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0 Introduction
This is an informative and analytical report on Sources of finance. The report is written as an assignment of Managing financial resources and decision module of the first semester for the evaluation of our understanding and knowledge of the sources of finance to the lecturer Mr. Chamila. This assignment also tests our knowledge on choosing the appropriate source of finance and financial planning. The report also provides analysis of Singer (Sri Lanka) PLCs balance sheet for sources of finance. All of the information and research for this report is through the World Wide Web.
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of finance is saved by the business as a back-up in times of financial needs and maybe used later for a companys development or expansion. Retained profits are a very valuable nocost source of finance.
Current liabilities Current liabilities are short-term debts that are in immediate need of settlement. Some examples of current liabilities are creditors, accruals, proposed dividends and tax owing. These obligations have to be paid within a year. Creditors also known as trade creditors are suppliers from whom the business purchased goods on credit. Paying the creditors as late as possible will ease cash flow requirements for a business. Accruals are the expenses owed by the business. Dividends proposed are the dividends payable for the year that is not yet paid. Tax owing is the sum of money owing as tax.
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Participating preference shares give the benefit of additional dividends to its shareholders above the fixed rate of dividends they receive. The additional dividend is usually paid in proportion to ordinary dividends declared. Convertible preference shares convertible preference shareholders have the option of converting their preference shares to ordinary shares.
2.2.2.1 Debentures
Debentures are issued in order to raise debt capital. Debenture holders are not owners but long-term creditors of the company. Debenture holders receive a fixed rate of interest annually whether the company makes a profit or loss. Debentures are issued only for a time period and thus the company must pay the amount back to the debenture holders at the end of the agreed period. Debentures can be secured, unsecured, fixed or floating.
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Secured debentures are debentures that are secured against an asset. They are also called mortgage debentures. Unsecured debentures these debentures do not have an asset as collateral. Fixed debentures have a fixed rate of interest. Floating debentures do not have fixed rate of interest and are not tied to any specific asset. Bearer debentures these debentures are easily transferable. Registered debentures are not easily transferable and legal procedures have to be followed in case of a transfer. Convertible debentures can be converted to stock at the end of the debenture repayment date.
2.2.2.3 Loan
Loans are amounts of money borrowed from banks or other financial institutions for large and long-term business projects such as the development or expansion of the business. However loans can be substituted by other alternative sources of finance which are more suitable.
gives the business the sole usage of the asset. The business on its part must pay monthly payments to the hire purchase firm amounting to the total value of the asset and charges of the hire purchase firm. At the end of the payment period the business has the option of purchasing the asset for a nominal value.
2.2.2.5 Lease
In a lease the leasing company buys the asset on behalf of the business and the asset is then provided for the business to its use. Unlike a hire purchase the ownership of the asset remains with the leasing company. The business pays a rent throughout the leasing period. The leasing firm is known as the lessor and the customer as lessee. Leasing is of two types, namely Finance lease and Operating lease. Finance Lease this is where the lessees monthly payments add up to at least 90% of the total value of the asset. Operating Lease this lease does not run for the full life of the asset and the lessee is not liable for the full value of the asset. The residual risk is taken up by the lessor.
2.2.2.6 Grant
Grants are funding given to businesses for programs or services that benefit the community or public at large. Grants can be given by the government or private firms. For example a grant may be given to open a new factory where unemployment is high.
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providing higher than average return for the investor. The investor expects to have some influence over the business.
2.2.2.8 Factoring
This is where the factoring company pays a proportion of the sales invoice of the business within a short time-frame to the business. The remainder of the money is paid to the business when the factoring company receives the money from the businesss debtor. The remainder of the money will be paid only after deducting the factoring companys service charges. Some factoring companies even offer to maintain the sales ledger of the business. Factoring is of two types: Recourse factoring and Non-recourse factoring. Recourse factoring In this type of factoring the client company is liable for bad debts. Non-recourse factoring is where the factor takes responsibility for the payment of the debtors. The client company is not liable if debtors do not pay back. Non-recourse factoring is usually more expensive because of the high risks experienced by the factor.
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Factoring Factors charge a rate of interest of about 1.5% to 3% of the invoice value as finance charges. Interest is calculated on a daily basis. Credit management and administrative fee are also charged and ranges from about 0.75% to 2.5% of turnover. Invoice discounting Invoice discounting also charges a rate of interest of about the same but its credit management and administrative charges are lower than a factors because only finance is provided and sales ledger is not maintained by an invoice discounting firm.
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4.0 Advantages and Disadvantages of the different sources of finance 4.1 Personal savings
Advantages The owner would not want collateral to lend money to the business. There is no paperwork required. The money need not necessarily be paid back to the owner on time. Can be interest free or carry a lower rate of interest since the owner provides the loan. Disadvantages Personal savings is not an option where very large amounts of funds are required. Since it is an informal agreement, if the owner demands the money back in a short notice it might cause cashflow problems for the business.
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Disadvantages There maybe opportunity costs involved. Retained profits are not available for starting up businesses or for those businesses that have been making losses for a long period.
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Large amounts of finance can be raised depending on the fixed asset sold. Would be the ideal source of finance if it was for an asset replacement. Disadvantages If the asset is sold then the business would lose opportunities to generate income from it. If the business wants to buy a similar asset later on it may cost more than it was sold for. If the asset is sold and the money is spent without return then the business is broke. The asset may be able to generate more income than the purpose it was sold for.
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Possible chances of takeover where an investor buys more than 50% of the total issued shares value. Groups of equity shareholders holding majority of shares can manipulate the control and management of the company. May result in over-capitalisation where dividend per share falls. Once issued the shares may not be bought back and therefore the capital structure cannot be changed.
Taxable income is not reduced by preference dividends unlike debentures where interest paid reduces taxable income. Have other drawbacks similar to ordinary share issues such as the cost, time consumption and legal requirements.
4.7 Debentures
Advantages Debenture holders do not have rights to vote at the companys general meetings. Tax benefits debenture interests are treated as expenses and charged against profits in the profit and loss account. Debentures can be redeemed when the company has surplus funds. Disadvantages Debenture interests have to be paid regardless the company makes a profit or loss. The money borrowed has to be paid back on an agreed date.
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Disadvantages There is a limit to the amount that can be overdrawn. Interest has to be paid on an overdraft that is calculated on a daily basis and sometimes the bank charges an overdraft facility fee too. Overdrafts are meant to cover only short-term financing and are not a permanent or long-term source of finance Interest is calculated on a variable rate and therefore it is difficult to calculate the cost of borrowings. Overdrafts can be recalled by the bank at any time if not stated in the agreement.
4.9 Loans
Advantages Large amounts can be borrowed. Suitable for long-term investments. The lender has no say on how the money is spent. Need not be paid back for a fixed time period and banks do not withdraw at a short notice. Interest rates are lower than for bank overdrafts and are set in advance.
Disadvantages Collateral is needed. The amount borrowed has to be repaid at the agreed date.
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4.11 Lease
Advantages The amount in full need not be paid in order to start using the asset. The total cost and the lease period is pre-determined and thus helps with budgeting cashflow. In an operating lease, payments are made only for the usage duration of the asset.
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Lease is inflation friendly where the agreed rate is paid even after five years when other costs increase due to inflation. It is easier to obtain a lease than a commercial loan. Disadvantages The ownership of the asset remains with the lessor even after payments but however in a finance lease the option is provided to buy the asset at a nominal value. In a finance lease the lessee ends up paying more than the value of the asset. Lease cannot be terminated whenever at lessees will.
4.12 Grants
Advantages Grants do not have to be paid back. There are no costs involved in obtaining a grant. Disadvantages Grants are given on certain restrictions and laws imposed by the government. Not all organisations are eligible for grants. Grants are given freely and therefore are very competitive because lots of firms try for the same source of fund.
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4.14 Factoring
Advantages A large proportion of money is received within a short time-frame. The sales ledger of the business can be outsourced to the factor. The money collections from debtors are undertaken by the factoring company. Helps a business to have a smooth cashflow operation. Non-recourse factoring protects the client company from bad debts.
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Disadvantages The business has to pay interests and fees for the factor for its services. The cost will be a reduction on the companys profit margin . Lack of privacy since the sales ledger is maintained by the factor. Costumers would not like factoring companies collecting debts from them.
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accept a source of finance that may even cost higher. The urgency of funds needs to be identified also because certain sources of finance need more time to be raised than other sources of finance. For example issuing shares is a very long and complex process where there are legal requirements and then the potential shareholders have to be informed (advertising) and after all these the money is collected through the process of application and allotment which takes more time.
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case potential lenders fears the business ability to be able to cope with more interest payments and debt settlement.
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Bank overdraft This appears in the balance sheet as a current liability since it is a short-term debt and has to be paid back within a year. The interest charges and bank overdraft fee if charged are deducted from the profit and loss account before tax is charged. Loan Loans are long-term debts and therefore come under long-term liabilities in a balance sheet. The loan when displayed on a balance sheet will usually contain information about the repayment date and the interest charged on the loan. The interest is charged in the profit and loss account.
Venture capital This is an amount of money invested in the business as equity capital and thus comes under equity capital in the balance sheet. The return for venture capitalists is a share of profits which is recorded in the appropriation account. Factoring and invoice discounting This does not appear in the balance sheet. However the money received from factoring and invoice discounting can show higher balances of cash. The interest charges and fee is recorded in the profit and loss account.
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o Profit after tax/Sales Financial stability / Solvency ratio o Financial gearing ratio o Debt/Asset ratio o Interest cover ratio Investment performance ratio o Dividend per share o Dividend yield o Earning per share o Price-Earnings ratio o Interest yield o Redemption yield The above ratios being calculated the performance of the business can be assessed and necessary decisions can be taken by relevant parties. Due to limited time the ratios have not been explored in detail.
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The business owner/manager who understands these concepts and uses them effectively to control the evolution of the business is practicing sound financial management thereby increasing the likelihood of success.
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9.1 Identifying sources of finance in Singer (Sri Lanka) PLCs balance sheet.
Fixed or Non-current assets that can be sold are potential sources of finance that is categorised as sales of assets o Property, Plant and Equipment = LKR 1,419,011,146 Working capital is current assets minus current liabilities o Working capital (7,855,964,730 6,302,249,382) = LKR 1,553,715,348 Retained earnings are the accumulated earnings of a company o = LKR 373,951,178 Share capital o = LKR 629,048,050 Loans and borrowings o = LKR 1,383,661,616
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10.0 Conclusion
Sources of finance is available from variety of sources but each source has its own cost and benefits. It is important to choose an appropriate and cheap source of finance for the smooth operation of the firm. There are important factors to consider when choosing a source of finance. However further work need to be done. The limitedness of time has not allowed for further research and more detail.
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