Small Firm Financing Essay Research Paper Financing

Small Firm Financing Essay, Research Paper

Financing a small firm can be achieved in three ways. The most preferable but at the same time the least likely is self financing from retained earnings, otherwise, the firm will have to resort to either one of the two following financial markets. Debt capital and equity capital ( which strictly speaking is the same as retained earnings, both having their advantages and disadvantages.

Only after 1979 did clearing banks start making loans with a maturity term in excess of ten years. In the case of a loan to smaller companies, the fixed interest rates are usually set at a premium over base rate ( 3% – 6%). Larger companies who have a good credit rating will probably be offerred the premium on the inter-bank rate which is lower than the base rate. Loans are usually secured on the personal guarantee of the Directors or the owner of small companies and in the case of larger ones, a charge is made against the assets of the company. If the charges are fixed , that means that they are linked with a specific asset of the company. Floating charges are made on the general assets.

All bank loans are based on three elements which the company has to be able to satisfy. The interest rate demanded by the bank, the security demanded by the bank and the terms of repayment which are open to individual arrangements between bank and borrower although they usually consist of systematic amortization payments made over the full time of the loan.

A small company will have to ensure its capability of all three in spite of the fact that in comparison to a larger company, it will be paying a higher interest rate, will be risking security based on the owner s personal assets rather than company assets and repayment terms will probably be more rigid rather than flexible as banks rightly see the small company borrower as a higher risk. (This is explained later on when discussing the problems faced by the small company in raising finance.)

There are sources of loans other than from banks. Companies usually resort to these financial institutions as a last resort because their interest payments are fixed and if inflation falls, this will make the borrowing very expensive. These financial sources can include pension funds, insurance companies, merchant banks, the European Investment Bank and the ICFC. (Investment and Commercial Finance Corp[oration)

There is also the medium term note open as an alternative which is a promisory note issued by the company promising to pay a specified amount on a specified date. The procedure is for the company to write the note and then to sell it in the market place. The interest rate can be fixed or may fluctuate and the maturity date of the note can be anything from under one year to as long as fifteen years.

The small company may issue a debenture, which is a document issued in return for money lent. There are various types of debentures but they all have some features in common. They are usually in the form of a bond, undertaking the repayment of a loan on a specified date and with regular stated payments of interest between the date of issue and the date of maturity. These dividends have priority to be paid before any other dividend is paid to any other class of shareholder. The Companies Acts define the word debenture as including debenture stock and bonds. Often the terms debenture and bond or loan stock are interchangeable although I shall mention Bond and Loan Stock a little later on.

There are a number of reasons why an investor would chose debentures in preference to other forms of company financing. The major factor has to do with risk. Debt financing usually has a fixed maturity. The investor enjoys priority both in interest and in the possibility of the company going into liquidation. In addition,debenture holders receive a fixed return on the investment and if the company does not make large profits, will continue to receive the fixed interest rate while the ordinary shareholders may have to wait the Board s decision on what and how much to pay out.

Now we must look at why a company would issue debentures. The primary advantage is that the cost of the debt is known and is limited. If the company makes greater profits, these are not shared out with the debenture holders. The cost of the debt is also limited because the risk of the debenture holders is lower than that of the shareholder. Also, and importantly, the interest payment that is made to the debenture holder is deductable against tax.

Debenture issues are not an unqualified benefit for the company. There are some disadvantages in that assumptions that were made ten years ago about the future trading position of the company might prove to be wrong and the decision for long term debt unwise. The company still has to repay the debt on the date of maturity.

A warrant, is in principle, a call option issued by the company on its own stock.The warrant holder is able to buy a specified number of shares at a specified price on a specified date. Problems that face the young company will be discussed later but for a company without a proven track record, raising finance can be difficult. The warrant can be used as an enticer. Debenture holders have no option to benefit from the company which performs well but companies can tempt investors to their debenture stock by issuing convertible