The sources of finance can generally be categorised on the basis of the provides of funds and the form of financing. Thus, sources of funds can, be internal and external, equity and debt, or short-term, medium-term and long-term. The sources of finance include:
Bank Overdraft
This is a loan facility granted by commercial banks to companies with current accounts to withdraw over and above the credit balances in their accounts. This is usually a life of credit in which the company cannot withdraw above an upper limit Overdrafts are short-term sources of finance and suitable for working capital.
They are usually repayable on demand such that their use in the acquisition of long-term assets amounts to over-trading and may result in a liquidity problem. The cost of making use of the overdraft facility is the interest, which is charged on the proportion of the line of credit used rather than on the upper limit as in loan arrangements. Overdrafts are generally more flexible.
Trade Credit
A trade credit is a short-term source of finance arising when the buyer company is allowed to take possession and ownership of goods without paying up (in full). The cost of making use of the facility can be determined by comparing the cash price of the goods and the price on credit basis.
Companies usually consider the risk of nonpayment or delay in payment in fixing the price of the goods under the trade credit arrangement.
Term loans
These are credits of a fixed sum of money for a fixed period of time. A rate of interest is charged on the upper limit of the facility whether or not the firm fully makes use of the fund. The repayment of the loan may take two forms. The repayment is either by fixed installment consisting of the principal and interest over a fixed period or the regular payment of interest and bulk repayment of principal at the end of the stated period.
The loans are medium term loans and confer the right on the company to make use of the funds for a considerable period of time. They are however not as flexible as overdrafts and require formalities to secure.
Factoring
This is a short-term finance, which provides finance to a company against the security of its sales invoice. The facility is attractive to companies which have fully utilized their overdraft facilities. The company receives an advance of money, which is a percentage of the face value of the sales invoice the factoring the company deducts the advance plus a commission and passes balance, if any, to the company.
Hire Purchase
This is an agreement to fired goods usually fixed assets for a specified period with an option for the hire to purchase such goods at the end of the agreement. The total cost of the assets is paid over a number of regular installments. The cost of the facility is the difference between the hire purchase price and the price on cash basis. Hire purchase, allows for the acquisition of assets when loans are not forthcoming.
As the installments are regular, it allows for cash flow planning and forecasting. The firm knows how much is to be paid and what it is to be paid.
Leasing
This is an arrangement whereby the legal owner of a property (lessor) gives the company (the lessee) the economic right of the property with the freedom to use it as he wishes, though possibly under certain conditions, in return for regular specified payment known as lease rental.
The legal ownership of the asset remains with the lessor. A lease agreement may take either of two forms. These are finance lease and operating lease. A finance lease is a medium or long-term non-cancellable lease agreement between the lessee and the lessor.
The lessee is responsible for the upkeep, insurance, servicing and maintenance of the asset. The lease has a primary period that covers the whole or most of the useful economic life of the asset. At the end of the primary period, the lessee has the option of continuing to lease the asset for an indefinite period, for a very low nominal rent. An operating lease is a short-term, cancellable lease between the lessor and the lessee.
The lease term does not cover most of the useful economic life. of the asset. The lessor is responsible for the upkeep, insurance, serving and maintenance of the asset. Leasing becomes attractive when the required large capital for acquiring the asset is not available. Even when capital is available a lease agreement may be reasonable where there are more profitable uses for the funds.
Ordinary Shares
These are issued by the Firm on incorporation. They provide the risk capital for the firm. Additional issue of ordinary shares may be made provided. It is within the limits of the authorized share capital. Ordinary shares are irredeemable, that is holders are not entitled to a return of their funds during the life of the firm.
For this reason the company can continuously make use of the funds and avoid the shock resulting from the planned redemption of capital. In addition, non-payment of dividends on ordinary shares is not a ground for liquidation. However, ordinary shares are higher cost source of capital for at least two reasons.
First, investors perceive ordinary share to be more risky than debenture and preference shares and thus require a higher return. Second, dividends unlike interest are not allowable for tax.
Preference shares
These are shares, which carry preferential rights over ordinary shares in terms of dividends payments and return of capital on liquidation. Preference shares like ordinary shares maybe issued to fully or partly finance a project. Preference shares carry fixed dividends rate, which allows for proper cashflow planning and budgeting.
Debenture Stock
Unlike ordinary and preference shares, debenture stock represent debt position of a company. The debentures and loan stocks are creditors of the company entitled to a fixed rate of interest on the debts. A debenture is a long-term promissory note for raising capital. It is a legal acknowledgment of debt incurred by a company. A debenture is usually issued with the provision that it shall be redeemed at the end of a specified period.
The company may be required to share its assets in return for debt capital. A trustee is appointed where the providers of the funds are more than one to ensure that the terms of the Debenture Trust Deed – a document containing the terms and condition of the loan arrangement are not breached by company.
Debenture usually caries a fixed rate of interest which allows for proper cash flow planning and forecast. Interest on debts are also tax deductible which make debts capital a cheaper source of finance than ordinary and preferences shares.
Venture Capital/Venture Financing
A venture financing is a long-term financing arrangement in which the venture capitalist provides funds to a company in return for equity participation in the debtor company. The return to the financier is in form of capital gains from the sales of share held after the firm becomes profitable venture capital may be available where other sources of finance are not available or inadequate.
Financial Institutions
Financial institutions are organisations that provides financial intermediation between the deficit sector and surplus sector of the economy. Financial intermediaries include:
Commercial Banks
These are money institutions that take deposit from the surplus sector and give credit to those with funds deficiency. Commercial banks are outlets for bank overdraft and loans. Some of these banks have subsidiaries that specialize in leasing, hire-purchase and factoring arrangements.
Merchant Banks
These are traditionally wholesale banks. The merchant bank accepts deposits from institutions, corporate bodies, and individuals through substantial investment. Merchant banks provide such services as leasing, foreign exchange, short-term loans.
They also provide investment management services and financial advice for companies on the raising of capital for expansion and development. In Nigeria there is no clear distinction between commercial and merchant bank.
Development Banks
In its bid to achieve economic growth and development, the Nigerian government established some specific banks for the purpose of developing certain specific sectors of the economy, for example, agriculture, commerce and industry. Such banks include the Nigeria Industrial Development Bank (NIDB), the Nigeria Bank for Commerce and Industry (NBCI) etc.
Stock Exchange/Capital Market
This is a market for the purchase or sales of shares and stocks. The market exists to bring together those wishing to buy a new firm or an existing firm, which is listed on the exchange, can raise funds by offering shares for sales to the public in general or a selective part of the public. In Nigeria the Stock Exchange arrangement exist in Lagos, Ibadan and Port-Harcourt.