CHAPTER 6

FINANCING THE NEW VENTURE

Meaning and Process of Finance

Finance can be defined as the art and science of

managing money.

Finance is concerned with the process,

institutions, markets involved in the transfer of
money among and between individuals, business
and governments.
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7.1.2 The Process of Finance
The process consists of five basic steps:
Step 1: Estimating month-by-month flow of funds
into the business from all the sources, including
gains on external investments.

Step 2: Estimating month-by-month flow of funds

out of the business, including both operating
expenses and capital investments.

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Step 3: Compare inflows and outflows.
 If cash flow is negative, determine how to make
it positive, either by reducing the outflows or
increasing the inflows.
If cash flow is positive, determine how to invest
excess funds most productively.
Step 4: Choose which capital investments should
be made for continued growth.

• Step5: Establish a system for tracking flow of

funds and measuring the return on investment.
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7.2 Cost of Finance
All financial resources have a cost.
The cost of capital is the cost encountered
when obtaining the money.
This cost takes one of two forms.
i) . Direct cost: is the direct charge faced for having an
overdraft, the interest on loans, the return expected by
investors, etc

ii). Opportunity cost: The potential return lost by not

putting the money to some alternative use.

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 Why businesses need money

• They are just starting and need to buy

premises and equipment.

• They have an opportunity to introduce a new

product or service.

• A major item of equipment or building needs

to be brought up to date.
 Factors Affecting Financing
• There are four basic factors that determine
how a firm is financed:
1. the firm’s economic potential
2. the size and maturity of the company
3. the nature of the firm’s assets
4. the personal preference of the owners as they
consider the tradeoffs between debt and
equity

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• An entrepreneurial firm that has high growth
potential has many more possible sources of
financing than does a firm that provides a good
lifestyle for the owner.
• The size and maturity of a company have a
direct bearing on the types of financing that
are available.
• Tangible assets serve as great collateral when a
business is requesting a bank loan; intangible
assets have little value as collateral.

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7.3 Venture Capital
Capital –is any form of wealth employed to
produce more wealth for the firm.

It is commonly categorized into three groups:

They are:
A) Fixed capital: is needed to purchase the
business’s permanent or fixed assets such as
building equipments, machinery etc.

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 B) Working capital: represents the business’s
temporary funds;
• it is the capital used to support the business’s
normal short-term operation.

It is current assets less current liabilities.

It is used to buy inventory, pay bills, finance

credit sales, pay wages and salaries and take care
of any unexpected emergencies.

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C) Growth capital
It is required when an existing business is
expanding or changing its primary direction.

In order to expand an existing business,

additional capital is needed to buy additional
facilities

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6.4. SOURCES & USES OF FUNDS
From where the firm can obtain the money it
needs?
The most obvious sources would be:
 revenues,

suppliers who may extend credit,

loans from financial institutions,
 through stocks and bonds.

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Generally speaking,
the goal of a company is to obtain money at the least
cost and risk, whereas;
the goal of lenders and investors is to receive the
highest possible returns on their investments at the
least risk.
On the same token, an entrepreneur can raise
finance through two major sources of fund;

 equityfinancing or
debt financing.

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1. Equity Financing
represents the personal investment of the owner
(owners) in business.
It typically does not require collateral and offers the
investor some form of ownership position in the
venture.
The investor shares in the profits of the venture, as
well as any disposition of assets on a pro rate basis.
It is sometimes called risk capital because these
investors assume the primary risk of losing their
funds if the business fails.
Raising new capital through equity means, giving up
some percent of the firm’s ownership.
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The advantages of equity capital are:
It does not have to be repaid as a loan does.
It guarantees the investor a voice in the
operation of the business and a percentage of
any future earnings.

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Some common sources of equity financing are:
Personal Savings – Personal savings are the
main sources of finance to start new businesses,
followed by borrowing from friends and
relatives.
This is money that the entrepreneur saves.
As a rule, the entrepreneur should expect to
provide at least half of the start-up funds in a
form of equity capital

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Friends and Relatives -The most important
alternative source of finance to own savings
is borrowing from friends and relatives.

Partners- Are those who contribute capital

together and share profits or losses.
There can be general partners and limited
partners.

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Public Stock Sales: The owner could elect to
incorporate and go public by selling stock.
 This is an effective method of raising needed
capital, but it can be an expensive and time
consuming process filled with regulatory
nightmares.
Before choosing to take a company public the
entrepreneur should consider carefully both the
advantages and disadvantages of making a public
offering

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Advantages
Ability to raise large amounts of capital
Improved access for future financing
Improved corporate image
Attracting and retaining key employees
Using stock for acquisition
Listing on a stock exchange
Disadvantages
Dilution of founders ownership
Loss of privacy

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2. Debt Capital Financing
Debt financing involves the funds that the
entrepreneur has borrowed and must repay with
interest.
Typically, debt financing requires some assets
such as car, house, plant, machine or land which
may be used as collateral.
Sources of Debt capital
A. Commercial Banks
They are the very heart of the financial market,
providing the greatest number and variety of
loans. 19
Types of loans granted
a) Short-term Loans
 They are used to replenish the working capital
amount to finance the purchase of more
inventories, boost output, finance credit sales to
customers or take advantage of cash discounts.
b) Intermediate and Long-term Loans
 They are used to increase fixed and growth capital
balances.
 It is granted for starting a business, constructing a
plant, purchasing real estate and equipment, and
other long-term investments.
 Loan repayments are normally made monthly or
quarterly. 20
• In making a loan decision, a banker always
considers the “five Cs of credit”:
1. the borrower’s character
2. the borrower’s capacity to repay the loan
3. the capital being invested in the venture by
the borrower
4. the conditions of the industry and economy
5. the collateral available to secure the loan

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• An entrepreneur should carefully evaluate
available banks and negotiate carefully by
considering the following:
– the interest rate,
– the loan maturity date,
– the repayment schedule, and
– the loan agreements.

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B. Commercial Finance Companies:
• They are institutions, which finance consumers
through companies.
• They lend to companies so that they can sell on
credit to consumers.
• However, they do not directly finance
consumers.

C. Savings and loan associations

• small business persons.

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D. Insurance companies
• They take the risks associated with doing
business.

• Besides, they give a financial guarantee to

business persons to undertake a business.

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 3. Government Programs
• State and local governments finance new
businesses in varying manners.
• Community-based financial institutions are
lenders that use funds from federal, state, and
private sources to serve low-income
communities and small companies that
otherwise would have little or no access to
startup funding.

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 Micro-Financing of small businesses in Ethiopia
 Micro Financing helps people start their own
small business by providing loans which will be
difficult to get from the main banking system.

 Small Enterprises are growing in Ethiopia and

oftentimes people who start small businesses do
not know where to go and what to do.

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