Final accounts-Part Three: External sources of finance

External sources of finance for a business is from third parties who have no right of ownership even if they participate in financing the organization. Based on the time duration each category finance the business, these sources are categorized in to two main perspectives, that is;

i)Non-current liabilities

ii)Current liabilities

 

Non-Current Liabilities

This is also referred to as long term liabilities or borrowed capital and it is characterized by fixed rate of interest. This is because the investors who forgo their financial or non-financial resources to invest in the organization in question do so in return of a fixed rate of return as a reward unlike in the case of ordinary share capital. This source of external financing is said to be long term for the repayment of the principal amount plus interest to the lender(s) is within a period of more than one financial year. This matter introduces to us two financial implications;

One; this source of finance/funds is repayable to the lender(s) for a period which is more than one year. This financial implication is a direct one.

Two; this is a long term source of financing/funding of the business for the lender allows the borrower to continue utilizing the funds for a longer period of more than one year instead of using his/her own generated sources such as retained earnings. That is, as long as the debt is not yet refunded, then its availability is categorized as a long source of funding.

Such kind of non-current liabilities are further classified in to two main categories

1.Debt capital

2.Preference share capital

 

Debt Capital

Debt capital is a long term source of financing where the borrower (the business or individual entrepreneur) receives cash or non-cash resources to leverage the business operations whereby the principle amount and the interest amount is repaid within a period of one or more years. Most long term sources of finance of this kind are characterized by strict lending covenants and laws between the concerned parties which minimize debt default instances. They also carry a fixed rate of return and hence a less risky investment by the lenders for there is an assurance of one receiving back the interest and principle amount for it is fixed. The common examples of debt capital are debentures, bond and bank loans. This sources of funds are issued by financial institutions such as banks or insurance companies and central or county governments. 

Definition one;

Debenture; this is a unit of debt. Or an acknowledgement of debt whereby the borrower is expected to repay the interest and the principle amount within a period of more than one year. A debenture is a type of debt instrument that is not backed by any collateral and usually has a term greater than 10 years. Debentures are backed only by the soundness and character of the issuing firm. Both corporations and governments frequently issue debentures to raise capital or funds.

Just as it is in the case of ordinary share capital, a debenture is issued to the public in terms of units with equal value such that, if the management of an organization want to raise one million US dollars as capital ($1,000,000), the management has many options of raising that amount. For instance, 

Option one-If Issuing price is $10

The management may wish to raise the aforementioned amount by issuing 100,000 debentures (units) at $10 each which if all are issued/sold to the public, and all the cash received, then the total capital raised will be $1,000,000 (ie $10*100,000).   

Option two-If Issuing price is $100

 The management may also decide to raise the aforementioned amount by issuing 10,000 debentures (units) at $100 which if all are issued/sold to the public, and all the cash received, then the total capital raised will be $1,000,000 (ie $100*10,000).

Option three-If Issuing price is $1,000

Further, the management may prefer to raise the same amount by issuing 1,000 debentures (units) at $1,000 each which if all are issued/sold to the public, and all the cash received, then the total capital raised will be $1,000,000 (ie $1,000*1,000).  

The units are equal for their monetary value is either $10 or $100 or $1,000 each as mentioned in options one to three accordingly. Therefore, if the company sell those debentures (units) to the public or privately, the one million US dollar target will be arrived at if we sum up all cash received from the public regardless of how much units of debentures each individual buy.

As an entrepreneur/learner, note this;

-the number of units of debentures (units) are said to be equal for they are all issued at the same price

-the issuing price is referred to as the nominal price, issuing price or par price or par value as it is in the case of ordinary share capital. It is also known as face value. The issuance price sometimes can be more than the nominal/par value hence referred to as premium as or lower than nominal hence discounted price.

-The amount of capital raised through issue of debentures using the nominal price is referred to as authorized debt capital. Remember the capital clause in the memorandum of association we discussed in level two of taccounting tutorial series that the promoters of the business has to state to the registrar of companies or the authority in charge of registration of businesses the mode of raising capital (capital structure which can either be pure equity or a combination of both internal and external debt). 

Definition two;

Bond; this is a unit of debt. Or an acknowledgement of debt whereby the borrower is expected to repay the interest and the principle amount within a period of more than one year. A bond is a fixed income instrument that represents a loan made by an investor to a borrower especially by the governmental. This is a common approach of raising funds by firms, municipalities, states, and central governments to finance projects and operations.

Just as it is in the case of ordinary share capital, a bond is issued to the public by governments especially when there is need of financing a major government project. It is usually issued in terms of units with equal value such that, if the government want to raise one million US dollars as capital ($1,000,000), it has many options of raising that amount. For instance’ 

Option one-If Issuing price is $1

The management may wish to raise the aforementioned amount by issuing 1,000,000 bond (units) at $1 each which if all are issued/sold to the public, and all the cash received, then the total capital raised will be $1,000,000 (ie $1*1,000,000).   

Option one-Issuing price $10

 The management may also decide to raise the aforementioned amount by issuing 100,000 bond (units) at $10 which if all are issued/sold to the public, and all the cash received, then the total capital raised will be $1,000,000 (ie $10*100,000).

Option three-Issuing price $1,000

Further, the management may prefer to raise the same amount by issuing 1,000 bond (units) at $1,000 each which if all are issued/sold to the public, and all the cash received, then the total capital raised will be $1,000,000 (ie $1,000*1,000).  

The units are equal for their monetary value is either $10 or $1 or $1,000 each as mentioned in options one to three accordingly. Therefore, if the company sell those bond (units) to the public or privately, the one million US dollar target will be arrived at if we sum up all cash received from the public regardless of how much units of bond each individual buy.

As an entrepreneur/learner, note this;

-the number of units of bond (units) are said to be equal for they are all issued at the same price

-the issuing price is referred to as the nominal price, issuing price or par price or par value. It is also known as face value. The issuance price sometimes can be more than the nominal/par value hence referred to as premium as or lower than nominal hence discounted price.

-The amount of capital raised through issue of debentures using the nominal price is referred to as authorized debt capital. Remember the capital clause in the memorandum of association we discussed in level two of this accounting tutorial series that the promoters of the business has to state to the registrar of companies or the authority in charge of registration of businesses the mode of raising capital (capital structure which can either be pure equity or a combination of both internal and external debt).

NOTE that both debentures and bonds are commonly issued at a nominal price of either $100 or $1,000 per unit 

Definition three;

Preference share capital is capital raised through issuance of preference shares. It is also referred to as preferred shares or quasi equity for it is carries hybrid characteristics. What do we mean by hybrid? This is a case whereby the shares have both characteristics of equity and debt aspect. This type of shares are bought by the owners of the company in addition to the ordinary shares they have already acquired. Am sure you can remember very well that we concluded that ordinary share capital is a risk venture and investors in this line of investment have a risk of not getting any returns in a particular year especially when the year is a bad one and profits are low. So to cushion that adverse effect, the ordinary shareholders who are the owners of the organization buy preference shares from the same company they own hence preference shares are referred to as quasi-equity for they are owned by the ordinary shareholders.

The second aspect is that the same preference shares carry a fixed rate of return as it is in the case of external debt such as debenture. Such that the holders of such shares are rest assured of receiving a fixed return whether profits are made or not. This makes the shares being classified as a quasi-debt. This reduces the riskiness associated to ordinary shares.

Now, just as it is in the case of ordinary share and debt capital, preference shares are issued to the public in terms of units with equal value such that, if the management of an organization want to raise one million US dollars as capital ($1,000,000), the management has many options of raising that amount. For instance,

Option one-If Issuing price is $1

The management may wish to raise the aforementioned amount by issuing 1,000,000 preference shares (units) at $1 each which if all are issued/sold to the public, and all the cash received, then the total capital raised will be $1,000,000 (ie $1*1,000,000).  

 

Option one-If Issuing price is $10

 The management may also decide to raise the aforementioned amount by issuing 100,000 preference shares (units) at $10 which if all are issued/sold to the public, and all the cash received, then the total capital raised will be $1,000,000 (ie $10*100,000).

Option three-If Issuing price is $1,000

Further, the management may prefer to raise the same amount by issuing 1,000 preference shares (units) at $1,000 each which if all are issued/sold to the public, and all the cash received, then the total capital raised will be $1,000,000 (ie $1,000*1,000).  

The units are equal for their monetary value is either $10 or $1 or $1,000 each as mentioned in options one to three respectively. Therefore, if the company sell those preference shares (units) to the public or privately, the one million US dollar target will be arrived at if we sum up all cash received from the public regardless of how much units of preference shares each individual buy.

As an entrepreneur/learner, note this;

-the number of preference shares (units) are said to be equal for they are all issued at the same price

-the issuing price is referred to as the nominal price, issuing price or par price or par value as it is in the case of other two capital sources aforementioned. It is also known as face value. The issuance price sometimes can be more than the nominal/par value hence referred to as premium as or lower than nominal hence discounted price.

-The amount of capital raised through issue of preference shares (units) using the nominal price is referred to as authorized preference share capital. Remember the capital clause in the memorandum of association we discussed in level two of this accounting tutorial series that the promoters of the business has to state to the registrar of companies or the authority in charge of registration of businesses the mode of raising capital (capital structure which can either be pure equity or a combination of both internal and external debt). 

Definition four;

Bank loan; unlike in the case of debenture and bond, a bank loan is a lump sum amount is cash borrowed from a bank by the business or the individual person. Therefore the aspect of issuance in unit form does not exist although the facility attracts fixed rate of return to the investor. Hence, the borrower wishing to raise one million US dollars as capital ($1,000,000), has one option of raising that amount. That is, he or she applies for the lump sum amount.

Lesson Two; Current Liabilities

Current liabilities are the short term sources of finance for a business this instrument provides finance to the business within a period of one year or less. In other words, this type of debt is re-payable within one financial period. They include;

1.Trade creditors/accounts payable

2.Bank overdraft

3.Income in advance

4.Accrued expense

5.Note payable

6.Part of lease finance repayable within one financial period etc.