Management of Business The Need for Capital and Source Of Finance

THE NEED FOR CAPITAL AND SOURCE OF FINANCE

Financing plays an integral role all in organisation’ however, sourcing finance may be difficult
for most businesses. Businesses use it capital in the establishment and operation. Capital is
defined as the money invested in a business venture which is used for the operation of the
business. It is also defined as goods (plant, machinery and equipment) that are used in the
production of goods and services. The need for capital can be classified into three categories:

 START-UP OR VENTURE CAPITAL

 WORKING CAPITAL
 INVESTMENT CAPITAL

START-UP CAPITAL – This the capital that is needed to establish a business. “Seed money”
which is simply the money needed to begin one’s business, to pay your first rent, licensing fees
and all costs associated with starting a business.

VENTURE CAPITAL – This refers to funds invested, or that are made available for
investment, in a business which offers favourable returns. This is started by wealthy individuals
who have surplus cash but do not have time to run a company. These venture capitalists will buy
shares for an average of 4-5 years and then sell them back to the entrepreneur at a profit.

ADVANTAGES OF START-UP OR VENTURE CAPITAL

 Raises much needed capital without losing control for very long
 Can have access to management advice from the venture capitalist
 Do not have to register on the stock exchange
 Less legal constraints
DISADVANTAGES OF START-UP OR VENTURE CAPITAL

 Although temporary, some control is lost

 Shared profits until the venture capitalist is repaid
 May have to repay high amounts to the venture capitalist

WORKING CAPITAL – The funds available to run the day to day operations of the business.
Working capital is used to meet short term obligations of the business, such as purchasing goods,
office supplies, paying rent and wages. It is calculated by using the equation:

Working Capital = Current Assets – Current Liabilities

Current assets include inventory, accounts receivable, bank and cash, while current liabilities
include accounts payable, bank overdraft and short-term loans.

Current assets – resources that the business expects to get rid of (convert into cash) within one
year or the businesses operating cycle, whichever is longer. Eg. Stock (Inventory), cash, bank,
accounts receivable

Current Liabilities – obligation that the business expects to pay within one year or the
businesses operating cycle, whichever is longer. Eg. Accounts payable, overdraft, short term
loans

A business’s working capital can be either positive or negative. If its current assets exceed its
current liabilities then its working capital will be positive, indicating that the business can pay for
its current liabilities or it is fairly liquid. However if current liabilities exceed the current assets
then the business will be negative. In order to prevent the working capital from becoming
negative proper systems are put in place to manage working capital.

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Management of Business The Need for Capital and Source Of Finance

HOW TO MANAGE WORKING CAPITAL

 Inventory - A number of businesses have liquidity problems because too many resources
(funds) are tied up in stock. Firms should ensure that its inventory level is neither too
high nor too low by determining the cost-effective level of stock that it should keep. It is
also important that the firm minimizes the time between when resources are purchased
and when income is generated from those resources. This will ensure that the firm’s cash
is not tied up in inventory that cannot be sold quickly enough to recover it.

 Bank- The firm may source financing from a bank in terms of loans or overdrafts.
However, being heavily indebted is never a positive sign for a business. In managing
working capital, firms may want to ensure that loans are spread in terms of repayment.
Borrowing on a long-term basis to finance short-term projects or purchases may not be a
good idea for businesses. The reason for this is that the purpose for which the money was
borrowed would have passed; however, the firm would still be repaying the loan.

 Cash management
This relates to the monitoring of the flows of cash into and out of the business. Cash
management should be of importance to every business as it is more susceptible to theft
and misplacement. Having a proper and efficient system of cash management can help to
prevent the firm from having liquidity problems – that is, not having enough cash to deal
with daily expenses. The firm can manage its cash by:
o Doing cash flow statements.
o Drafting cash budgets which give a breakdown of how it expects or plans to spend
and earn its cash
o Making the best use of its excess cash. This could be done by investing it.

HOW TO INCREASE WORKING CAPITAL

A firm that has liquidity problems has a number of options that can be used to increase working
capital. However, each must be carefully analysed before the decision is made. Some of the
options are outlined below:

 Additional funds from owner(s) - This is where owners invest additional funds in the
business, this can be done through personal saving, money from family and friends, sale
of shares, depending on the type of business.
 Dispose of non-productive assets- This is where the business sells (dispose) fixed assets
that are not being used. The sale of the non-productive assets will increase the amount of
cash available in thus business thus increasing the working capital
 Increase net profit- If the net profit of the firm is increased this will result in an increase
in the cash or bank of the firm. A business can increase its net profit by increasing it
revenue gained from the sale of products. It can also increase its net profit reducing the
firm’s expenses. Also the net profit can increase by cutting wastage of resources which
helps thefirm to save money that would otherwise be lost.
 Debt switching – This is where a firm substitute loan from short term to long term. This
is done through refinancing, where a firm takes a new loan to pay off existing loans. This
can provideextra cash for businesses in the short to medium term.
 Factoring- This is an agreement, between a specialist finance company and a business
that is in need of ready cash, to purchase the amount owed by debtors. In essence, the
factoring company will wait for the payments from the debtors while the firm will get the
cash needed. The amount paid by the factoring company to the firm will usually be less
than the amount owed to the firm by the debtors.
 Increasing stock turnover- The amount of times that stock turns over is also of interest to
the organisation. A high rate of turnover will provide the business with more cash in hand
to cover its day-to-day expenses and bills.
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INVESTMENT CAPITAL

Money put back into the business to foster growth and productive capacity. For example, it may
include investment in better machinery or a bigger plant (factory). As businesses become more
and more established, the need for more capital will arise. This money may be used to purchase
new and improved equipment and machinery, for expansion of the plant or to take on a new
project

SOURCES OF FINANCE

In sourcing finance, businesses need to assess the following options before making a final
decision:

 Equity capital versus debt capital

 Internal versus external.

Debt Financing – When companies Borrow from lending institutions, they take on loans (which
are a form of debt), which they repay over time with added interest. Trade Credit is also a form
of debt financing where businesses are allowed to buy supplies and stock on credit, to be repaid
at a later date often within the short term.

Equity Financing – is money or funding that is raised from the issuing of shares. It is also seen as
a personal investment in a business by its owner(s). Unlike debt financing which must be repaid
over time, equity financing does not have to be repaid. Equity also comes in the form of direct
capital investment. However, with Equity financing the owner(s) stand(s) to lose all the money
that was invested in the business should it fail.

DEBT VS EQUITY

FORMS OF EQUITY

* Capital – The profit retained in the company by the directors for investment purposes.
This profit still belongs to the shareholders since they are the owners but it will not be
paid to them unless the business is liquidated.

* Shares – The sale of shares raises finance of a company in exchange for part ownership in
the company. Dividends are part of the profits that are paid to shareholders as a return on
their investment.

FORMS OF DEBT

* Debentures – long term debt which is unsecured, meaning that there is no collateral put
up in the event that the debt is not repaid to the borrower. The two parties sign an
agreement called an indenture

* Bonds – issued for a period of a year or more and are a means of raising capital. There is
a written agreement to repay and the debt is secured against assets of the company.
Governments, corporations and other institutions issue bonds. Some bonds do not pay
interest but even if this is the case, the principal amount is repaid.

* Short term debts – to be repaid within one year or the businesses operating cycle
whichever is longer.

INTERNAL VERSUS EXTENAL-

Internal sources of finance

 Sale of Fixed Assets

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Management of Business The Need for Capital and Source Of Finance

 Retained profit (earnings) – this represents a business’s after-tax profit that is

ploughed back into the business.
 Working capital –This also serves as a source of funds for the business which
can reduce it stock balance by selling more, collecting outstanding funds from
debtors or increasing its creditors.

External sources of finance

 Some of the major external sources of finance include:

 Issue of shares
 Bank loans and overdrafts
 Debentures
 Venture capital
 Government assistance.

CRITERIA FOR SEEKING FINANCE

Sources of Short-Term Finance

Short-term’ usually refers to a period of time of one year or less.

 Bank overdraft and short-term bank loans
 Trade credit- is the deferment of payment for goods or services supplied to the
business. The supplier delivers the product but an arrangement is made to collect the
payment due at a later agreed date
 Debt factoring

SOURCES OF MEDIUM-TERM FINANCE

 Hire Purchase- This is an agreement between a buyer and a seller, under the
agreement an initial amount is paid as a down payment and the balance is paid over
time in fixed installments along with any interest accrued for the period.
 Leasing- a financial arrangement in which a person, company etc. pays to use a
property owner by another party for a specified period of time.
 Medium Term Bank Loans- These are set sums of money that are borrowed by the
business from either a bank or other financial institutions such as credit unions.

SOURCES OF LONG-TERM FINANCE

 Debentures- are fixed-interest loans that are issued to companies and are secured
against its assets. The lender of the funds is issued with a debenture certificate which
will specify the rate of interest to be paid by the company
 Mortgage- This is a loan that is given to a person or a business and is secured over or
guaranteed by the mortgagor’s property. The rate of interest charged can be either
fixed or variable.
 Venture capital- This was discussed earlier in this chapter. The period of time for
payment would be used to categorize it as long term or medium term. However, such
financing is usually seen as being long term.
 Bonds- Bonds are often called ‘fixed income securities’. A bond is a loan from
individuals or firms at a fixed income rate and for a defined period of time
 Sale of shares- The sale of shares is the major source of capital for limited companies.
A share can be defined simply as a unit of ownership in a company.
 Assistance from Government-Some businesses have benefited from government
assistance. This can be in the form of grants, subsidies or loan guarantees. This type

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of assistance is usually given to sectors that are critical within the country but are
undergoing financial difficulties.

HOW TO CHOOSE FROM THESE SOURCES OF FUNDS?

In choosing among the sources of finance, a business needs to consider the following factors.
Careful consideration of each factor will assist the business in making a decision:

Cost to the firm

The costs incurred by a firm sourcing finance will include administrative costs and interest
payments on loans and bank overdrafts. The business may want to use sources of finance that
charge lower fees and interest. For example, a firm may choose to issue shares rather than
undertake debentures.

The use of the funds

As mentioned earlier, it is not a wise decision to use short-term funding for long-term projects.
Long-term funding is usually more suited to projects that will take large amounts of capital
outlay or expenditure. For example, a cash register would be purchased on hire purchase rather
than by taking out a mortgage.

Size of the firm

A larger firm is more likely to secure certain sources of finance than a smaller firm. A number of
financial institutions would rather give a loan to a company than to a sole trader. On the other
hand, larger firms are more likely to secure collateral for loans than smaller firms.

Financial stability

Banks and other financial institutions normally ascertain the financial viability of the business
and the project being undertaken before they will lend funds. A firm that is financially unstable
is less likely to secure certain financing and even if the loan is given the rate of interest may be
very high.

Gearing of the firm

A company’s gearing refers to the relationship of its equity capital (ordinary shares) to loan
capital (long-term loans and preference shares). A company is said to be highly geared if its loan
capital is significantly higher than its share capital. It is low geared if its loan capital is smaller
than its share capital. The gearing ratio will also be used to determine the source of financing
undertaken by the company. A highly geared company may refuse to sink itself further into debt
by borrowing, therefore it may seek other sources of finance such as issuing additional shares.

INTERNATIONAL FINANCIAL INSTITUTIONS

While potential entrepreneurs and businesses can raise their own finance, there are a number of
agencies and institutions throughout the Caribbean that can provide meaningful information
about business operations. These institutions provide a myriad of services, including technical
support, managerial advice, conducting feasibility studies, doing economic appraisals of
countries and providing financing in some cases.

Caribbean Development Bank (CDB)

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Management of Business The Need for Capital and Source Of Finance

The CDB was established in 1969, with its main purpose being ‘to contribute to the harmonious
economic growth and development of member states and to promote economic cooperation and
integration’. As a regional body, members would be exposed to a number of benefits that may
have been problematic in sourcing from international bodies. The CDB has the following
functions:

 To assist the borrowing member countries in optimizing the use of their resources,
developing their economies and expanding production and trade
 To promote private and public investment, encourage the development of the financial
upturn in the region and facilitate business activity and expansion
 To mobilize financial resources from both within and outside the region for development
 To provide technical assistance to its regional borrowing members
 To support regional and local financial institutions and a regional market for credit and
savings
 To support and stimulate the development of capital markets in the region.

Since its establishment the bank has contributed financing to projects in agriculture, livestock,
fisheries, forestry, tourism, export services and education, among others.

Inter-American Development Bank (IDB)

The IDB was established in 1959, with a mission ‘to contribute to the acceleration of the process
of individual and collective social and economic development of member countries’. In carrying
out its mandate the IDB provides financial and technical support for its Caribbean members. This
assistance can be further highlighted as follows:

It provides loans, grants and guarantees to assist countries in the areas of education, health and
environmental preservation

It fosters social equity and policies that are geared towards poverty alleviation

It lends support to regional integration and the enhancement of free trade in the region

Technical assistance is given in the planning and implementing of development projects and
reform policies.

In January 2009, the Prime Minister of Jamaica signed an agreement with the IDB for a loan of
US$329m to assist with the country’s Competitiveness Enhancement Programme and Reform of
Public Sector Management Programme. The Trinidad and Tobago Government also signed an
agreement in May 2009 with the IDB for a loan of US$48.75m to support an education
programme to improve early childhood care and education centres.

World Bank

The World Bank was established in 1944 and since then has provided financial and technical
assistance to a number of developing countries around the world, including those in the
Caribbean. The bank is made up of two major institutions which, though they are different, work
in collaboration in carrying out its mission. These institutions are:

 The International Bank for Reconstruction and Development (IBRD), which focuses on
middle-income and creditworthy poor countries
 The International Development Association (IDA), which focuses on the poorest
countries in the world.

Both institutions work toward the achievement of the following functions of the bank:

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 It facilitates capital investment for the restoration of economies affected by war and the
development of productive facilities and resources in less developed countries
 It provides loans for developing countries to be used in the areas of health, education and
water supply
 To promote international trade and equilibrium in countries’ balance of payments.

International Monetary Fund (IMF)

The International Monetary Fund was established in 1944, with the main purpose of establishing
a framework to prevent a recurrence of the economic policies that led to the Great Depression in
the 1930s. This framework would guide the IMF to achieve its purposes of:

 Promoting international monetary cooperation

 Facilitating steady growth of international trade
 Offering its resources to correct balance of payments disequilibrium
 Promoting stability in the exchange rates of member states.

The work of the IMF can be categorized in three main areas:

 Surveillance – in this area, the IMF monitors economic and financial developments and
provides policy advice in an effort to prevent economic and financial crisis
 Lending – funding is made available to countries that are experiencing balance of
payments disequilibrium. Loans are also given to low-income countries in order to reduce
poverty
 Technical assistance – technical advice is given to its members on how to manage their
economic policy issues and financial affairs.

THE MONEY AND CAPITAL MARKETS

The money market

This is a market where financial institutions such as banks lend and borrow money from each
other on a short-term basis. It is a source of funds for government and institutions that have
short-term cash problems. Institutions in the money market will lend money by using a variety of
different securities including Treasury bills and certificates of deposit. These securities are very
liquid and mature in the short term. While larger money markets are found in places such as
London and some states in the USA, financial institutions in the Caribbean have given investors
access to such markets. One such institution in the region is the Jamaica Money Market Brokers
(JMMB). In 1999, the JMMB entered a joint venture to establish the Caribbean Money Market
Brokers (CMMB) in Trinidad and Barbados.

The capital market or stock market

This market involves the buying and selling of company stocks and shares and government
bonds. The stock market provides the link between companies that are in need of financing and
people who have money to invest. The stock market is divided into a primary market, where
capital is raised through the issue of new securities (stocks, shares and bonds), and the secondary
market, where existing securities are traded. The trading in the stock market is done through a
marketplace known as the stock exchange. The stock exchange has the following basic functions:

 To provide a channel through which people can save and invest

 To foster the expansion and growth of the financial service sector

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 To offer some level of protection to its savers from inflation

 To help to minimize borrowing by providing companies with equity financing.

Jamaica Stock Exchange (JSE)

The Jamaica Stock Exchange was incorporated in 1968 and started trading in 1969, with its main
role of ‘promoting the development of a vibrant capital market and ensuring orderly trading in
listed securities’. JSE is regulated by a council which monitors its activities by setting guidelines,
rules and standards for its operation. The council also reserves the right to suspend from trading
any companies who violate the rules.

Shares are traded through agents called stockbrokers. A sale is made when the broker of the
buyer and the broker of the seller agree on a price for the share. The price of a share is
determined by its demand and supply and the level of confidence that investors have in its value.
If more people are offering to buy than sell a share, its value will increase; the opposite is also
true. Confidence in a company’s shares may be influenced by the company’s growth prospects
and capabilities.

It is important to note that government bonds are not traded through the JSE but are sold by the
Bank of Jamaica

Other stock markets in the region include:

 The Trinidad and Tobago Stock Exchange (TTSE)

 The Barbados Stock Exchange (BSE)
 The New York Stock Exchange (NYSE)
 The London Stock Exchange (LSE)