SHORT TERM FINANCE AND LONG TERM FINANCE Long term financing provides businesses funds for the

period over 1 year. It contrasts to short term financing because short term financing provides funds for the period of 1 year or less whether an established corporation or new business, it is common that many small and large companies have some kind of debt throughout the life of their business. These businesses normally borrows not only to expand their companies or to purchase equipment, but also to finance operating capital to even out cash flow.

What is Short Term Financing? hort term financing is essentially to provide businesses funds for a short term period of a year or ess!

What is short term "inancing "or? These funds are usually for businesses to run their day!to!day operations including payment of wages to employees, purchase of goods and supplies. "n example of short tern financing could be when a firm places an order for raw materials, it pays with finance and anticipates getting back this finance by selling these goods over the period of a year.

Di""erence #et$een Short term an% Long Term "inancing In contrast long!term financing decisions are involved when a firm purchases a special machine that will reduce operating costs over, say, the next five years. hort term borrowing is used for working capital requirements for day to day operations of a business. Industries with seasonal peaks and troughs and those engaged in international trade will be heavy users of short term borrowing finance.
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Department of Business and

LONG TERM FINANCE '! (y iss)ing shares " company can raise capital by issuing shares. There are two types of shares $ ordinary or equity shares and preference shares. Feat)res o" Or%inary Shares or E*)ities+ • • • • • • • The money given for shares is never returned to the shareholders. The ordinary shareholders get dividend out of profit and only if there is sufficient profit. The ordinary shareholders are paid dividend after the preference shareholders are paid. The ordinary shareholders can attend the "nnual %eneral &eeting and elect the board of directors. The ordinary shareholders are the owners of the company. The ordinary shareholders have more control over the company as they elect the board of directors by the principle of 'one share $ one vote(. )hen a company closes down, the ordinary shareholders are paid last.

Feat)res o" ,re"erence shares+ • • • • • • The money given for shares is never returned to the shareholders. The preference shareholders get fixed rate of dividend in return. The preference shareholders are paid dividend before the ordinary shareholders. The preference shareholders can attend the "nnual %eneral &eeting and elect the board of directors if they are paid in arrears. The preference shareholders are the owners of the company. )hen a company closes down, the preference shareholders are paid before the ordinary shareholders.

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CALC-LATION OF SHARE DI.IDEND+ " company issued the following shares, which were fully paid up for* +.,- .reference shares 3rdinary shares /00,000 1 20.,0 /00,000 1 21.00

The company also issued debentures worth 21,0,000, which carried an interest of 4-. The net profit available for distribution before paying the debenture interest was 25,,000. The company decides to distribute three fourths of the net profit to the shareholders and to keep the balance as ploughed back profit. #alculate* 6ate of dividend per ordinary share. .rofit 7ebenture interest 81,0,000x49100: ; <alance =et profit .rofit to be distributed to shareholders* 2 >>,000x>95; .reference share dividend 2100,000x+.,9100; .rofit to be given to ordinary shareholders 7ividend per ordinary share 8214,/,09/00,000: ; 6ate of dividend per ordinary share; 7ividend per ordinary share x 100 Aalue per ordinary share 2 0.0@ x 100 ; 21.00 @2 /,,?,0 2 +,,00 2 14,/,0 2 0.0@ 2 5,,000 2 1/,000 2 >>,000

/! (y iss)ing De#ent)res " company can also raise capital by issuing debentures. The following are the features of debentures* 3

#ommerce & Students’ Guide Computing

Department of Business and

Feat)res o" De#ent)res+ • • • • • • • These are like stock or long!term loans given to the company. The debentures carry a fixed rate of interest and are repayable on a fixed day. The debenture holders are paid interest every year whether the company makes a profit or loss. The debenture holders are secured against the property of the company. The debenture holders are the creditors of the company. The debenture holders can sell their claims on the stock exchange. )hen a company closes down, the debenture holders are paid first.

DIFFERENCES (ETWEEN SHARES AND DE(ENT-RES SHARES 1. /. >. 5. hare capital is an investment. DE(ENT-RES 7ebenture capital is a loan.

hareholders are the owners of 7ebenture holders are the creditors of the company. the company. hareholders earn dividend, which is paid out of profits. hareholders have voting rights 7ebenture holders earn fixed rate of interest, whether profits are made or not.

and hence have control over the 7ebenture holders have no voting rights and hence have no control over the company. ,. +. hareholders hareholders against company. ?. )hen a company closes down the shareholders are paid after the debenture holders. the cannot are not face a company. 7ebenture holders can force a company secured into liquidation on non payment of of the interest, 7ebenture holders are secured against the property of the company. )hen a company closes down the debenture holders are paid first. 0! Commercia mortgages " mortgage is a form of loan, which is taken out against property 8real estate:.
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company into liquidation. property

Finance

The definition of property may include a house, a flat, or an apartment, although mortgages cannot be taken out against any other assets such as a vehicle, stocks and shares, or other investments. " mortgage can also be taken out against an office, a shop or a factory 8this is known as a commercial mortgage:, or against a property which the owner intends to rent out to other tenants 8buy!to!let mortgage:. ome companies may own the freehold of real estate premises in the form of factories, office accommodation or warehouses. These assets will have a value in the companyBs accounts. If the business wants to raise a capital sum for investment in new assets, it could take out a commercial mortgage with a property company. =ormally the maximum mortgage will be between +0- and ?0- of the property value. The premises themselves are used as security, and the mortgage loan will usually be for the long term. The advantage of this arrangement is that the business can continue to use the premises as before, but must service the commercial mortgage in terms of interest payments and eventually repaying the capital sum. "nother plus is that any increase in property values over time still belongs to the business and not the property company to which it has been mortgaged. 1! (an2 oans "ll the maCor banks offer a range of business loans. They range from a few months to up to /, year ome loans are at a fixed rate of interest which is agreed at the start of the loan period and applied throughout the period of the loan. 3ther types of loan may have a variable rate of interest. Dere, the interest rate will fluctuate over the period of the loan in line with interest rates in the economy. <anks will usually tailor a loan package to suit the requirements of individual businesses and will also carry out a risk assessment on the business before going ahead with the loan. 7epending upon the outcome of the risk assessment, the lender will normally require some form of security 8either business or personal 5

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Department of Business and

assets: to guarantee the loan and may require the business to issue a debenture to the bank. Erom the point of view of the business, there will be the need to meet interest payments and make provision to repay the loan itself. 3! Sa e an% ease#ac2 This option relates to real estate assets. F)here a business owns premises and needs to raise finance, it may sell the freehold and simultaneously arrange to lease it back. The business would be converting the real estate fixed asset into cash, but will continue to be able to use the property as before. of the asset to the organisation. The advantage of this method, compared to the commercial mortgage option, is that 100- of the freehold value is realised, which is higher that is possible with a mortgage. Dowever, on the other hand, the business will not enCoy any future increase in the propertyBs market value. ale and leaseback may also be possible for certain types of capital equipment, such as large machinery. SHORT TERM FINANCE '! (an2 o4er%ra"t ome businesses may need to withdraw money from their accounts when there are insufficient funds in their accounts. They may request their banks to allow them to overdraw from their accounts for a short period. Interest will be charged on the amount overdrawn. This is an informal way of borrowing money from the bank. uch arrangements are generally very long term to guarantee the continued availability

Feat)res o" #an2 o4er%ra"t • • • <orrower need not have a current account. The borrower has to go through formal procedures for applying for a loan. Interest is charged on the whole amount borrowed for the full period of the loan.
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Finance

• •

&oney paid into the borrowerBs account does not reduce the loan. Lower interest is charged as the banker knows the amount of loan.

/! In4oice "actoring Invoice factoring is an alternative to an overdraft in situations where there is always a time lag between the issuing of invoices and the receipt of payments, resulting in a cash flow problem for the business. In the simple cash flow example above, the business is making sales in Ganuary but is getting no cash payment for them until &arch. In effect, the business is allowing customers +0 days credit. It may well be that this is necessary in order to get the sales in the first place. The way in which factoring works is illustrated in Eigure
Selling Company 1 Buying Company

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Factoring Company

3

The selling company sells to the buying company and invoices in the normal way 81: and for the normal credit terms of +0 days. " copy invoice is sent to the factoring company. )hen it receives the invoice, the factoring company will pay 40- of the invoice value to the selling company 8/:. In the example above, the selling company would send out H+,000 of invoices in Ganuary and will get 40- of this 8i.e. H5,400: immediately. In +0 days time, the buying company makes its payment, but sends it to the factoring company 8>: and not to the selling company. )hen the factor receives payment, it sends the /0- balance to its client, the selling company. The factoring company makes its money by charging its client a percentage of the value of the invoices it has factored. This is usually done on a monthly basis. To the selling company, this represents the cost of balancing cash flow to the issuing of invoices on a credit basis. If a particular customer fails to pay I perhaps because it have gone into liquidation I the factoring company cannot reclaim the 40- it has already paid to its client. This is known as non recourse factoring. <ecause of this, factoring companies always examine the credit track record of 'customer( companies. If a 7

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Department of Business and

particular companyBs credit rating gives cause for concern, the factor will simply inform its client business that it will not factor invoices to that particular company. Invoice factoring can be seen as an alternative to an overdraft for a business. <usinesses will look at the comparative costs of both before deciding which facility to choose. 0! Leasing If a business needs assets I such as a new computer system or fleet of vehicles I it has the choice of buying them outright or leasing them. In practice, leasing is a form of hire under which the business has the use of the computers or vehicles for an agreed period. The business leasing the assets is obliged to look after maintenance. Leasing is particularly advantageous in situations of uncertainty or where the business is not willing to commit large capital sums to buy assets. It can also make sense where technology changes rapidly and a business needs to update its equipment regularly. Eurther, leasing can have tax advantages for both the business leasing the assets and the lessor. Leasing is available to all types of business. In some cases, there may be an option to buy the assets at the end of the lease. This arrangement is called lease/purchase 1! Tra%e cre%it "nother possible solution to the short run cash flow problem is to try to find ways of delaying payments to suppliers. To achieve this, a business will try to negotiate trade credit terms with its suppliers. <efore being allowed such credit, a new business is likely to have to establish a credit track record by paying cash with orders for some time. )hen trade credit terms can be arranged, the business can order materials from suppliers and perhaps process them into finished goods for sale before it has to pay for them.
Prepared By: Emmanuel George

Finance

The maCor advantage of trade credit is that it is interest free. ome suppliers who give trade credit will also offer cash discounts to buyers who pay early. 3! Hire ,)rchase Agreement The customer can hire goods and can buy them at the end of the hire period. #onsumer durables like freeJers are sold in this way. The goods remain the property of the seller till the last payment is made. Feat)res o" Hire 5)rchase • • • • The hire purchase agreement is an agreement to hire with an option to purchase. 3wnership lies in the hands of the seller till the buyer pays the full amount. If the buyer fails to pay the installment, the goods will be repossessed by the seller. Dire purchase is suitable for capital goods

A%4antages o" hire 5)rchase to the #)yer '! It enables the poor people to obtain goods. /! %oods can be bought immediately and the payments can be made in installment. 0! %ood quality goods can be bought when they are needed the most. A%4antages o" hire 5)rchase to the se er '! It helps to increase the sales. /! If the payment is not made the seller can take back the goods by low. Disa%4antages o" hire 5)rchase to the #)yer '! %oods once bought cannot be sold until the last installment has been paid up. /! %oods can be bought only from those sellers who offer hire purchase credit. 0! The prices of the goods are high. 1! Dire purchase restricts the purchase of goods to only those that are large and have a resale value. 3! Dire purchase system motivates the people to buy unnecessary luxury items. Disa%4antages o" hire 5)rchase to the se er !

#ommerce & Students’ Guide Computing

Department of Business and

'! 6isk of bad debts. /! %oods repossessed may not be in a good condition and may have little resale value. 0! Dire purchase buying increases the capital required by the seller to run the business. 1! &ore administrative expenses insure to record and keep track of installment due. METHODS OF SELF FINANCING '! Retaine% ,ro"its an% sa4ings )hen a business makes a profit, a proportion will generally be paid out to the owners I in the form of drawings in the case of sole traders and partnerships or dividends on shares in the case of limited companies and .L#s. The rest of the profit will be retained in the business and can be used to finance the growth of the business in the form of new investment in plant and machinery. "s we have seen, there is no obligation on a company to pay out a particular amount as a dividend or even to make such payments to shareholders at all. Eor sole traders and partnerships, the owners may be willing to forego any drawings in the interest of ploughing back the profits into the business in the expectation that further profits will be forthcoming in the future. Thus, retaining profits represents an important option for a business seeking additional funds. In practice, for unincorporated businesses and limited companies, retained profits are the main source of finance over both the short and long term. If these businesses are to grow, then they must earn profit and retain much of it in the business.

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Finance

(-SINESS FINANCE Ca5ita #apital refers to the value of the things owned by a business. Ca5ita 6 Assets & ia#i ities '! Fi7e% Ca5ita This consists of the durable 8long lasting: assets of a business which are used over a long period of time and are tied up in permanent use, for example, land, buildings, machinery, furniture, motor vehicle etc. /! Wor2ing Ca5ita )orking #apital is the amount of capital, which is available to the day to day running of the business. It is the excess of current assets over current liabilities. )orking #apital ; #urrent "ssets $ #urrent Liabilities )# ; #" $ #L C)rrent Assets #urrent assets are those assets, which can be converted into cash within a short period of time, generally one year period. Kg stock of goods, debtors, cash at bank, cash in hand etc. C)rrent Lia#i ity #urrent liabilities are those liabilities of the business which has to be paid within a short period of time, generally one year. Kg. #reditors, <ank 397, short term loans etc. )orking capital is also known as circulating capital or 6evolving #apital. Eor example, cash is used to buy raw material, which is transferred into finished goods. Then the finished goods are sold in the market and realiJe the cash. This process goes on in business.

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Cash

A%4antages o" $or2ing ca5ita
Sales

Raw materials

ufficient working capital enables a firm to* 1. &ake prompt payment to the creditors and be able to enCoy cash discounts. /. Take advantage of change in price of raw materials by making bulk purchase of seasonal goods. >. 3btain loans from banks and Finished other financial institutions. 5. &ake prompt payment of expenses like wages, salaries, rent, interest etc. ,. Knsure smooth working of the business. Ways o" increasing the $or2ing ca5ita ! 1. Investing more cash capital by the owner. /. 3btaining loans and advances from banks or other sorces of finance. >. <y making profit on itBs trading. 5. <y selling some of its fixed assets for cash. ,. <y issuing new shares and debentures 8 in the case of .ublic Limited #ompanies: Reasons "or re%)ction in $or2ing ca5ita 1. The owner of the business withdraw cash for his personal use. /. Thew company declaring a dividend, which increases the current liability of the company. >. The company making loss on its trading. 5. The purchase of fixed assets for cash. Wor2ing Ca5ita Ratio 8C)rrent Ratio9 It is the ratio of current assets to current liabilities. It can be calculated by dividing current assets with current liabilities. This ratio is used to show the extent of the business financial stability. /*1 is the generally accepted working capital ratio. Wor2ing Ca5ita Ratio 6
12 Goods

C)rrent Assets C)rrent Lia#i ities

Prepared By: Emmanuel George

Finance

0! T)rno4er Turnover is another name for net sales. =et sales mean sales minus sales returns. " business can make profit only when there is turnover. Digh turnover results in high profit. but increase in profits doesnBt have direct proportion to increase in turnover. T)rno4er 6 Sa es & Sa es Ret)rn 1! ,ro"it <usiness is carried on mainly to make profit. This is done by purchasing goods at lower price and selling them at high price after charging its condition. %enerally profit is calculated by deducting cost of goods sold and expenses from sales. <ut profits can be correctly estimated only after considering the following points* a! T)rno4er Turnover is another name for net sales. =et sales mean sales minus sales returns. " business can make profit only when there is turnover. Digh turnover results in high profit. but increase in profits doesnBt have direct proportion to increase in turnover. #! Cost o" Goo%s So % #ost of %oods sale. #ost of goods sold ; 3. stock L net purchase L direct expenses ; closing stock or ales $ %ross .rofit. c! Gross ,ro"it! %ross .rofit is the difference between turnover and cost of goods sold. %ross profit is not true profit, because it is the profit before deducting any expenses incurred in selling the goods such as rent of premises, wages, 13 old includes the total cost of goods purchased for sales and all direct expenses incurred on the goods for making them ready for

#ommerce & Students’ Guide Computing

Department of Business and

interest on capital etc. Digh gross profit shows that there is enough profit to meet the expenses and leaves a certain amount as net profit. Gross ,ro"it 6 Net Sa es & Cost o" Goo%s So % %! Net ,ro"it =et .rofit is the true profit obtainable from trading. It is amount remaining after deducting all expenses from the gross profit. Net ,ro"it 6 Gross ,ro"it : other incomes & e75enses! ,ercentage o" ,ro"it '! Margin &argin is the gross profit as a percentage of sales 8turnover:. &argin is also known as %ross profit turnover or %ross profit margin. Margin 6 Gross ,ro"it ; '<< Sa es /! Mar2= )5 &ark $ up is the gross profit as a percentage of cost of goods sold. Mar2=)5 6 Gross 5ro"it Cost o" goo%s so % 0! Net ,ro"it ,ercentage or N, T)rno4er 6 Net 5ro"it ; '<< T)rno4er ; '<<

Remem#er+ If Mark-up is 25% = ¼, then margin should be ¼ + the numerator of mark-up to the denominator of margin. Then it should be !5. It is e"ual to 2#%.

Reasons "or "a in Gross ,ro"it ,ercentage 1. Increase in cost of goods sold.
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Finance

/. Mnnecessary expenses incurred. >. Inefficiency of workers. 5. Loss or damage of stock. ,. Lower selling price. +. #hanges in fashion, taste etc. Reasons "or Rise in Gross ,ro"it ,ercentage 1. 7ecrease in cost of goods sold. /. Increased efficiency. >. 6eduction in unnecessary expenses. 5. 7ecrease in loss due to theft or damage. ,. Increased selling price. Ho$ to Increase Net ,ro"it ,ercentage? =et profit percentage can be increased by increasing turnover, reducing cost of goods sold and reducing expenses. Turnover can be increased by increasing selling price, using more advertising, sales promotion or by allowing more credit. #ost of goods sold can be reduced by purchasing goods in bulk at a lower price or by finding out better and cheaper suppliers Kxpenses can be reduced by reducing costly advertising, reducing the number of employees or reducing free services offered. Ca5ita an% ,ro"it! " businessman can get a clear picture of the profitability of his business only when he compares the profit with the capital invested. <y this he can find out the percentage of profit on the capital invested and also can compare the profit with what he could have earned by investing the money in banks or building societies. Rate o" Stoc2 T)rno4er or Stoc2 T)rno4er 6ate of stock turnover is a measurement of how immediately goods are sold in a given period of time, usually one year. This ratio is generally expressed in terms of times. 6ate of Turnover may vary from firm to firm. Eor high quality, expensive items rate of turnover will be low because such goods are sold very slowly. <ut for perishables like fresh fish, vegetables, fruits, newspapers etc the rate of turnover will be high because these goods are sold quickly.

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Rate o" Stoc2 T)rno4er 6 Cost o" Goo%s So % A4erage Stoc2 A4erage Stoc2 6 O5ening Stoc2 : C osing Stoc2 / Im5ortance o" Rate o" Stoc2 T)rno4er " firm with high rate of stock turnover will be more efficient because* 1. Less capital will be tied up. /. Kxpenses are spread over a large volume of sales. >. tocks are quickly sold off and the cash so recovered can be used to pay off creditors. 5. Erequent purchase of stock from its suppliers makes it possible to buy in more favourable terms. ,. Loss due to damage, spoilage and changes in fashion will be very low. Ho$ to im5ro4e the rate o" stoc2 t)rno4er? 1. (y re%)cing the si>e o" the a4erage stoc2 nee%e%! This can be done by eliminating the slow lines or by placing smaller orders with suppliers. /. (y c)tting 5rices, especially for luxury goods, if demand is price elastic >. <y advertising and sales promotion. 5. <y offering credit

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Finance

?-ESTIONS 1. Eig. shows several sources of finance. SO-RCES OF FINANCE Long term Short Term <ank Loan <ank overdraft 7ebentures Dire .urchase 3rdinary shares Trade #redit Mse Eig. to help you to answer the following questions. 8a: 7istinguish between long term and short term sources of finance. 8c: Kxplain three differences between a bank loan and a bank overdraft. in Eig. that a limited company might use to* 8i: 8ii: 8iii: purchase a new factory pay for computer software make repairs to its office building. N>O N>O N>O N5O N+O 8b: =ame one other source of long term finance not shown in the diagram. N1O 8d: %iving reasons for each of your choices, recommend a source of finance given

/. Eig. shows a limited company with the following sources of finance available to it.

8a: Erom Eig. identify* 8i: two short!term sources of finance 8ii: one long!term source of finance. 8b: Kxplain the differences between a debenture and an ordinary share. given in Eig. that a limited company might use* 8i: to build an extension to its offices 8ii: to pay for a new computer system 17 N>O N/O N1O N5O

8c: %iving reasons for each of your answers, recommend a source of finance

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Department of Business and

8iii: to obtain stock from a supplier. rather than any of the sources of finance listed in Eig. >. 8a: )hat are the main characteristics of a bank loanP rather than a bank overdraftP 8c: The building company wishes to obtain a loan of 2+00000.

N>O N5O N+O N5O

8d: Kxplain two reasons why this company might prefer to use retained profits

8b: In what circumstances would a building company make use of a bank loan

8i: Imagine that you are a bank manager. )hat information would you require from the building company before you decide whether or not to offer a bank loanP company will pay each year if it obtains the 2+00 000 loan. working. proCect. N,O how your N/O N>O 8ii: Interest rates are +- per year. #alculate how much interest the building

8d: Kxplain why the building company might use its retained profits to finance a

5. " small company manufacturing garden machinery has the following three financial problems* • an immediate shortage of cash to pay some unexpected bills • the need to replace all the out!of!date office computers • expansion plans for the business over the next five years. &ethods of finance available to the company are* M I=% 6KT"I=K7 .63EIT LK" I=% KRMI.&K=T I MI=% &36K D"6K 3<T"I=I=% " <"=Q L3"= 6KRMK TI=% " <"=Q 3AK676"ET

Msing the list of methods of finance given above, answer the following questions. 8a: %iving an example of each from the list above, distinguish between long! term and short!term methods of finance. N5O 8b: Erom the list above, recommend the best method of finance to solve each of the companyBs three financial problems. In each case gi4e three reasons for your choice. N1/O 8c: It would be possible to use debentures to finance the companyBs expansion
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Finance

plans. tate and explain two reasons why the company reCected this source of finance for this proCect. N5O

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