CHAPTER Six

SOURCE OF FINANCE FOR SMALL BUSINESS

Introduction
Obtaining finance is the major obstacle entrepreneur’s face while shorting business. Basically
there are two alternative source of finance. These are equity financing and debt financing.
Having access to these sources does not reduce the problem for entrepreneurs. In addition to the
problem of lack of sources for finds, making tradeoff between the two alternatives is difficult for
small business operators.
 Sources of funds
Debt or equity financing
There are two types of finance come to mind when the entrepreneur wants fund to operate his/her
business debt financing and equity financing. Debt financing is a method of obtaining finance,
which involve an interest on the amount of money borrowed. Usually debt financing requires
that some kind of asset to be used as a collateral.
Debt financing requires the borrower to pay back the amount of funds borrowed plus an interest.
If financing is short-term (less than one year), the money is usually used to provide working -
capital to purchase inventory, to finance accounts receivables, or to operate the business. The
funds are typically, repaid from the resulting sales and profits during the year. Long-term debt is
frequently used to purchase some assets such as machinery, land, and other assets, which can be
used as collateral for the long-term loan.
Borrowing large amount to fund is not good because it will create problem in repayment time.
Thus, businesses should borrow reasonable amount of fund.
Unlike debt financing, equity financing does not require collateral and offers the investor some
form of ownership in the venture. The investor shares in the profit of the venture, as well as any
dispassion of its assets on a prorate basis.
Key factors to use one type of financing over another are:
 Availability of funds,
 The asset of the firm, and
 The interest rate

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Usually, organizations meet their financial needs by using a combination of debt and equity
financing.
Internal or External Financing
From another angle, finance is available from internal or external funds. The type of funds most
frequently employed is internally generated funds. Internally generated funds can come from
several sources within the company. Profits, sale of asset reduction in working capital, extended
payment terms, and account receivable.
In most cases, the startup years involve reinvesting generated profits back in to the business.
Sometimes, the needed funds can be obtained by selling least-used asset.
Short-term internal sources of funds can be obtained by the following methods:
Reducing short-term asset: inventory, cash, and other working capital items,
Extended payment terms from suppliers/collecting bills (account receivable) more
quickly.
The other general source of funds is external to the venture. Alternative sources of external
financing needs to be evaluated and three bases:
1. The length of time funds is available;
2. The cost (interest rate) involved; and
3. The amount of company control last.
The more frequently used sources of funds are personal funds, family and funds, and commercial
banks.
Personal Funds
Most of new businesses are started with the funds of the entrepreneur that he/she saved. This is
the least expensive funds interims cost and control. It is also absolutely essential in attracting
outside funding, particularly from banks, & private investors. Personal funds minimize the
suspicion that outside funding individuals and institutions had on the commitment of the
entrepreneurs. This commitment is reflected in the percentage of total asset available the
entrepreneur has invested, not necessary the amount of money committed.
Family and Friends
Family and friends are the next most common source of capital to start a business. They are most
likely to invest due to their relationship with the businessperson as well as their accessibility.
Family and friends provide a small amount of equity. Even if it is relatively easy to obtain money

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from family and friends, like all sauces of capital there are positive and negative aspects. If it is
in the form of equity financing, the family or friend then has an ownership position in the
business and all rights and privileges of that position. This may make them feel that have a direct
in put to the operation of the business, which may have a negative effect.
The order to solve such kind of problems, the entrepreneur must be aware of he negative and
positive aspect of using funds of family and friends. One thing that helps to minimize any future
problem is to make the business arrangements strictly business like.
Commercial Banks
Commercial banks are the most frequently used sources of funds when collateral are available.
The funds provided are in the form of debt financing, as such require some tangible quarantine or
collateral; some asset with value. The collateral can be in the form of business asset, & personal
asset. There are several types of Bank loans available. To ensure repayment, these loans are
based on the asset or cash flow of the venture.
Advantages of Equity and Debt Financing
The major advantages of equity financing are:
A. No interest charges must be paid
B. Particular advantage in an economic slump.. Their solvency is less likely to be threatened
by an inability to meet obligation to lenders.
C. Profits produced by a business financed by owners belong to owners and are not reduced
by loan payment.
The major disadvantages of equity financing are;
A. Capital needs of business vary over time. If requirement decrease invested money may
remain idle and not produce income.
B. Greater total investment by owners is required to a given scope operation when little or
no borrowed money is used.
C. Equity financing has the major draw back of diluting ownership. In effect, the original
owners sacrifice a portion of their control & profits.
Advantages of debt financing
A. Interest paid to the use of borrowed money is not taxed. This effectively reduces the cost
of using the money.

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 B. Borrowing is convenient for short-term needs. It makes it unnecessary to keep large
amount of cash for peak needs.
C. Borrowed money provides additional capital with out giving up an ownership or control
of the business.
D. Owners who are able to borrow money a make profits with it increasing their investment.
The ability to create profit form the total capital part of its owned and the rest borrowed,
is called leverage.
Debt financing has the following disadvantages:
A. Borrowed money is some times unavailable or can only be obtained at a high interest
rate. Businesses that key on debt financing may encounter many difficulties
B. Businesses that use borrowed money must meet interest payments regularly. This can be
a burden or even impossibility, when revenues are down or the company is facing other
financial difficulties.
Short Term & Long Term Debt Financing
Short term debt financing
There are varieties or sources for companies those want to borrow money for short-term periods.
Accounts Receivable loans
Accounts Receivable provides a good basis for a lean especially if the customer is well known &
credit worthy. in this case, the bank ''buys'' the accounts receivable at a value below the face
value of the sale and collects the money directly from the account.
Inventory loan
Inventory is another form of the firm's asset that is often a basis for loan, particularly when the
inventory is liquid. (i.e. that can be easily converted in to cash). Usually, the finished goods
inventory can be financed up to 50 percent of its value. Trust receipts are a unique type of
inventory loan used to finance retailers, such as automobile and appliance dealer. In trust receipts
the bank advances a large percentage of the invoice price of the goods and is paid on a pro rata
basis as the inventory sold.
Installment Loans
Installment loans can be obtained by a venture with a track of records of sales and profit. These
short-term funds are frequently used to cover working capital needs for a period of time, such as
when seasonal financing is needed. These loans are usually for 30 to 40 days.

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 Direct short term Loan
Businesses can borrow money for short-term use from banks and other financial institutions.
Many different instruments and borrowing methods are used. These loans may or may not
require collateral.
Unsecured Loans
These loans are obtained from banks and other lending institutions, individuals, or other
companies. The most common forms are promissory notes and lines of credit. A promissory note
is also one way of formulating a direct loan.
A line of credit is an agreement between the lender and borrower that loans up to a specified
maximum will be extended if needed.
Second short term loan
These kinds of loans require collateral. Equipment & other movable goods such as cars and
automobiles are commonly used as collateral. Other business facilities, such as building, may be
used, although this is less usual for short-term loans. Inventories, whether of semi finished, or
finished goods are commonly used.
Long Term Debt Financing
Large companies require a big amount of money than small businesses. it is also impossible for
them to repay the money with in a short period of time. Two sources of these funds are loan and
bonds. Only big organizations and government can usually issue bonds.
Long-term Loan
When there is a need for long time use, long-term loans are used. These loans can make funds
available for up to 10 years. The debt is usually repaid according to a fixed interest and principal,
although the principal can some times start being repaid in the third or second year of the loan,
with interest being paid the first year.
The most common long-term loan is mortgage. This loan is secured by some kind of valuable
property. Tangible property such as building, land, and other equipments may be used as a
collateral.
Long-Term Equity Financing
Equity financing is gained by selling a financial instrument called stock.
Corporate Stock
The two main sources of stockholder’s equity are

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 1. Investment contributed by the stock holders called paid in capital or contributed capital,
and
2. Net in come retained in the business, called retained earnings.
Individuals and or generations that own corporate stock actually own shares of the assets of the
corporation. This distinguishes stockholders from bondholders who have lent money to the
company. Bond holders do not participate in ownerships of assets of the organization to whom
they lend money.
Par Value
When issued, many stocks have a price assigned to them. The price is called par value, but it has
little relation to the actually value of selling price of the stock many companies issue non par-
value stocks.
Dividends
Having a share in profit is the main reason that in dividable or organizations acquires ownership.
Based on the amount of shares of stocks, corporations distribute surplus profits among
stockholders. Rules about the distribution of profit make an important distinction between the
two major types of stock: preferred and common.
Common stock versus preferred stock
The kind of stock stockholders acquire, has a clear impact on the rights & privileges in the
distribution of profit and participation in the decision making process. If a corporation issues
only common stock, each share generally has equal right. A corporation may provide one or
more classes of stocks with various preferential rights. The preference usually relates the right to
share in the distribution of earning such stock is generally called preferred stock.
A corporation with both preferred and common stock may declare dividends on the common
only after it meets the requirements of the stated dividend on the preferred.
Participating and Non-Participating
Preferred Stock
Holders of common stock have the possibility of receiving larger dividends than preferred stock
holders. The preferred stockholder's preferential right to dividend is usually limited to certain
amount such stock is said to be non-participating.
Preferred stocks, which provides for the possibility of dividend in excess of a certain amount is
said to be participating. Preferred shares may participate with common shares to varying degree,

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and the agreement with the shareholders must be examined to determine the extent of this
participation.

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