The basic precepts for funding any organisation, be it small, medium or large-scale; and for funding national development projects at various levels including local, district, municipal, metropolitan, regional or national level, are initial savings by the owner or owners (in the case of business units or organisations); and revenues mobilised through taxes and exports (in the case of a country or an economy). However, it is possible for the initial capital outlay required for successful take-off of a given project to exceed funds mobilised by the business owners. Further, the initial capital outlay could be in excess of funds readily available to stewards of a given national economy.
Under the foregoing circumstance, one of the identified ways through which the implied businesses and economies could off-set the financing gap is resorting to borrowing from varied forms of lending institutions, including local banks, investment banks, savings and loans companies (mostly for business establishments); and borrowing from bilateral and multilateral financial institutions (essentially for national economies). Sources of funding available to varied forms of business units could serve as a springboard or catalyst toward making cogent investment decisions that could lead to their expansion and growth, and have positive implications for their respective national economies. Discussion in the following section is advanced with strong emphasis on borrowing by business entities; albeit the factors may be applicable to national borrowing.
The success of a loan application is predicated on the customer’s background and provision of valid and reliable information to lenders. Information required for a credit decision can be obtained from customer’s bank records, credit reporting agencies; and directly from the customer. Reiteratively, information provided by the applicant is very vital to the success of the loan application. Assessment of loan application involves the use of different methods with varying degrees of effectiveness. Canons of lending remain one of the effective principles of lending. Canons of lending are called a balanced lending process because they provide full risk appraisal; and a structured and professional approach to the completion of customer loan application.
Balanced Lending Process
Effective understanding of the basic tenets is pivotal to successful completion of a good lending process. Thus, it remains imperative for parties to a lending contract to be abreast of the underlying principles that could assure expeditious and incident-free completion of originated loan applications. Generally, the balanced lending process or canons cover the following lending principles: purpose, amount, repayment, terms and security; which is often summarised in the acronym, PARTS. This balanced lending process constitutes one of the complex methods used in assessing loan applications. Stated in different terms, loan approvals do not rest solely on analysis of the lending principles. Rather, other pertinent extraneous factors are equally considered during loan approvals.
Purpose
The concept of purpose addresses the question of why the applicant needs the loan. Specifically, the bank requires the applicant to state the benefits, viability, legality, necessity, morality or ethics; price and estimated useful life of the purchasing asset (item); and compatibility of the loan with existing activities, among others. Applicants’ statements in relation to the foregoing vary from one loan application to the other; and the statements are crucial to decisions on lending.
Amount
It is important for the bank to determine whether the amount requested is sufficient for the intended purpose. Banks are usually not interested in providing funds for a particular project only to be approached for additional funds for the same project within a short period of time. The bank must find out the cost of the item and the customer’s contribution to the cost. Further, it is incumbent on the bank to identify the source of the applicant’s contribution; determine whether the loan amount covers the entire cost of the item or project; and to affirm whether or not the loan amount is a true reflection of the intended purpose. Thus, due diligence is required during the process of determination; and award of the loan amount.
Repayment
It remains the responsibility of the bank to assess the customer’s ability to pay back the loan. This assessment may be carried out through checks on the customer’s credit history. For an organisation, the bank considers the credit-worthiness of its owners; the firm’s profitability in the past, present and future; as well as its cash flows prior to loan approvals. The bank requires the firm to conduct the following sensibility analysis: the firm understands the impact of its repayment measures on profitability and liquidity; it understands the effect of increased or decreased sales on expectations; and the firm is certain on the payment of personal financial commitments from business income. Moreover, it should be possible for the firm to measure approximate levels of turnover at which profits would be recorded.
Term
This refers to the estimated life of the loan, which is based on factors related to the business and its owners. Term of the loan may not extend beyond the life of the purchased item. The loan term must be carefully considered by the lender and borrower prior to agreement. An extended payment period gives the borrower peace of mind, but ends up overpaying on the loan.
Security
Any asset the borrower provides as a guarantee for the loan is termed as security or collateral. In many advanced economies, the security does not substitute for proper background check on the borrower. In addition to the foregoing, the bank may be interested in estimating the write-down value of the asset presented as security. Write-down value relates to a bank’s internal assessment of a security’s value. To illustrate, lending financial institution may decide to write down the value of a security to say, 70% of open market value; with all borrowings deducted from the calculated figure. It is the bank’s responsibility to determine whether the security is measurable or valuable; easily realisable, stable in value; or likely to increase in value in the long run.
Financial Statements
As part of decision-making in the lending process, lending financial institutions examine the financial statements of borrowers to assess their financial strength; and ability to repay the contracted loans. Analysis and interpretation of applicants’ financial statements aid in decision-making for lending propositions. Some financial statements considered in the analytical process include balance sheet, profit and loss statement, cash flow statement, budget; and cash flow forecast.
The balance sheet is also called statement of financial position or statement of financial condition. It shows the position of the assets, liabilities, and owners’ equity of a business at a specific date. The balance sheet is representative of the accounting equation which states, assets (A) equal liabilities (L) plus owners’ equity (OE). That is, A=L+OE. Information on the balance sheet can be used to calculate liquidity and solvency ratios such as the current ratio, quick or acid-test ratio, debt ratio, among others.
Profit and loss statements are also called income statement, earnings statement or operating statement. Profit and loss statement presents detail information on the revenues and expenses of an organisation over a given period of time. Details contained in a profit and loss statement can be used to compute performance and profitability ratios such as return on assets, asset turnover ratio, return on equity ratio, among others.
The cash flows statement outlines the cash inflows and outflows of a business over a given time period. It separates cash inflows and outflows into three distinct activities: operating, investing and financing activities. The cash flows statement can be used to determine the cash cow and interest payment status of a firm using the following ratios: cash flow adequacy ratio, cash flow-to-net income ratio and cash times interest earned ratio.
The term cash cow relates to specific organisational activity that requires minimal investment capital; and yet, provides positive cash flows on a consistent basis. The economic usefulness of these cash flows is exemplified in their allocation to other units that may be experiencing financial challenges within the organisation. Stated in simple terms, cash cows are the pivots around which an organisation survives, thrives and remains very competitive in the business environment.
The budget spells out planned activities and the related costs of an organisation over a given financial period, usually a year. A budget is drawn based on a firm’s active plans for the future. Thus, a budget is nucleated around the future plans of an organisation. The future could be immediate (short), medium or long-term.
Cash flow forecast addresses situations in which the management of an organisation draws on its prior experience to estimate financial figures for the future. Based on its past experience, a firm could project its cash inflows and outflows. Suppose Firm A’s respective cash flows for 2020 and 2021 were GH¢520,000 and GH¢600,000. Given the economic conditions for 2022 and expected economic conditions in the next two years, Firm A could project respective cash flows of GH¢650,000, GH¢680,000 and GH¢700,000 for 2022, 2023 and 2024.
Principles Underlying Financial Lending
Available data from the United Nations Development Programme (UNDP) in recent years revealed about 80% of businesses operating in economies across the globe fall within the category of small and medium-scale enterprises (SMEs). It is noteworthy that the percentage distribution of firms in various business categories in Ghana is not too different from the statistics released by the United Nations Development Programme. Indeed, about 80% of business establishments in Ghana are SMEs.
However, access to credit by small and medium-scale enterprises (SMEs) from lending financial institutions has been a subject for debate in recent and prior years. Sad to relate, it is increasingly challenging for SMEs to access loans from the major banks to ease their expansion and growth, and to contribute meaningfully to the socio-economic development of their respective economies, especially the Ghanaian economy. Some finance experts argued several factors account for the banks’ reluctance to lend to small and medium-scale enterprises. For instance, during 2015, the Bank of Ghana reported non-performing loans (NPLs) of GH¢4.2billion. This amount surged to GH¢6.2billion during 2016; and the difference (GH¢2.0 billion) represented nearly 48% (47.6191%) increase in non-performing loans over the comparative period.
Non-performing loans as a percentage of total loans contracted as at February 2021 was estimated at 15.3%. This remained 0.6% higher than the ratio recorded during January 2021(14.7%). The concerned finance experts are of the firm belief the surge in non-performing loans and other extraneous factors account strongly for the banks’ decision to ‘relax’ lending to SMEs in recent and previous fiscal periods. It may not be out of place to lend credence to the foregoing arguments. However, it is worth emphasising that a financial institution’s decision to lend money to a borrower, or group of borrowers may be premised on adherence to a set of principles, including liquidity, safety, diversity, stability, profitability of the borrower or borrowers.
Liquidity
Liquidity remains an essential principle of lending in banking. Banks lend money which can be withdrawn at any time by depositors. To this end, they prefer to lend for a short period of time. For processed loans, banks would like to accept as collateral, assets that are readily marketable; and convertible into cash within a short period of time, usually three months.
Debentures and shares of large companies can be easily marketed or converted into cash. However, it is quite challenging to market the debentures and shares of small firms without adjusting their price downward. The foregoing makes it imperative for banks to invest in government securities, stocks and debentures of renowned institutions rather than focus their investment attention on the securities of institutions that are unknown and non-performing. Debentures and shares of corporations are linked to their earnings. These earnings are likely to fluctuate with the level of business activities within the economy. Peace, security and political stability are important factors that affect the safety of governments’ securities and securities issued by corporate bodies.
Safety
The concept of safety measures a borrower’s ability to repay loans with interest on a regular basis without default. Like any other investment, investments undertaken by banks involve risks. The type of collateral determines the level of risk. Generally, central governments’ securities are safer than those of municipalities because the financial resources of the former are more than those of the latter; and are more than those of individual corporations. Similarly, securities of municipalities are safer than those issued by corporations. Factors such as financial standing, character and the ability to repay inform the borrower’s preparedness to pay back a contracted loan.
Diversity
The principle of diversity is important in the choice of an investment portfolio for a commercial bank. It is not advisable for a bank to invest all its surplus funds in a particular security. Rather, the funds should be invested in a number of securities. The purpose of diversification is to minimise risk inherent in the investment portfolio of lending institutions. It is important for a bank to choose and invest in shares and debentures of different firms in different parts of the country. This principle must be followed and applied in the case of government and municipal investments. Banks must apply the diversity principle when advancing loans to various forms of trades, businesses, firms and industries. It is essential for a bank not to ‘put all its eggs in one basket’, implying loans must be extended to organisations or applicants in different parts of the country to ensure diversity in banks’ investment; and to increase the chances of recouping loaned funds.
Stability
The stability principle posits, the investment policy of a bank must consider the need to invest in stocks and debentures or securities with a high degree of price stability. The bank cannot afford to invest its excess funds in securities with fluctuating prices. Moreover, it cannot afford to lose on its investments. Therefore, it is essential for banks to invest in businesses where the possibility of decline in value is remote. The investment of banks in bonds and debentures is more stable than in the shares of organisations. This is because the respective bonds and debentures of governments and firms carry fixed interest rates. Values of these securities change with changes in the market interest rate. In times of financial crisis, banks are compelled to liquidate a portion of the securities to meet their cash requirements. In the absence of crises, the securities run their full term, usually more than five years; with minimal negative effect of changes in market interest rates.
Profitability
An important principle underlying a bank’s investment decision is maximising profits and minimising losses. This makes it imperative for banks to invest in securities that would assure them of fairly stable returns on their investments. Factors such as tax, dividend and interest rates determine the earning capacity of securities and stocks. Generally, government and municipal securities, and shares of some new corporations are exempted from taxes. However, it is advisable for banks to invest more in government and municipal securities than in corporate securities because the former are safer than the latter.
In Ghana, municipal securities are not actively traded in the securities market, although the existing financial regulations allow Metropolitan, Municipal and District Assemblies (MMDAs) to access loans in the financial market, using the District Assembly Common Fund (DACF) as a guarantee. It is hoped that successive elected governments would adapt proactive measures to enhance the autonomy of MMDAs to ease their active participation in the securities market.
Funding Sources for Corporate Bodies
Funds required for efficient and effective operations of corporations are obtained from two main sources. These include internal and external sources. Internal sources relate to funds generated through retained earnings or profits, and sales of company assets. Retained earnings refer to part of the company’s profit that is not distributed to shareholders in a form of dividend, but withheld for present and future expansion projects. In some cases, management may deem it necessary to dispose of or sell some of the company’s assets due to wear and tear, or due to the introduction of more sophisticated machinery than previous or existing ones, or the need to pay off debts. Proceeds from the sales serve as source of internal funds to the organisation.
The external sources commonly refer to funds raised through borrowing and sale of shares in the primary markets. Borrowing includes contracting of loans from financial institutions and sale of financial securities on short-term and long-term basis.
Common Forms of Corporate Financing
The instruments used to finance the activities of an organisation can be broadly categorised into short-term borrowing instruments and long-term borrowing instruments. Short-term borrowing instruments include commercial paper, trade credit, overdraft facility, acceptance credit, short-term bank credit, among others. Commercial paper is a short-term marketable, unsecured promissory note often issued by credible organisations, including finance companies, bank holding companies and others, purchased directly by companies. The involvement of secondary markets in this transaction is relatively low.
Trade Credit
This banking concept explains mutually arranged commodity credit between manufacturing companies and wholesale firms; and mutually arranged commodity credit between sellers and buyers outside the initial control of the banking system. Trade credit serves as a source of short-term working capital to buyers who obtain goods and services on account from suppliers. It is drawn by the seller and accepted by the buyer. Trade credit transactions are manifested in commercial bills of exchange. The buyer agrees to pay the amount incurred at a specified future date. Through the arrangement, the buyer holds on to an ‘IOU’ during the term of the contract. Where the seller is in dire need of funds and cannot wait till the maturity date, he or she can discount the bill of exchange and sell to raise funds.
Merits and Demerits
To begin with, loan repayments and trade turnover tend to increase when trade credit is used. Also, it is convenient since it provides suppliers the needed security to contract bank loans prior to the maturity of trade bills. Finally, trade credit helps firms to increase their working capital in times of credit restrictions.
In spite of its contribution to loan facilitation, trade credit is believed to be inherent with some practical challenges. First, trade credit minimises the effectiveness of credit control and sanctions imposed by central banks such as the Bank of Ghana (BoG). Second, lack of settlement discounter or payment delay may render trade credit transactions costly. Finally, trade credit may contribute to inflation by increasing total credit in the economy beyond the expected limit. The foregoing demerits notwithstanding, banking experts stress the need for trade credit to be encouraged during periods of recession to ensure faster economic recovery through increased economic stimulation.
Bank Overdrafts
Banks, through overdraft facility, allow their corporate and some individual customers to withdraw in excess of the total balances in their respective accounts, preferably current deposit accounts. An overdraft fee is usually charged by the bank when an overdrawn amount is not repaid within 24 hours. A bank may provide protection for its customers for a year, and the overdraft agreement may be renewed after one year. It is arguably the most common form of borrowing initiated by organisations.
Benefits and Challenges
An overdraft facility is usually not tied to a specific transaction. This makes it flexible and suitable for financing daily working capital requirements of businesses. Further, interest charges on overdrafts may be lower compared with interest charges on other loan facilities. Moreover, the documentation process for the award of overdraft to bank customers is simple and fast; while risks associated with secured overdrafts are usually low. This enables banks to charge lower interest rates on secured overdrafts, and allows bank customers to save on interest charges.
However, a major challenge is the tendency for the borrower to be exposed to interest rate fluctuations, especially when the rate is tied to the base rate. The foregoing, notwithstanding, fluctuations in this case may not be as volatile as the inter-bank rates. An overdraft is usually repayable on demand; and this makes it an unsafe form of borrowing. Even in difficult economic times, the borrower is compelled to repay the overdraft. Sometimes, base rates are higher than inter-bank rates. In such situations, overdrafts attract higher charges than loan facilities.
Acceptance Credit
This is a bill of exchange guaranteed by a credit insurance company or bank for a commission. Under the acceptance credit, a bank is approached by a corporate customer; and the bank permits the corporate customer to draw a bill of exchange after an agreement has been reached. A credit limit is placed on the bill of exchange by the bank. It may be easy for the customer to find a third party in the financial market to discount the bill after its acceptance by the bank. Discounted bill of exchange means the buyer purchases it at a price below its face value.
The difference between the price paid by the discounting bank and the face value of the bill is termed as acceptance commission. Basically, the acceptance commission is representative of the interest rate. A commercial bill is described as a bank bill if it is accepted by the bank. An eligible commercial bill accepted by an eligible bank is called an eligible bank bill. An eligible bank meets the minimum requirements of the central bank, namely reciprocal treatment of local and foreign banks, quality of acceptance business, and market standing.
Advantages and Disadvantages
The discount rate of an acceptable credit is often below the inter-bank rate. The discount rate associated with an acceptance credit is an eligible bill rate; meaning, the discount rate is a fine rate. Cost of borrowing is not affected by subsequent changes in interest rate since the effective interest rate or discount rate is determined at the beginning of operations. Acceptance credit is considered flexible because it can be drawn for various amounts of different maturities up to 187 days. When the borrowing company pays the credit and the main transaction is carried out successfully, the acceptance credit is said to be self-liquidating.
The acceptance credit policy is in tandem with the real bill doctrine; an acceptance credit is often guaranteed. This facilitates removal of the commitment fee charged on short-term bank credit. Corporate customers sometimes arrange for acceptance credits in bulk. The issuing company is not obliged to be tied only to the accepting bank. This makes it possible for the issuing firm to discount its credit bill with another discounter – with better terms and conditions. Removal of the commitment fee allows for individual bills to be drawn without negotiation after an agreement has been reached on bulk credits.
The foregoing notwithstanding, the issuing firm may discount the credit acceptance bill. The discounting firm or bank may again, rediscount or resell the bill. The purchasing firm or agent may rediscount for another buyer. This buyer would in turn, rediscount to another buyer. This process may continue over a considerable period, thereby creating an unfavourable image about the issuing firm to the public. Besides, if there is an agreed trade transaction but no discounter, issuance of the credit will be difficult.
Short-Term Bank Credit
A firm may decide to borrow from a lending institution on a short-term basis in order to buy short-term assets to raise funds needed to be added to sale of existing assets to obtain the amount required for the purchase of a new asset; and mobilise the requisite funds to replenish its working capital, among other pertinent financial considerations. Working capital replenishment implies raising the funds needed to meet day-to-day operations, while waiting on debtors for payments on account.
Merits and Demerits
A standardised and simple process is maintained for documentation of short-term bank credit. There may be no restrictions to the use of funds by the borrower. That is, the borrower may be at liberty to apply the funds to any transaction. An example is an overdraft facility. The lender makes the funds available, after contract-signing, for the borrower; and this makes the funds readily available for the borrower when needed. The funds may be available for the borrower when there is a contractual clause that permits the lender to withdraw the funds without notice to the borrower.
In spite of the benefits outlined above, short-term bank credit has some challenges. For instance, higher volatility of inter-bank rates than the bank base rates could expose short-term credit to higher interest rates than rates charged on overdrafts. Besides, the borrower may be subjected to more charges than may apply in external corporate financing. For example, the borrower may pay fees for committing to set up the credit facility, may pay fees on the undrawn portion of the credit facility, and pay interest on the used portion of the loan facility. The foregoing makes bank credit inappropriate for borrowers who do not meet certain financial requirements.
Long-Term Borrowing Instruments
These include equity finance, company bonds, bank loan and documentation, debentures, lease financing, among others. For competitive reasons, banks tailor their financial or loan packages to suit the needs of their teeming corporate borrowers. Provision of adequate services helps banks to expand their clientele base. Definition of long-term borrowing varies from one financial institution to the other. For instance, commercial banks define term-to-maturity beyond one year as long-term, and a term-to-maturity up to one year as short-term.
In the case of Development banks, term-to-maturity up to five years is short-term, and maturity above five years is long-term. Some banks define medium-term to include one to five years; long-term, from one to ten years. Mortgage contracts may be signed from ten to thirty years. A term loan may be retired earlier than its maturity date. When this occurs, an early cancellation fee may be charged by the bank or financial institution, depending on the under-writing clause or agreement.
Types of Interest Rate
Interest charged on long-term loans may be fixed or variable. A fixed interest rate remains stable for a considerable period of time, usually over the life of the loan facility. The life of a loan may be fixed if it is for a short period, usually three years. Loan terms which extend beyond this period may have a portion being fixed, and another being variable. An interest rate that has both fixed and variable components can be described as semi-variable interest rate. A variable interest rate changes with the level of financial factors prevailing within an economy. Generally, variable interest rate increases when there is inflation and decreases when there is a fall in prices. A fall in price leads to lower inflationary levels and rates.
Loan Security and Covenants
Most banks require a security or collateral to back corporate or individual customer loan agreement. A security is often in a form of assets. The lender may institute floating charges against the assets of the borrower. In addition to the floating charges, there may be specific charges for maximum loan protection. Covenants in a loan agreement may compel the borrower to maintain minimum financial ratios. An example is the capital gearing ratio, which measures the proportion of debt to equity.
Loan Charges
Most banks charge commitment fee for arranging the loan facility, and they charge other fees to off-set tying of their funds or capital in the loan to the borrower. The capital adequacy concept requires banks to maintain certain amount of money to meet specific demands at all times. In some cases, commercial banks’ lending exceeds the maximum threshold. When the foregoing occurs (that is, the commercial bank does not meet its capital adequacy requirement), the central bank may impose a cost, fine or penalty on the commercial bank.
Sometimes, a loan amount required by a corporate customer may be exorbitant for one bank. Here, the bank may try to form a syndicate with one or more banks to raise the needed funds for the borrower. The organising bank plays a leading role and negotiates with the borrower on behalf of the syndicated banks contributing to the finance of the corporate loans.
Commercial Paper and Syndicated Loans
In some cases, the loan amount required by the borrower may not be too high for the lender. However, the lender may not wish to be exposed to one borrower, or to one sector of the market. Use of commercial paper becomes more popular in booming economic periods than bank loans. This becomes the case when commercial paper facility does not involve an intermediation. The reverse is however, true.
Syndicated loans allow banks to enter into new transactions or contracts, and earn selling participation fees. The cost of borrowing becomes lower for corporate borrowers under syndicated loans than it may cost when smaller amounts are raised from a number of individual banks.
Lease Financing
This explains a contractual agreement between the owner of an asset, called lessor, and the user of the asset, called lessee. A lease contract requires the lessee to make specific payments to the lessor at specific dates over a given period of time. Leases can be grouped into two: operating lease and capital lease.
Capital lease refers to a long-term financing lease that has non-binding obligation, and transfers ownership of the asset to the lessee at the end of the lease term. The lessee is given the option to own the asset at the end of the lease financing period. Amount required to be paid by the lessee at the end of the lease term is usually low. An example is mortgage payments. The lower payment amount required by the lessor at the end of the lease term makes an exercise of the option reasonably certain. Seventy-five percent (75%) or more of the estimated life of the leased asset constitutes the term of the lease. At the beginning of the lease, ninety percent (90%) or more of the fair value is equivalent to the minimum lease payments’ present value. The value of a capital lease is recorded and capitalised on the balance sheet.
Operating lease relates to a short-term financing lease that has non-binding obligation and does not transfer ownership of the asset to the lessee at the end of the lease term. Thus, the lessee does not have the option to own the asset at the end of the lease financing period; ownership is reverted to the lessor at the end of the lease term. An example is rental of equipment, property or building. The value of an operating lease is not recorded on the balance sheet.
Capital Lease and Operating Lease – The Difference
The total amount of a capital lease is discounted to the present value on the balance sheet. On the income statement, it is treated in relation to an agreement between purchaser and borrower. The intangible asset account is amortised or written off over the life of the lease with an annual expense deduction.
Regular amortisation is used to write off the liability account, using an implied interest expense on the outstanding present value of the liability. The foregoing explanations affirm the existence of a similarity between contracting a loan (borrowing) to purchase an asset on one hand, and a capital lease on the other. An operating lease has no specific amortisation. Rather, some deductions are made on an annual basis to equal the lease payment. Here, the lessee uses the equipment released on agreement by the lessor at no additional liability on the lessee’s balance sheet. Operating lease is suitable for a firm that is close to its debt capacity and would not like to jeopardise its credit ratings.
Sale-leaseback agreement is where a lessee sells an asset already owned to a lessor and leases it back. This arrangement enables the lessee to increase business capital while using the assets for business operations. The cost of owning the asset is usually higher than the cost of leasing, and the merits associated with the sale-leaseback are higher than the cost of direct purchase.
Economic Benefits of Lease Financing
Use of lease as a means of funding the operations of a business is useful in several ways. First, conditions associated with a bond debenture are more restrictive than those of lease obligations. Second, lease obligations often do not require down payments compared with an outright purchase of an asset. The non-down payment allows the lessee to secure a larger indirect loan.
Third, the incidence and negative effect of obsolescence are reduced since the lessor usually possesses specific knowledge which allows for selection of product maintenance, and eventual resale of the leased assets. Fourth, bankruptcy and re-organisation proceedings tend to limit creditors’ claims on certain types of leases such as real estate. However, the limitation does not apply to leases on chattels or non-real estate items. Finally, lease agreements allow a lessee to acquire assets that hitherto may not be possible under a direct purchase.
Debentures
Debentures remain negotiable instruments. They are a type of bond issued by an organisation to holders, promising to pay a fixed premium or interest, usually on a semi-annual basis. A debenture holder is a creditor of the issuing firm. Maturity period of debentures may be extended to 15 years, 20 years or more. Debentures, especially those of public-listed companies, can be traded on the stock exchange market. The market price of debentures sometimes has an inverse relationship with current interest rates.
Merits and Demerits
Raising corporate funds through debentures is useful in diverse ways. First, servicing and interest costs are known with certainty by the issuing firm. In addition, the issuing company could repurchase the loan stock from holders in the market at a later date. Also, the repurchase may be economical in periods of lower interest rates, and lower refinancing costs. Finally, funds generated through debentures are used as capital over a considerable period of time.
In spite of the numerous benefits associated with the use of debentures as essential fund mobilisation vehicle, there are some identified challenges. For instance, borrowing through issuance of debentures becomes very unattractive in periods of high interest rates; companies prefer to stay away from high interest payments over a long period of time. Similarly, debenture agreements may limit the life span of a firm when the loan is backed by a trust deed. The deed may restrict the future borrowing size and condition of the firm. In such a situation, the issuing firm may be required to settle all outstanding debenture loans before continuing with its operations.
Company Bonds
A bond is a financial instrument with long-term maturity periods. It is a debt obligation issued by organisations and governments. A company bond is a certificate bearing the company’s promise to make payments to the holder at specific dates. A bondholder receives premium, not interest and dividend. Premium payments on bonds are often made on semi-annual or annual basis until the bond matures, during which the principal is also paid. A company bond is similar to debt of an IOU issued by a firm to its creditors. An organisation may be declared bankrupt if it fails to honour its bond payment at maturity. Bondholders are legally entitled to premium payments before dividends payment to shareholders.
Convertible loan stock refers to the type of bond that provides holders with an option to convert it into equity shares at a specific price within a given time period. Loan stock that has a warrant cannot be converted directly into equity shares. However, the loan stockholder has the right to buy specific numbers of the organisation’s shares at specific future dates at an agreed price. Comparatively, bonds are less risky than preferred shares; the latter is less risky than ordinary shares. Bondholders are usually paid in inflationary currency. This is because bond prices increase over time.
Equity Financing
This describes an organisation’s ability to raise funds for its day-to-day operations through sale or flotation of shares in the primary market (companies issuing the shares directly to investors or shareholders), and in the secondary market (trading of shares on the stock exchange and other legally sanctioned markets other than the issuing company’s primary market). Equity financing is believed to be the most significant source of long-term financing for corporations. It involves issuance of two shares: ordinary shares and preferred shares; the former is the most popular form of equity financing. Ordinary shareholders are called true owners of the company; they have voting rights at annual general meetings (AGMs); and they are the last to receive dividends. Raising funds through equity financing includes the following methods.
New Issue
This method allows the company to increase the number of its shareholders, while raising significant capital for its operations and expansions. New issues safeguard the company against possible future takeovers. A new issue usually includes an offer for sale and placing. Under an offer for sale, the firm sells each share at a fixed price to an issuing house. The issuing house in turn, sells the shares at a fixed price to the general public through a prospectus. The issuing house often sets a minimum price and invites bids at prices above the minimum when the offer is by a tender. Placing relates to the transactional situation in which the issuing house purchases the company’s shares and sells them directly to its own clients, not to the general public.
Rights of Issue
This explains issuance of new shares to existing shareholders at a discount. This means existing shareholders are allowed to purchase the new shares at an amount below the prevailing price on the stock exchange. The existing shareholder may buy or sell the new number of shares allotted to him or her on the stock exchange. Should the existing shareholder allow his or her rights to lapse, the firm will sell the shares in the market and pay any profit derived from the sale to the existing shareholder. Raising capital through rights of issue is simpler and cheaper than new issue. Gains from such an investment accrue to existing shareholders. It allows a company to increase its capital without increasing the number of owners when the new shares are purchased directly by the existing shareholders.
Challenges
The rights of issue are believed to be fraught with some challenges. For instance, if existing shareholders allow their rights to lapse or sell their rights to new shareholders, the number of shareholders would increase and the existing shareholders may lose control over the organisation. Further, use of rights of issue may not be feasible when the amount of finance required by the organisation is relatively large.
Merits and Demerits of Equity Financing
The following statements affirm some of the benefits inherent in the application of equity financing to organisational finance and investments. Shareholders stand the chance of receiving higher dividends in times of high profits, and these higher dividends may be translated into improved living conditions of shareholders. Shareholders would earn capital gains when the value of the company’s shares increases and this is likely to increase the ownership share of individual shareholders. Flotation of shares allows the issuing company to access long-term capital which requires no servicing even under unfavourable trading conditions. Equity shares cannot be redeemed with relative ease without the consent of the courts. The company may be obliged to pay dividends only when profits are derived. However, in the case of debts, the company is obliged to honour payments at maturity dates.
On the other hand, the decision-making power of existing shareholders may be affected when new shares are issued; especially when the new shareowners come on-board with views and philosophies contrary to those of the original owners. Shareholders may not receive dividends in periods of losses, and they may experience dwindling fortunes in share values as price falls and rises. Shareholders are the last to be paid back their investment during periods of liquidation as indebtedness to bondholders is usually paid before commitments to shareholders are met.
Retention of Earnings
This refers to the portion of an organisation’s profit which is not distributed to shareholders in a form of dividend, but withheld as means of raising funds from shareholders. This method is simple and flexible, and all benefits derived thereof accrue to shareholders. The undistributed profit does not include brokerage costs; it has positive implications for long-term growth of the organisation. Retention of earnings reduces dividend payments. This may be a challenge to the firm when the expectations of shareholders on dividend payments are high.
Venture Capital
A company may raise venture capital from a number of sources: venture capital units, government-owned funds, bank loans, business expansion scheme, pension funds, among others. A venture capital is often employed to finance industries which are innovative or characterised by high technology. As a result, venture capital investment involves a great deal of risk. A venture capital often has a long-term focus, not short-term.
A venture capitalist may take active part in the day-to-to running of a given company, in addition to his or her financial investment. Through active participation, the venture capitalist brings prior experience in other ventures to bear on the current company. Should the venture be successful, venture capitalists may realise their investments through the flotation of shares by the implied organisation.
Probate Advances and Traditional Bank Loans
Probate is a legal document. Receipt of probate is the first step in the legal process of administering the estate of a deceased person. That is, resolving all claims and distributing the deceased person’s property under a will. A probate court (surrogate court) decides the legal validity of a testator’s (person’s) will and grants its approval; also known as granting probate to the executor. The probated would then become a legal instrument that may be enforced by the executor in the law courts if necessary. A probate officially appoints the executor or personal representative generally named in the will, as having legal power to dispose of the testator’s assets in the manner specified in the testator’s will. However, through the probate process a will may be contested.
Most banks in the United States do not advance or loan their customers money based on eventual inheritance. Such an advance or loan may be processed as a probate cash advance. While nearly all heirs want or need their inheritance funds right away, the probate process keeps them from seeing their inheritance money for 1 to 2 years. In the United States, an heir cannot apply for an inheritance advance at a traditional bank; traditional banks may refuse to assist a customer due to the delay in the release of inheritance funds. The probate process is sometimes long.
There is a sharp contrast between probate advances and traditional bank loans. For instance, under probate advances, no credit check is required and a bank never comes for the borrower’s personal belongings. However, under traditional banks, loans are mostly approved based on customer’s credit history, and the bank may come for the borrower’s personal belongings in case of payments default.
Economic Benefits of Funds
Funds generated through internal and external sources help an organisation to have liquid assets. The generated funds help the implied organisation to develop and form gross domestic fixed capital, record an increase in the book value of shares, invest in the securities of domestic companies, invest in companies abroad, to acquire other financial assets, among other essential operating and financing benefits. In times of low interest rates, companies prefer to maintain liquid funds in the form of notes, coins and chequable deposits. However, reverse of the foregoing statement is true. The desire of most organisations is to maintain competitive edge in the ever-changing global business environment.
This notwithstanding, competitiveness of firms at the national, sub-regional, regional and global levels is enhanced when they secure the requisite funds for investments and operations, apply the secured funds to the purposes intended, and when they remain productive while assuring quality and quantity in their respective industries and economic markets.
The writer is Chartered Economist/Business Consultant
