Features and Characteristics in Considering Potential Sources of Financing for a Business

ACADEMIC ANALYSIS
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Academic Analysis
Part 1: Financial Statements
1.1. Balance Sheet for the ABC Pty Ltd for the Year Ended 30/06/2019
All Values in $000's

$000

$000

Current Assets



Cash

200


Account Receivables

235


Inventory

370




805

Non-Current Assets



Vehicles

235


Plant and Equipment

310


Land & Building

1210




1755

Total Assets


2560




Liabilities



Account Payable

270


Tax Liability

90


Bank Loan

320


Bank Overdraft

330


Corporate Bonds

430




1440

Equity



Preference Shares

260


Ordinary Shares

690


Retained Earnings

170




1120

Total Liabilities and Equity


2560

1.2. Income Statement for the ABC Pty Ltd for the Year Ended 30/06/2019
All Values in $000's

$000

$000

Sales


992

Cost of Goods Sold



Opening Inventory

272


Plus: Purchases

554


Subtract: Closing Inventory

-257




569

Gross Income


423

Expenses



Utilities

-57


Rent

-82


Wages

-117




-256

Operating Income


167

Non-Operating Loss (Loss form Sale of Machinery)


-10

Dividend Income


50

Earnings Before Interest and Taxes (EBIT)


207

Interest

-27


Tax

-10




-37

Net Income


170

1.3. Statement of Cash Flows for ABC Pty Ltd for the Year Ended 30/06/2019
All Values in $000's

$000

$000

Operating Activities



Cash Received from Customers

460


Cash Paid to Suppliers

-240


Wages Paid

-130


Interest Paid

-12


Taxes Paid

-8


Interest Received

10


Dividend Received

9


Net Cash Flow from Operating Activities


89




Investing Activities



Proceeds from Sale of Plant, Property, and Equipment

80


Purchases of Plant, Property, and Equipment

-350


Net Cash Flow from Investing Activities


-270




Financing Activities



Dividends Paid

-26


Repayment of Long-Term Borrowings

-24


Proceeds from Long-Term Borrowings

155


Proceeds from Issue of New Shares

85


Cost of Buying Back Shares

-31


Payment of Finance Lease Liabilities

-48


Net Cash Flow from Financing Activities


111

Cash at the beginning of the Year


270

Cash at the End of the Year


200

Part 2: Financing – Risks and Returns
2.1. Five Features and Characteristics for Consideration in Potential Sources of Financing for a Business
An organization requires continuous funding to support its operational, investment, and expansion activities. Therefore, sustainable competitive advantage depends on the organization's ability to identify the relevant investment opportunities and then select the one that provides the high rate of return in short-term and long-term objectives. The two most important sources of finance are equity and debt finance. The debt finance option enables the organization to borrow financial funds from financial institutions or any lender. On the other hand, the equity finance option helps the organization generate new financial resources by selling the ownership of the business. The five most important characteristics to consider before selecting between equity and debt finance are mentioned below.
1. Long-Term Objectives
An organization's long-term objectives define its future in the competitive business environment. Therefore, business owners need to have a proper plan to ensure that the business survives and ensures continuous growth to accomplish organizational objectives. Generally, company preference may change if the management thinks of generating extra capital for the long-term period. The rule is simple; debt finance is the least costlier option than equity finance in the long term (Lackland 2021). However, in the short term, equity finance is suitable because the company does not have to rapidly improve its financial performance to meet the shareholders' required rate of return.
The debt finance for the company's long-term objectives provides exceptional benefits. The first and the most important one is; debt finance provides higher tax benefits. The interest payment helps lower the taxable net income, indicating that the actual effective cost of borrowing is generally lower than the mentioned or stated interest rate (Lackland 2021). The second significant benefit is that shareholders do not dictate the company's management. Dependence on equity finance means that shareholders become the company's owner – a situation worth avoiding for companies looking to expand their operational activities without too much dictation from the shareholders. Therefore, if the company plans to find a new source of finance to accomplish long-term objectives, then debt finance is more suitable because it provides space and additional time to the management to improve financial performance and meet the debtholders' required rate of return.
2. Capital Structure of the Business
The current capital structure is another important factor that requires examination before making the final selection between equity and debt finance. From a company's perspective, debt finance is a suitable or cheapest option; however, it also contains interest payments – the principle is that higher the interest rate, lower the net profit (Müller 2005). Therefore, the low amount of net income will be available for shareholders in the form of dividends. Therefore, the shareholders can raise specific concerns about the high levels of debt. Another perspective is; more debt finance raises the financial risk. Hence, the company needs to continuously measure its capital gearing ratio to maintain a reasonable level of debt finance; otherwise, the liquidation challenge becomes unavoidable (Nusinov, Burkova and Shura 2020).
Management responsibility also includes measuring times interest earned ratio to ensure that the company's EBIT (Earnings Before Interest and Expense) is enough to meet the interest payments. Continuous changes in the capital structure lead to mistrust issues among stakeholders because it fluctuates profits. Hence, the organization should conduct a proper strategic planning process that plan is in place to opt for equity or debt finance. If the company decides to depend more on equity finance, then the new capital structure can negatively impact the controlling rights, leading to less ownership and more interference by stakeholders. Hence, the capital structure needs to be compatible with the financial business requirements and overall industry environment. Otherwise, the financing decisions negatively impact management and may make it challenging to accomplish strategic objectives.
3. Risks Minimizing Capabilities of a Business
Both sources of finance, equity or debt, contain some kinds of risks. The debt finance contains interest payments payable in a year and then the principal amount payable over a specific period. The management needs to examine its liquidity ratios like current, quick, and working capital to identify its ability to meet short-term obligations like interest payments. If the organization faces difficulty meeting the debt payments, then the risk of losing assets exists – those that are pledged for the collateral, leading to bankruptcy. Equity finance consists of risks like higher return expectations and higher chances of conflicts between the management and shareholders. In this scenario, the management needs to ensure that all efforts are invested properly to create new value for shareholders.
The best way to create new value is by investing in new projects that generate new streams of cash inflows, leading to higher net profit margins and more dividends for shareholders. Hence, the business management may also need to examine its dividend and retained earnings policy before deciding between debt and equity finance.
4. Volatility in the Company's Operating Profit
Volatile operating profits raise concerns for investors and lenders – a vital business risk that demands detailed examination before selecting a suitable source of finance. Monthly or quarterly financial results provide relevant information about the vitality levels in the profits. The higher the changes in profits, the lower the company's chance to opt for the debt finance option. It leads to the natural inclination of the company towards equity finance. Multinational companies usually face challenges maintaining sustainable operating income growth rates. Therefore, they prefer to opt for equity finance, and it provides an additional benefit, such as; the company is not under any legal obligation to pay off the equity dividend.
5. Availability and Current Situation of the Equity Markets
Management needs to analyze the historical situation of issuing new shares to generate the equity finance before generating additional financial capital from investors. This type of analysis is important because it allows management to select the most suitable period to maximize proceeds from launching new shares. The current pandemic negatively impacts the equity markets, leading to a situation where companies may not sell additional shares at low prices to generate equity finance. However, the company still has the option of right issues, enabling the company to issue shares to existing owners. Therefore, the equity markets situation can encourage or discourage the company from generating additional financial resources from equity finance.
Another critical situation is the bear market, where the equity markets tend to show a trend of continuous decrease over a sustained period. A bear market is a reflection of low investors' confidence (Benson 2021). Therefore, the company expects to receive low proceeds from issuing additional shares, and the expectation is that it will automatically move towards the debt finance for generating additional financial resources.
2.2. Three Sources of Financing for Start-Up Business and Their Significance at this Stage of Lifecycle
Like other businesses, startups also require continuous financing to compete and grow in a specific business environment. However, raising financial capital is challenging for new companies because sustainability issues lead to ineffective financing decisions. The three most important sources of finance for startup businesses are mentioned below.
1. Angel Investors
Angel financing enables the investors to provide financing amounts for specific ownership in a startup. In recent years, the number of angel investors and the total amount of investment has risen across different countries. Lerner, Schoar, Sokolinski, and Wilson (2015) identify that the angel investments in the region like the US create a high positive impact on the performance and growth of the startups in the competitive environment. According to an estimate, the total value of the angel industry will become $250 billion by 2024 (Ergocun, Turan and Atar 2019). At the initial stage of business launch, angel investment is a blessing for entrepreneurs because there is a high risk of failure. An angel investor might consider different factors before investing. Important factors are:
* Development of minimum viable product by the startup,
* Target market and pilot customers,
* Strategic partnerships with the other companies in the ind...