LECTURE 4

SOURCES AND USES OF FUNDS

DISTINCTION BETWEEN SHORT TERM AND LONG-TERM FUND *

To attain the company's targets, it must includes sufficient funding of any corporate investment.
Funding sources are, generally speaking, capital raised by issuing new debt and equity, which is self-
generated by the company and capital from outside investors or funders.

In terms of strategy and cash flow, management must seek to align the long-term or short-term
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funding mix as closely as possible with the assets being funded.

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SHORT-TERM FINANCING *

Short-term funding can be adapted for a duration of up to one year to enable companies to pay
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primarily for their short-term needs.

Uses of Short-Term Funds

The best way to understand why firms resort to short-term financing is to look into its operations. Firms
need to access short-term funds for the following reasons:

1. 1. To sustain occasional rise in demand for its goods and services- The company would need to
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acquire more inventories and supplies. Additional manpower will require more funds to devote to
salaries.

2. Payment of short-term obligations- Firms need to satisfy their financial obligations. At times they have
to resort to short-term loans in order to repay other obligations such as the supply credits and tax
liabilities.

3. Funding for short-term projects or programs- Short-term plans and programs are identified during the
annual planning of any firm. Even at that point, the finance manager should already have an idea of
whether there would be sufficient funds or not.

4. Allowance for receivables- It may take some time before a firm is able to collect money that is owed to
them by customers. Before sales are actually converted into cash, the firm has to supply funding to
cover maturing obligations and replenish inventory.

5. Funding for unforeseen events- Such events may be economic such as sharp increase in the prices of
inputs and prime commodities, a natural calamity or anything that may arise as a result of the firm’s
operations like a defective product that negatively affected a customer.

Sources of Short-Term Funds

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Given here are sources of short-term funds for different firms:

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1. Supplier’s Credit- As raw materials and supplies are part of working capital , the best sources of these
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are the suppliers providing credit to business owners. This is the reason why a good relationship has to
be nurtured with suppliers. As much as possible, honor the credit terms. Some suppliers charge a small
interest rate on their deliveries to their customers if not paid on time.

2. Advances from stockholders- personal funds advanced by a stockholder to a company that usually
requires interest. These usually require little to no interest on advances, especially if the owner is
 advancing funds to assist the company in sudden liquidity crisis. This source, however, is depended on
the availability of funds of an individual.

3. Credit cooperatives- provides lending services to its members. Members usually pay contributions to
the cooperative.

4. Banks – provide several loan products catering to different types of needs. It can be short-term or long-
term loans. Some banks also provide credit facilities, not just to big corporations but also to small and
medium enterprises (SME) like government banks such as the Development Bank of the Philippines
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(DBP) and Land Bank of the Philippines (LBP).

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5. Lending Companies – companies that are dedicated to lending. They usually charge higher interest
than banks, but their credit requirements are more lenient compared to banks.

6. Informal lending sources such as “5/6”- Interest is usually paid per month, and monthly interest is (6-
5)/5 or 20%. Annual interest is actually 20%*12 or 240%. Therefore, this source of financing should
never be considered because you will end up working for the creditor.

The financial instruments below are used in short term financing of companies.
* *

• Commercial Paper *

“This is an unsecured promissory note on the global money market , with a predetermined maturity of 1
“ ” * *

to 364 days or within 1 year. Large corporations issue it to get financing to fulfill short-term debt obligations.
This is only backed by a commitment made by an issuing bank or company to pay the face sum on the date
of maturity indicated on the note. Only companies with outstanding credit ratings from legitimate rating
departments and agencies would be able to trade their commercial papers at a fair price because commercial
papers are not supported by collateral; thus, it is only backed by issuer’s integrity. ”

• Asset-backed commercial paper (ABCP) *

Naturally, ABCP is a short-term instrument that matures between 1 and 180 days from date of
“ * * *

issuance of financial institutions like banks. Other financial assets serve as collateral for this type of
commercial paper .” *

• Promissory Note *

This type of instrument is a kind of negotiable instrument used by issuer and payee under which one
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party (the issuer) makes an unconditional promise or written commitment to pay the other (the payee) a
certain amount of money in certain conditions, either at a specified future period or on the payee 's request
(on demand of the payee ). *

• Asset-based Loan *

This form of loan, mostly in the short term , is backed by the assets of a firm. The usual assets that are
**

used to collateralize the loan are real estate, accounts receivable (A / R), inventory and equipment. A single
asset category or a combination of assets ( for example, a combination of Accounts receivables and
equipment) may be used as collateral .

• Repurchase Agreements *

“The maturity of these instruments range from one day to less than two weeks, though typically it is
only traded for just one day. There is an agreed fixed price and fixed date as arranged by the issuer of
security and the investor. ”
LONG-TERM FINANCING

A long-term source of funds or long-term financing is tapped by firms to fund their long-term capital
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requirement.

Uses of Long-term funds:

a. Acquisition of machineries and equipment

b. Acquisition of furniture and fixtures
c. Building of a new plant
d. Major upgrade facilities
e. Acquisition of an existing firm
f. To organize a new venture or additional strategic business unit

REMEMBER!

Long-term investments have to be financed by long-term sources of funds to

minimize default risk* which means that a firm may not be able to meet maturing
obligations. The returns on long-term* investments may not be realized
immediately, and therefore require more patient source of financing.

Sources of Long-term Funds *

• Equity Financing *

This involves preferred stocks and common stocks which are less volatile in terms of cash flow
“ ** *

commitments . It does, however, result in a dispersion of shareholding, control and profit. The cost of equity
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is therefore usually higher than the cost of debt-which is, however, a deductible expense -and so equity
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investment will result in a higher threshold rate that can reduce some decline in the risk of cash flow. ”

• Corporate Bond *

A corporate bond is a bond issued by a company to help raise capital to grow and develop its
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enterprise. The term is typically attributed to longer-term debt instruments , with a maturity date commonly
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following at least one year after their issuance date. ”

Some corporate bonds have an embedded call right allowing the borrower to repay the debt before
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its due date. Many bonds, or convertible bonds, make it possible for creditors to turn the bond into equity . *

• Capital Notes *

Capital notes are a type of convertible security which can be exchanged into shares. This is the
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reason why they are termed as equity vehicles . Capital notes are similar to bonds, in that they also have no
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expiry date or exercise price (thus, the entire fee that the corporation hopes to obtain is charged when the
capital note is released for the future issue of shares).
Capital notes are often issued in conjunction with a debt-for-equity exchange restructuring: instead
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of selling the shares (which substitute debt) at present, the corporation offers investors convertible securities *

– capital notes – so the dilution or dispersion of ownership will just happen at a later period.
 • Internally generated funds

Not all profits are distributed to stockholders. Most of the profits are re-invested and used by companies
to finance their needs. Instead of declaring cash dividends, the company can use internally generated funds for
expansion or to finance other types of capital investments.

• Banks

They provide long-term loans which also depends on the type of business needs. For instance, a 5-year
to 10-year loan may be granted if the purpose of the loan is construction of an office building. They provide lower
interest rates than other institutions in the market but they have a lot of requirements and processes.
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DEBT AND EQUITY FINANCING

Choosing between investing in equity and taking out a loan for a company is a struggle for all entrepreneurs
when they need capital to grow a business. A dilemma between opting for a bank loan to finance your business
operation and looking for a venture capitalist or investor is a very tough decision for the financial manager.
Equity funding also includes giving an investor more shares of common stock. With more common stock
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shares issued and outstanding, the level of ownership of previous stockholders is being reduced.
Debt financing means borrowing money and not sacrificing property. Debt financing also has rigid terms or
“ * *

covenants, as well as having to pay interest and principal on set dates. Failure to meet the debt criteria would
have serious repercussions. Debt interest is a deductible expense when calculating taxable earnings. It means
that if the business is profitable the effective interest cost is less than the reported interest. Having too much
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debt would raise the potential cost of borrowing capital for the company and it will bring risk to the organization. ”

Consider the advantages and disadvantages of each to determine which type of financing is best for your
business:

▪ Equity financing

If an entrepreneur wants to grow a company but cannot afford the risk to take on debt, an investor that
is willing to finance the operations of the company may seem like the perfect answer to that. It's capital
without the redemption or interest-causing- headache, after all. Yet the Pesos come with big strings
attached: with the venture capitalist or angel investor, you have to split the profits depending on the
predetermined agreement.

Advantages of equity financing : *

➢ Since investors understand that you do not have to pay or return anything back, it's less expensive than
a loan. It is then a nice choice if you do not want to take the risk of having debt.
➢ Accessing the investor's network can contribute to the business' reputation. • Investors usually have a
long-term plan for their investment and most of them do not seek an instant gain on their investment.
➢ You 're not going to have to direct income to repay the loan.
➢ You 're going to have more cash available for company expansion.
➢ In the event of bankruptcy, there is no obligation to return the investment.

Disadvantages of equity financing : *

➢ Sometimes, expected returns may be more than the rate you would have paid instead for a bank loan *

➢ The investor would need the company's ownership and a part of the income. You do not want to
relinquish this kind of power over your company.
➢ You'll need to inform investors before making major (or routine) decisions — and you may differ with
your investors’ decisions arising to conflict.
 ➢ In the event of disputes with investors, you will need to cash the percentage of your ownership and
permit investors to take over the company without your presence.
➢ Finding the best investor for your business requires time and dedication.

▪ Debt financing **

The banking arrangement or terms that you have with a bank that loans you money is somewhat
different from an investor's loan — it does not demand you to give up a portion of ownership of your
business. But if you're carrying on too much debt, it is a problem that may hinder the expansion of your
firm.

Advantages of debt financing : *

➢ The bank or lending agency (such as the Small Business Administration ) does not have any influence
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on your methods of business operations your and it has no any control over the company.
➢ If the money is paid back, the business agreement ends with it.
➢ Tax free interest on the loan.
➢ there is flexibility of choosing between short-term or long-term loans .
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➢ Principal and interest rates are established statistics that you should prepare and include in your
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budget ( for as long as your rate of loan is not variable).

Disadvantages of debt financing : *

➢ Maturity period of your debt must be met which means it should be paid back on time
➢ The owner might struggle to meet the obligations to the bank if the company’s capital structure has
more percentage of debt financing. This will then negatively affect the cash flow of the company.
➢ When you hold too much debt, prospective investors will see you as a "high risk" – which would affect
your company in the future for it may limit your ability to raise capital through possible equity funding.
➢ Debt funding will make business susceptible to financial issues in times of difficulty when profits fall due
to fluctuation of sales.
➢ Because of the significant cost of repaying the loan, it may make it hard for the organization to expand.
➢ Company properties can be retained by the lender as collateral. And the company's owner is always
expected to guarantee the loan's repayment in person.

“ Many companies choose the combination of both equity and debt funding to meet their needs especially
when a company decided to expand its operations in the market. A good combination of the two methods
of funding will be much more effective to reduce each of their drawbacks. The right balance will vary based
on the business size, cash flow, income and the amount of money you need to improve your business. ”

For the purpose of identifying the bank and non-bank institutions that may be source of funds , the roles of
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the following institutions are reiterated:

• Commercial Banks *

Accepting deposits and providing convenience and guarantee to the customers that their money is
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secured in their institution are the main purposes of commercial banks. One aspects of the banks' original
intent is to provide safe keeping for their money to customers. When holding physical cash at home or in a
pocket, the possibility of loss due to robbery and injuries is present, not to mention the loss of future interest
income. Customers no longer have to hold huge quantities of money on hand now that banks can do it for
them. In addition, purchases can be done with checks, debit cards or credit cards. ”

Commercial banks often offer loans that individuals and companies use to buy products or increase
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business activities , resulting in more deposited funds finding their way into banks. These institutions earn
money by charging higher rates to loans than what they have to pay to their depositors and covering of their
business operational expenses. ”

Banks often play under-estimated roles as payment agents within a country and among nations. In
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addition to issuing debit cards that allow account holders to pay for products with a card swipe, banks may
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also organize wire transfers with other entities. Banks effectively underwrite financial transactions by lending
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their integrity and legitimacy to the transaction; a check is simply just a promissory note between two
individuals, but no merchant will approve it without a bank 's name and identification on that note. The banks
make financial transactions even more convenient as payment agents;; Credit cards, checks and debit cards
are now typically accepted and allowed in different enterprises so holding huge amount of money is not
needed anymore. ”

Nonbank Financial Institutions *

These institutions are not banks but they offer similar services as provided by commercial banks . *

• Savings and Loans *

Savings and loan companies, also called S&Ls or thrifts, in many respects emulate banks' services and
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operations. The discrepancies between commercial banks and S&Ls are unclear to most customers. lBy
regulation, companies with savings and loans must have 65 percent or more of their loans in mortgage debt
or residential loans, although other types of loans are permitted. ”

S&Ls have evolved considerably in reaction to commercial banks' uniqueness. There was a time when
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banks would only accept deposits, with references, from people of relatively high wealth and would not lend
to ordinary workers. Savings and loans typically offered lower borrowing rates and higher interest rates on
deposits than commercial banks which are more appreciated by different entities; However, savings and
loans have lower profit because they are mutually owned. ”

• Credit Unions
“Another substitute to standard commercial banks is the credit unions. Unlike S&Ls, credit unions
typically pay higher savings rates and lower loan charges relative to commercial banks. Nearly all the credit
unions are structured as non-profit cooperatives. Unlike banks and S&Ls, credit unions can be chartered at
the state or federal level. ”

“ There is one specific limitation on credit unions, in return for a little additional benefits; not everyone
can access the facilities of credit unions because they are only exclusive to a small category of members. In
the past, this has meant that the only people eligible to join a credit union were workers of certain businesses,
members of certain religions and so on. However, as to the evolution of the financial markets over the years,
this limitation has been gradually changing. ”

• Shadow Banks *

It is a group of investment banks , insurers and other non-bank financial institutions that imitate some
“ ** * *

of regulated banks' operations, but do not function under the same setting that is regulated and monitored
closely. ”

In the Philippines, the shadow banking system cashed a lot of money into the residential mortgage
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market. Insurance companies would purchase mortgage bonds from investment banks, which would then
use the revenue to purchase more mortgages , enabling them to issue more mortgages . Revenues from the
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mortgage sales are then utilized more by shadow banks to capitalize more on mortgages.

A lot of financial experts calculated the size of the shadow banking system in the Philippines and they
implied that it had prosper to that of the size of the traditional Philippine banking system in the year 2008 .
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The complexity of the operations within the shadow banking system created a lot of issues besides
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having lack of regulatory and documenting requirements. In particular, most of them "borrowed short" to
"lend long." This means that they were utilizing short-term sources to fund long-term debt commitments. This
left these institutions very vulnerable to short-term rate rises, and when those rates increased, many
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institutions were forced to scramble to liquidate their properties and assets and make margin calls . *
Furthermore, as these institutions were not part of the formal banking system , they did not have access to
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the same emergency funding facilities . * ”

DOCUMENTATION LOAN REQUIREMENTS

A documentation loan is a type of loan demanding full details to substantiate income and asset
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statements by a borrower to obtain financing . The huge percentage of loans are loans related to secured
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loans requiring full documents. The borrowers use the documentation given during the underwriting process
to ensure that the funding application is correct and to further evaluate the conditions of a loan agreement.
In comparison, "No doc" loans do not involve assessing collaterals or any proof of income. No doc loans are
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also classified as "extreme risk" loans, and they can also violate the rules of regular lending. It is still better
to obtain a loan for documentation by presenting the requisite details on loan for security purposes. ”

Income Verification *

“The most important aspect you would need to provide a creditor to indicate you can repay a loan is to
check your company profits and your proof of income. There are many ways to check profits, which can have
different criteria for each lender. One choice that works with most borrowers is to supply tax details and
audited financial statements for at least 2 years. For example, send copies of W-2 reports valued over the
past two years that document your real income. Alternatively, if you are self-employed, you would need to
include related business papers of your own business transactions. ”

Creditors can also consider the employer 's pay-check slips or proof of income. Even so, almost all
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lenders would check if for at least two years you have earned income that is approximately equivalent to
your present level of income. yThe ideal outcome is to demonstrate continued jobs with the same employer
with a growing income for two years, or evidences that you maintain good business operations. ”

Asset Verification *

“Creditors will recognize your assets as they verify your financial capability in full. Not everyone need to
learn your "total value" to get your loan prolonged or stretched. And, if you put any collateral on a loan, with
extensive reports, you would need to check the value of that collateral. The statement provided by the primary
lender will represent how much equity you obtained. It shows the second lender how much he would
anticipate to get back if you were ever to fail on paying the loan and the debtor wanted to reclaim your
properties. ”

Liens and Liabilities *

“Debtors can't quantify your assets to assess the financial security alone. We must always take into
account the loans and obligations. For instance, if you or your company take out a mortgage, your mortgage
lender may require information whether you have loans to other lending institutions as well. This will impact
your ability to have a new loan on the basis of your present income. Liabilities can be identified by simply
testing the credit. Your credit report should represent all your debts and liabilities in respect of your assets.
A credit review is done without you having to submit any proof or supporting documents. Everything you
need to know is your Social Security number , Tax Payer Identity or Credit Report number, etc. With your
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permission, the lender will process the credit check. ”

LOW OR NO DOCUMENTATION LOAN *

There is also what we call low documentation loan that demands hardly any examination of the
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statements when applying for a loan. Documentation loans allow a borrower to provide proof of income,
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proof of assets and other documentation before the underwriting process progresses. None of these items
are needed by low documentation loan. Then, the borrower just needs to put enough money as a down
payment to get the loan. The borrower will have to consider higher interest rates and borrowing costs as well
*

as a lower loan-to - value ratio on an asset, in return for the relative simplicity of the lending process.
* ”

General Steps in Loan Application:

• Loan applicant inquires with the loan officer to apply for a loan.

• The loan officer provides the loan applicant a loan application form and interviews the client.
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• The loan officer then decides what type of loan product the borrower qualifies in, and then
provides them a list of requirements.

• The applicant then submits the requirements along with the loan application form.

• If collateral is required, the corresponding mortgage documents are made ready.

• The loan officer then forwards the documents to the credit evaluation department.

• The credit evaluation department checks whether the applicant provided the complete
documents.

• Credit investigation is done, and the credit worthiness of the loan applicant is evaluated.

• The credit analyst prepares a recommendation and will present the recommendation before a
loan committee who approves the loan application. The loan committee is generally composed
of top executives from the bank.

• If the loan is approved, then the post-approval requirements will be sent to the loan applicant for
compliance.

The 5Cs of Credit

Financial institutions or intermediaries need a way to evaluate the credit worthiness of potential clients-
individuals and firms who apply for credit. This serves as the basic requirement when applying for a loan.

✓ Character –this refers to an applicant reputation and the enthusiasm of the borrower to meet his or her
obligations to the lending institutions or entities

✓ Capacity – a customer’s ability to generate cash flows; for a firm, a solid business plan is needed

✓ Collateral – security pledged for payment of the loan to minimize default risk

✓ Capital – sources of finances* of the borrower

✓ Condition – present conditions of the market, economy and even politics

*

DUTIES OF THE BORROWER TO CREDITORS

➢ Pay the creditors based on the payment schedule agreed upon. If you cannot pay on time, notify the
creditors ahead of time.

➢ Provide the collaterals as agreed upon in the loan negotiation with proper documentation, if necessary
and if applicable (e.g. annotation of the TCT or CCT). Ensure that these collaterals are in the physical
condition perceived by the creditors in determining the loanable value of the loans.

➢ Comply with the provisions of loan covenant such as maintaining certain liquidity and leverage ratios.
These conditions are supposed to benefit the borrower so that his company will not be over-exposed to
borrowing or he will monitor the liquidity position on a more regular basis.
➢ Notify the creditor if the company is acquiring another company or the company is now the subject of
acquisition. The interest of creditors may be jeopardized if new owners take over the company or if the
company is going to acquire another company.

➢ Do not default on the loans as much as possible. Aside from the creditors, there may be other parties
such as the guarantors of the loan who will be put at a disadvantage if the borrower defaults.