UNIVERSITY OF NAIROBI

DBM 102: FINANCIAL MANAGEMENT

RUSHITA MORJARIA
L123/22651/2019

ASSIGNMENT
 1. Explain the following types of business organizations:
a) Sole trader

An individual who runs an unincorporated business on his or her own. Sometimes otherwise
known as a "sole proprietor" or (in the case of professional services) a "sole practitioner".

The sole trader structure is the most straight-forward option. The individual is taxed under the
Inland Revenue's Self-Assessment system, with income tax calculated after deduction for
legitimate business expenses and personal allowances. A sole trader is personally liable for the
debts of the business, but also owns all the profits.

The main advantages of setting up as a sole trader are:

 Total control of the business by the owner.

 Cheap and easy to start up – few forms to fill in and to start trading the sole trader does
not need to employ any specialist services, other than setting up a bank account and
informing the tax offices.
 Keep all the profit – as the owner, all the profit belongs to the sole trader.
 Business affairs are private – competitors cannot see what you are earning, so will know
less about how the business works and how it succeeds.

The reasons why sole traders are often successful are:

 Can offer specialist services to customers – e.g. appliance repair specialists.

 Can be sensitive to the needs of customers – since they are closer to the customer and
will react more quickly, because they are the decision makers too.
 Can cater for the needs of local people – a small business in a local area can build up a
following in the community due to trust – if people can see the owner they feel more
comfortable than if the owner is in some far off town, not able to hear the views of the
local community.

The legal requirements of a sole trader are to:

 Keep proper business accounts and records for the Inland Revenue (who collect the tax
on profits) and if necessary, VAT accounts
 Comply with legal requirements that concern protection of the customer (e.g. Sale of
Goods Act)

The main disadvantages of being a sole trader are:

 Unlimited liability
 Can be difficult to raise finance, because they are small, banks will not lend them large
sums and they will not be able to use any other form of long-term finance unless they
change their ownership status.
  Can be difficult to enjoy economies of scale, i.e. lower costs per unit due to higher levels
of production. A sole trader, for instance, may not be able to buy in bulk and enjoy the
same discounts as larger businesses.

There is a problem of continuity if the sole trader retires or dies – what happens to the business
next?

The reasons for being a sole trader are often a balance between business and personal costs and
benefits. Many will prefer the satisfaction of running a business with little paper work against the
risks, pressure and probably long working hours.

A sole trader is liable for any debts that the business incurs. This means that any money that the
owner has put into the business could be lost, but importantly, if the business continues to incur
further costs then the owner has to pay these as well. In some cases, they may have sold some of
their own possessions to pay creditors.

Such a risk often puts potential sole traders off setting up businesses, but also makes them
consider the other forms of business structure.

b) Partnership

A partnership is an association of two or more people formed for the purpose of carrying on a
business. Partnerships are governed by the Partnership Act (1890). Unlike an incorporated
company, a partnership does not have a "legal personality" of its own. Therefore, the Partners are
liable for any debts of the business.

Partner liability can take several forms. General Partners (the usual situation) are fully liable for
business debts. Limited Partners are limited to the amount of investment they have made in the
Partnership. Nominal Partners also sometimes exist. These are people who allow their names to
be used for the benefit of the partnership, usually for remuneration, but they do not get a share of
the partnership profits.

A partner is normally set up using a Deed of Partnership. This contains:

 Amount of capital each partner should provide (i.e. starting cash).

 How profits or losses should be divided.
 How many votes each partner has (usually based on proportion of capital provided).
 Rules on how to take on new partners.
 How the partnership is brought to an end, or how a partner leaves.

The advantages of a sole trader becoming a partnership are:

 Spreads the risk across more people, so if the business gets into difficulty then there are
more people to share the burden of debt
  Partner may bring money and resources to the business (e.g. better premises to work
from)
 Partner may bring other skills and ideas to the business, complementing the work already
done by the original partner
 Increased credibility with potential customers and suppliers – who may see dealing with
the business as less risky than trading with just a sole trader

For example, a builder, working originally as a sole trader, may team up with an architect or
carpenter to form a partnership. Either would bring added expertise, but also might bring added
capital and/or contacts. Of course, the builder could team up with another builder as well –
sharing the risk, and potentially the workload.

The main disadvantages of becoming a partnership are:

 Have to share the profits.

 Less control of the business for the individual.
 Disputes over workload.
 Problems if partners disagree over of direction of business.

The next step for a partnership is to move towards becoming a private limited company.
However, some partnerships do not want to move to this stage.

The advantages of remaining a partnership rather than becoming a private limited company are:

 Costs money to set up limited company (may need to employ a solicitor to set up the
paper work).
 Company accounts are filed so the public can view them (and competitors).
 May need to spend money on an auditor to check the accounts before they are filed.

When a partnership finishes then, depending on how the Deed of Partnership is set up, each
partner has an agreed slice of the business.

Types of partnerships:

 General partnership - A general partnership is a partnership with only general partners.

Each general partner must actively participate in managing the business and any partner
may sign a contract on behalf of the partnership. The partners must agree to major
decisions, acting as a corporate board of directors. Because, general partners actively
participate, they all must take personal responsibility for the liabilities of the business and
for debts incurred by other partners. If one partner is sued, all partners are held liable. A
partner's personal assets may be taken by a court or creditor. General partnerships are the
least desirable for this reason.
  Limited partnership - A limited partnership includes both general partners and limited
partners. In many cases, there is one general partner who manages the business and a
number of limited partners. A limited partner does not participate in the day-to-day
management of the partnership and his/her liability is limited to his investment in the
business. In many cases, the limited partners are merely investors who do not wish to
participate in the partnership other than to provide capital and to receive a share of the
profits. Because limited partners don't participate in management, they are considered
passive investors. This means they can't take partnership losses off their income tax
return if they don't have other income to offset it.
 Limited liability partnership - A limited liability partnership gives limited liability to
every owner. This means that each partner is protected from financial and legal mistakes
of the other partners. As a result, a limited liability partnership has some elements of both
partnerships and corporations.

c) Companies

Incorporation is a complicated and sometimes costly legal process which private and public
companies must go through before they can begin trading. Once all the requirements of the
process have been met, the Registrar of Companies will issue a Certificate of Incorporation.

Both private and public limited companies must have a Board of Directors.

Private Limited Companies – a company owned by shareholders. A limited number of shares are
issued and they are not able to be sold on the Stock Exchange.

Features of private limited companies:

 Limited or Ltd in their title

 Incorporated organization
 Owned by shareholders
 Limited Liability
 Board of Directors

Advantages of private limited companies:

 Raise capital through the selling of shares

 Separate legal identity from its owners
 In the event of a death of a shareholder, the business will be unaffected and continue to
trade normally.
 Limited Liability
 More privacy than a public limited company
Disadvantages of private limited companies:

 Some financial information needs to be made available to the general public.

 Registering through Companies House can be time-consuming
 Cannot offer shares for sale to the general public.
 Difficult to expand if the existing shareholders are unable to provide additional capital.
 Dividends for shareholders can drain company profits.

Public Limited Companies – a business owned by shareholders. Shares are sold on the Stock
Exchange.

Features of public limited companies:

 PLC in their title

 Incorporated organization
 Owned by shareholders
 Limited Liability
 Board of Directors
 Share capital has to be over £50,000.

Advantages of public limited companies:

 Raise capital through the selling of shares on the stock exchange.

 Limited Liability
 Greater access to capital to fund expansion

Disadvantages of public limited companies:

 Cost of setting up
 Financial information is available to the general public.
 Other businesses can buy up large quantities of the company’s shares which could result
in a takeover.
 Shareholders own the company but unless they have a large number of shares, they will
not have a say in the way the business is run.

2. Explain the classification of sources of finance:

a) Long term sources and short-term sources

Long-term financing means capital requirements for a period of more than 5 years to 10, 15, 20
years or maybe more depending on other factors. Capital expenditures in fixed assets like plant
and machinery, land and building, etc of business are funded using long-term sources of finance.
Part of working capital which permanently stays with the business is also financed with long-
term sources of funds. Long-term financing sources can be in the form of any of them:
 Share capital - Main source of finance for most Limited Liability Companies. It is the money
raised from selling shares in the company.
 Leasing - Form of hiring whereby a contract is agreed between a leasing company (the
lessor) and the customer (the lessee). When the lessor grants the lessee the right to its
exclusive possession and use for a specific period of under specified conditions, in return for
lease payments or specified periodic rental. A long term written lease is called deed.
 Debenture - Debentures are another common means of finance used by companies who
prefer debt over the equity. Debt is considered to be the cheaper mode of finance compared
to equity. It does not share control with investors. It is because the interest paid to debenture
holders is tax deductible. Rest of process of debentures issue is similar to equity issue. It is
offered to the common public and therefore necessary legislations need to be complied with.
Debentures also involve some cost of issuing and they are collateralized by some assets of
the company.
 Term Loans from Financial Institutes, Government, and Commercial Banks - obtained from
commercial lenders such as banks. Interest charges are imposed and can be Fixed of
Variable, depending on the agreement between borrower and lender. The amount borrowed is
paid back in installments over a predetermined period, such as 5, 10 or 25 years.

For e.g, Mortgage (secured loan for the purchase of property such as land or buildings). If the
borrower fails to repay (default), then the lender can repossess (take back) the property.
 Venture capital - It is a capital invested in a project in which there is a substantial element of
risk, typically a new or expanding business. Venture Capitalists, seek to invest in a small to
medium sized businesses that have high growth potential. There is a considerable chance of
business failure but also significant returns if the business succeeds. They can also provide
invaluable advice about the strategic direction of the business. Venture Capitalists and
Business Angels look at a number of criteria before committing their capital in an investment
project, such as:
 Return on Investment - Each business in their investment portfolio has to have good
potential to be highly profitable because they know that a huge majority of business start-
ups fail outright. Investors Demand a return on their capital.
 The Business Plan - This should outline the long-term aim and purpose of the business
venture. It is to create direction and an identity for the business; which is central to
securing finance from investors. Investors must feel confident that the business fully
understands the market in which it operates. They want to see that the idea allows the
business to compete in a high-growth market with few competitors.
 People - No matter how good an idea might be in the business plan, success will only
materialize if the business has a good team of people. Ineffective people management is a
major cause of business failure; therefore, it is an aspect that venture capitalists will
examine carefully.
 Track Record - Investors will assess the past track record of a business and its
management before investing any capital. This might include an investigation into the
firm's ability to pay back previous lenders and the success record of the entrepreneurs.

Short term financing means financing for a period of less than 1 year. The need for short-term
finance arises to finance the current assets of a business like an inventory of raw material and
finished goods, debtors, minimum cash and bank balance etc. Short-term financing is also named
as working capital financing. Short term finances are available in the form of:
 Trade credit - Allows the business to buy now, and pay later. Although a sale is made at
the time of purchase, the seller or credit provider does not receive any cash from the
buyer until a later date. Creditors do this - they offer trade credit. Usually between 30-60
days for their customers (debtors) to pay back. Credit Cards are also similar to Trade
Credit; except that the creditor is not a supplier but a financial institution such as banks. It
is also a vital source of external finance for sole traders and partnerships.
 Bank overdraft - This allows a business to temporarily overdraw on it's bank account; to
take out more money than it has in it's account. It is commonly used when businesses
have minor cash flow problems. It is usually more cost effective than bank loans even
though it can demand a relatively high rate of interest, because Overdrafts are used as
short term sources of finance. It provides flexibility for businesses that might
occasionally face cash flow problems.
 Factoring in debt - It is an arrangement whereby the business sells its account
receivables/ debtors at a discount. In this arrangement, the buyer, who is known as the
factor, collects the money from the debtors on behalf of the business and charges a
premium for this service. If the debtor does not pay for any reason, the factor can get
back to the business for the payment.
 Advances received from customers

b) Equity sources and debt sources

Equity financing is selling a stake in the company to raise funds. Equity financing not only
involves the sale of equity shares but also includes the sale of other equity instruments like
common shares, share warrants, preferred stock, convertible preferred stock, etc.
 Angel investors - Those who buy equity in small firms are known as angel investors.
Normally such investors are friends or acquaintances of the entrepreneur. The
contribution of angels is supposed to be greater and they do influence the decisions. But
finding angels is difficult.
 Venture capital firms - A venture capital firm is a limited liability partnership
specializing in raising money to invest in the private equity of young firms. On the other
hand, Intel, General Electric, and Sun Microsystems, act as corporate ventures by
providing equity capital to new innovative companies.
 Institutional investors - Insurance companies, pension funds, mutual funds, endowments
and foundations, having large amount of money, are the major investors in private sector
companies.
 Corporate investors - Many established companies purchase equity in younger, private
companies. The investing companies are known as strategic partners, strategic investors,
corporate investors, or corporate partners. Such investors create a network of companies.
 Retainer earnings - Firms can obtain equity financing by retaining earnings rather than by
distributing the earnings to their owners. For permanently retaining the earnings the
company may issue bonus shares to its shareholders.

Business is in continuous need of funds for working capital needs or for incurring capital
expenditures. In such scenarios, when the business borrows money from the lenders at a fixed or
floating rate of interest and for a fixed span of time, it is termed as debt financing. The sources of
debt financing for a company include banks, credit union, etc.

 Loans - Loans are the most common and popular mode of debt finance for a company.
Businesses borrow money from commercial lenders like banks by keeping some
collateral security against the loan. Loans from banks and other commercial lenders are
for a fixed period and business needs to pay regular interest for it. The loans can be for
short, intermediate or long-term depending upon the financial requirements of the
business.
 Trade credit - is an arrangement in which the business can purchase the goods now and
pay for them later. This way the business can avail debt financing for short term. Trade
credit is a good mode of finance for startups as they cannot afford to obtain loans of the
higher amount by placing a collateral society.
 Installment purchase - Purchasing the capital goods on installment is another type of debt
financing. Installment purchase comprises of buying an asset and making payment in pre-
determined installments. The buyer has to mortgage its asset until full payment of
installment is made. A business that has higher credit rating may not have to mortgage
any asset. Banks and finance companies provide the facility of installment purchase to the
business.
 Bonds - are a source of debt capital for businesses that are well established and need
funds for long-term growth of the business. The company can raise funds by selling
bonds to different buyers and sharing profits on the projects for which bonds are issued.

c) Permanent sources

Permanent financing is used to purchase or develop long-term fixed assets like factories and
machinery. Since the payoff from a long-term asset tends to be over a period of time, financing
through long-term options reduce the risk of principal payoff not being made (in the case of debt
financing).

 Issue of shares - Issue of shares is the most important sources for raising the
permanent working capital. Shares are of two types – Equity shares and preference
shares. Maximum amount of permanent working capital should be raised by the issue
of equity shares.
 Retained earnings - It means the reinvestment by a concern of its surplus earning in
its business. This is, a part of the earned profits may be ploughed back by the firm, in
meeting their working capital needs. It is an internal source of finance and is most
suitable.