organisation. And, it is mentioned that the amount is very short. So, the best type for this source is short term finance.
Requirement 7: Printing & Publications
Finance Type: Short Term
Explanation: Printing and publications is also an example of regular needs of an organisation as well as it’s a temporary need, and the mentioned amount is also very short. So, it falls under short term sources of finance.
From the above boxed paragraphs we have gained certain knowledge about three different types of sources of finance that might help John to understand classifying his financial needs.
Below stats Task C –
1.1.3 Debt & Equity Finance
We can see a variety of sources of finance that are mentioned in the given case study. Some of these are personal savings, share capital, bank loan, invoice factoring etc. Like these all of the different sources of finance available for business fall under two of the categories. These ares-
Equity: It provides become owner or shareholder of a business. Equity capital consists of long term funds provided by the shareholders. A firm can obtain equity capital either by retaining earnings rather than paying them out as dividends to its stockholders, or by selling common or preferred stock. Any loss or profit that happens shares the shareholders.
Debt: It provides become creditor of a business. Debt capital includes all long term borrowing incurred by a firm, including bonds.
John’s friend said him about a variety of sources of finance. Let’s see under which category, equity or debt, these sources fall:
Table 1.1 Financial Categories
Category
Sources of Finance
Equity
Invoice Factoring, Share Capital, Retained Earnings.
Debt
Bank Loan, Trade Credit, Hire Purchase, Mortgage Loan, Bond & Debenture, Leasing.
None
Personal Savings, Invoice Discounting, Cash Management
Conclusion
This is the end of the chapter 1, and we have gained certain knowledge about different sources of finance available in business. And these sources of finance can be short term, mid-term, or long term. Short term finance represents sources like trade credit, cash credits, overdrafts etc. On the other hand, long term finance represents sources like shares, debentures, retained earnings etc. Again, all this sources of finance are of two categories – equity and debt.
Finally, it can be said that the concerning chapter should help John to identify the sources of finance available in business.
Chapter Two
Effects of Different Financial Sources
Basic Contents:
â-¡ Introduction; â-¡ 1.2.1 Leasing Contract- Risks & Benefits;
â-¡ 1.2.2 Factoring & Discounting- Safety & Quality vs. Cheaper Techniques; â-¡ 1.2.3 Trade Credit- Another Finance Option for Businesses; â-¡ 1.2.4 Shares & Debentures – Its Costs & Risks
1.2
Introduction
Earlier in Chapter One, we have discussed about different financial sources, and now, we are known to these sources that are available in businesses. In the concerning chapter, tasks are divided into four parts; there we will discuss about the effects of the financial sources. John is unable to predict or understand the outcomes of different financial sources. So, this chapter will help John to understand the effects of different financial sources in terms of cost, risk, or quality.
We will begin with Task D –
1.2.1 Leasing Contract- Risks & Benefits
Again, John’s friend who is an investment banker, suggested him to go for leasing contract for building & fixtures. Before, accepting his suggestion John needs to have a clear concept about leasing contract. In the following paragraphs we will explain about leasing contract to John, and also the risks and other implications of leasing.
Leasing Contract
Basically, a leasing contract means a financial arrangement between the “lessor”, owner of the asset and the “lessee”, user of the asset. Leasing is useful to both the parties for gaining tax benefits or doing tax planning. There are some companies or special firms those provide leases.
In General, a lease effectively means that the business is paying for using rather than owing a product. It is very similar to “hiring” or “renting”. For Example, if John decides to go for leasing contract for building and fixtures, it states that John pays a certain amount in certain period of time that he leases, and at the end of the leasing period the building returns to the owner.
Risks and Benefits of Leasing
Before going in detail, let’s have a quick check on the types of leasing. There are different types of leasing based on the variation in the elements of a lease. Very prominent leases are financial lease and operating lease. Other than these, there are also sale and lease back and direct lease, single investor lease, leveraged lease, and domestic and international lease.
Let’s see the benefits of leasing below:
Firstly, it can be cheaper to arrange a lease rather than having to buy equipment outright.
Leases are very flexible. One might need equipments for shorter period of time. In that case leasing is beneficial because he can lease those equipments for certain period of time.
The leasing company that owns the equipment, machinery or vehicles is responsible for the maintenance and this can help reduce maintenance costs for the business.
If technology is changing quickly or equipment wears out quickly it can be regularly updated or replaced.
The payments are generally fixed and therefore, it won’t change as interest rates change. This helps business plan more effectively.
Now we will look on some risks of leasing below:
Leasing is more expensive in the long run, because the leasing company charges fees which make the total cost greater than the original cost.
There is no ownership of property in leasing. So, leasing company has every right to go in a different contract after ending of existing leasing period.
Recommendation
Considering all the issues those we have discussed in risks and benefits, it can be said that leasing is good for shorter period of time, more specifically for short term financing. In the given case study, John’s friend Sandy suggested him to for leasing contract for building & fixtures. But, considering the issues that we have found in risks and benefits we can see that if John goes for leasing contract there will no ownership of the building. And, as a result leasing company could go for a different contract with other party.
Finally, in my opinion, it can be said that long term financing like building and fixture should not be financed from leasing company. At the end of the day it’s John’s choice whether he goes for leasing.
Invoice Factoring & Discounting starts below in Task E-
1.2.2 Factoring & Discounting – Safety & Quality vs. Cheaper Techniques
John heard about the terms “invoice factoring” and “invoice discounting”. But, he doesn’t actually have good knowledge about its effects and working system. The following paragraphs will suggest John about the uses of “factoring” and “discounting” in different situations, and choosing one between those considering the cost and quality.
Invoice Factoring
A factoring finance generally involves in business when a company needs working capital and cash flow in a business.
Factoring means selling a company’s invoices to a third party. In return, the third party will process the invoices and permit the company to draw funds against the money owed to business. Third party means any financial institution or commercial bank that provides this facility. The factoring company usually called “factor” in term of finance. Factoring is also known as ‘debt factoring’.
In the given case study, it is mentioned that John doesn’t know about the mechanisms that how actually factoring works. Let’s see in detail about factoring below
Factoring Procedures
We have known it earlier that factoring allows a company to draw money against its invoice. Actually, factoring involves three parties. They are-
A company (the seller)
Buyer (company that buys on credit)
Factor (the factoring institution)
Let’s see how those above parties involve in the factoring –
Generally, factoring provides a form of fast advance against a company’s trade receivables. Company doesn’t have to wait for cash from its credit customers as the factor agrees to pay for a proportion of the debts upfront; it permits company to enhance its working capital and pick up cash flow. Generally, a factor pays up to 85% of approved invoices.
Generally, factoring procedures complete in two stages. That are-
Raising Invoice
Paying the Invoice
If there remains any unpaid invoice, there might include one more stage in factoring procedures that is –
unpaid invoice
Now, we will look in detail what actually happen in the above three stages of factoring procedures. Let’s see below-
Raising and Paying the Invoice
When any sale is done in credit, the company raises invoices itself in the usual way and sends them to its customers. The company also sends a copy of that invoice to the factor. After getting that invoice the factor pays an agreed percentage against the company’s invoice. It also takes on the credit control function.
When a factoring agreement is done, customers must pay the total amount of each invoice directly to the factor. Each invoice must specify the factor’s remittance details on it. After getting the money, the factor will then deduct its fees, its interest, and its advance from the remittance before paying the balance to the company.
Unpaid invoice
Unpaid invoice is a special case of factoring procedure stage. It only happens if any customer doesn’t pay to the factor. It depends on the types of factoring agreement. A type of factoring is recourse factoring where factor doesn’t take risk of the bad debts of customer. In case of recourse factoring, the company should be liable to refund the advance to the factor if customer doesn’t pay.
Another type of factoring agreement is non-recourse factoring. In case of this type of factoring the factor takes the risk of bad debts of customer. This type of factoring is costly than the first one.
So, it’s all about invoice factoring procedures. Now, we should look on invoice discounting as John doesn’t about discounting also.
Invoice Discounting
Like factoring, invoice discounting is another way of obtaining advance on invoices. Sometimes it is called as an alternative way of drawing money against invoices. Many finance organisations offer this alternative of factoring or invoice discounting. The organisation that provides the invoice discounting called as invoice discounter.
Discounting Procedures
We know that the invoice discounting is very similar to factoring. However, the fundamental difference between these two is that the company retains control over the administration of sales ledger of the business.
Discounting procedures generally involves three stages like the factoring. But, it’s different from factoring procedures. Let’s see in detail at below.
Raising Invoice
Like factoring, discounting procedures also involve invoice raising. At first, the company raises its invoice to the discounter. Then the discounter performs checks on the company, its credit history, its systems, and its customers. It may then agree to advance a certain percentage of the total outstanding sales ledger value. The discounter demands an agreed monthly fee for the service and interest on all amounts advanced.
Collecting Money
Here is the difference between factoring and discounting that in case of discounting; the company retains control over the administration of sales ledger by collecting money from the customer.
However, the advanced money by the discounter can be drawn by the company as required. Either the company repays the money each month, or the discounter advances more money to the company. It actually depends on how the company collects money from the customers. If the total amount owing to the company by its credit customers increases, money should be repaid; if decreases, money should be advanced by the discounter.
Balancing Money
We have seen from the above earlier paragraph that collecting money happens severally. So, very after raising invoice, and receiving cash by the company, the discounter needs to recalculate it every time to balance the transaction
Uses of Invoice Factoring & Discounting
In the given case study, John is really unknown to use these types of finances effectively, the factoring & discounting. To be effective one should know when to use these finances. So, we will at when John should use these sources of finance.
When a company falls under liquidity crisis that means lacks of working capital, the company should best utilize these sources of finances at that time
If a company wants to sell huge amount on credit, the company should go for either factoring or discounting
The above two are the main situation to go for factoring or discounting. So, John should concern about the above situations for using invoice factoring and discounting.
Invoice Factoring & Discounting Regarding Cost & Quality
Factoring is one of the easiest forms of finance to increase the cashflow in a business. It has very little paper work that makes tasks easier for any company. But the thing is factoring is little bit costly than other finance options. Again, there are two types of factoring that we have already said. One is recourse factoring, and the other one is non-recourse factoring. Recourse factoring costs more than the non-recourse factoring. In return, the factor ensures the all kinds of liability that makes company’s tasks easier and convenient.
Factoring includes costs like interests and fees. There are some additional fees like discount charge and credit management fees also includes in factoring. Credit management is specialized in controlling credit systems so that the company doesn’t need to have extra employees as the factor is doing this for the company. Moreover, the company gets better quality and service as it is a specialized section.
On the other hand, invoice discounting is an alternative to factoring, but cheaper than factoring. Typical fees are added to discounting. These fees are less because as discounting provides lower quality of service than the factoring. Moreover, in discounting, it needs more employees for the company as the company does the credit control here. So, this is the concerning thing that the companies are not the specialized like financial institution regarding credit control. So, quality is little bit lower here.
Recommendation
We learnt it from the case study that John is looking for the safety and quality rather than the cheaper techniques. So, it would be better for him that he would go for factoring. Still, there are certain conditions that he might have to consider in taking such decisions. After all, at the end of the day it’s John who will take the decision. But, in my opinion, according to cost and quality, invoice factoring is the right option for John.
1.2.3 Trade Credit- Another Finance Option for Businesses
Task F in the given case study belongs to trade credit. From there we can see that John’s friend Sandy gave him an idea about trade credit. And, really John can use trade credit for few of the costs of his business. Before suggesting him the costs, let’s know about the trade credit.
Trade credit
Trade credit is a very popular finance source in the world. Company like Wall-Mart prefers trade credit rather than borrowing from bank. Actually trade credit is a period of time that a business gets to pay for goods that’s they received. That means the customer can buy goods without paying any cash. For this the customer needs to have an agreement with the seller. Normally, a buyer on trade credit allows around 30-60 days to pay the credit. Actually, it depends on agreement. However, extending this period can improve short-term finance position in a business.
Below are some of the benefits of trade credit:
Trade credit is an essential element in reducing the capital investment that is required to operate a business.
Acquiring a trade credit is lot easier than bank loan as it doesn’t need any formal papers, and can also be taken in a faster pace than the bank loan.
However, there are certain issues those are concerning. One such issue is time period for paying the credit. It is comparatively much shorter than the bank loans. Moreover, when one seeks for trade credit seems that it’s little bit costly.
Costs that can be financed by Trade Credit
In Task A, we have seen that John estimated finance costs that would be needed in his business. From those costs, some of the costs can be done by trade credit. These are – security system, office stationary and printing & publications.
When John was looking for more funds for his business, he thought about share capital and bond/debentures. Task G will say the detail in the below:
1.2.4 Shares & Debentures – Theirs Costs & Risks
We know that the all of the different sources of finance available for business fall under two of the categories. These are- (i) Equity; and (ii) Debt
Between shares and debentures, shares fall under equity finance, and debentures fall under debt finance. Both shares and debentures have some costs and risks. But, before going to those issues let’s see what is actually share and debenture.
Shares
Shares those we see in the stock market are generally issued to the general public. Those who hold shares are called share holder or the owners of the business.
There are two types of share capital. These are –
Equity share
Preference share
Not every form business can issue share capital. Only Public Limited Company can issue share capital in the market.
Debentures
Debentures are also issued to the general public. The holders of debentures are the creditors of the company.
In case of borrowing large amount of money for long but fixed period of time, it can be borrowed from general public rather than any financial institution by issuing loan certificates called Debentures.
A debenture is issued under the common seal of the company. It is a written acknowledgement of borrowing money. Terms and conditions including interest rate, time repayment and security offered are specified in the acknowledgement.
Differences between Share Capital & Debentures
The main difference between shares and debentures is that shares provide ownership capital which is not refundable, and on the other hand, debentures provide loans for a specific period that needs to be paid back.
The amount that the shareholders get is not fixed. It varies up on the profit of the company. So, persons who want to take risk do invest in shares. For debentures, the interest that a company pays is fixed. It remains same even if the company is in loss. Non-risk takers are most welcomed here.
Share holders are the real owners of the company. They have the right to vote and frame the objectives and policies of the company. But, debenture holders don’t have the right make policies or any change in the company.
For issuing shares, no security is required. In case of debentures, it is needed to have sufficient fixed assets as the debentures are secured.
Maximum risk is there for the shareholders as their capital will be paid back only after repaying the loan of debenture holders. Debentures holders have the priority of repayment over shareholders. .
So, above are the some of the explanations of differences between the share capital and debenture. It is noticeable from the differences that we can infer the risk and cost of shares and debentures instantly. Let’s have a look on that issue.
Costs & Risks of Shares and Debentures
If John decides to raise fund issuing shares or debentures, it’s a matter of decision taking ability whether he should go for shares or debentures. We can help John by disclosing the facts those are related to costs and risks of shares and debentures.
In case of raising funds the features of shares are given below according to costs and risks
A company can raise fixed capital by issuing equity shares without creating any charge on its fixed assets. The capital raised by issuing equity shares is not required to be paid back during the life time of the company. It will be paid back only if the company is wound up.
Moreover, there is no liability on the company regarding payment of dividend on equity shares. The company may declare dividends only if there are enough profits.
In addition to the above, if a company raises more capital by issuing equity shares, it leads to greater confidence among the investors and creditors.
On the other hand, if we look on debentures, the followings can be seen –
Since debentures are ordinarily issued for a fixed period, the company can make the best use of the money. It helps long term planning.
Interest paid on debentures is treated as an expense and is charged to the profits of the company. The company thus saves income tax.
As the interests on debentures have to be paid every year whether there are profits or not, it becomes burdensome in case the company incurs losses.
Usually the debentures are secured. The company creates a charge on its assets in favor of debenture holders. So a company which does not own enough fixed assets cannot borrow money by issuing debentures. Moreover, the assets of the company once mortgaged cannot be used for further borrowing.
In case of raising funds debentures are cost effective. The interest on debenture is deductible on the corporation’s income tax return. On the other hand, dividends on stock are not deductible on the income tax return.
Another cost benefit in debentures is that the ownership interest in the corporation will not be diluted by adding more owners. Debenture holders and other lenders are not owners of the assets or of the corporation. Therefore, all of the gain in the value of the assets belongs to the stockholders. The bondholders will receive only the agreed upon interest.
From the above it can be said that issuing share contains low risk, but it costs high. On the other hand, issuing debentures contains
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