CHAPTER SIX

BUSINESS FINANCING
 INTRODUCTION
• Sourcing money may be done for a variety of reasons. Traditional
areas of need may be for capital asset acquisition- new machinery or
the construction of a new building.
• The development of new products can be costly but capital may be
required. Such developments are financed internally, whereas capital
for the acquisition of machinery may come from external sources.
• In this day and age of light liquidity, many organizations have to look
for short term capital in the way of loans, working capital etc., in
order to provide a cash flow cushion. This chapter of the module
discusses about financing of firms.
 Financial Requirements
• All businesses need money to finance a host of different requirements
In looking at the types and adequacy of funds available, it is important
to match the use of the funds with appropriate funding methods
1) Permanent Capital
• The permanent capital base of a small firm usually comes from equity
investment in shares in a limited company or share company, or
personal loans to form partners or to invest in sole proprietorship.
• It is used to finance the start - up costs of an enterprise, or major
developments and expansions in its life - cycle. It may be required for
a significant innovation, such as a new product development.
• Equity capital usually provides a stake in the ownership of the
business, and therefore the investor accepts some element of risk in
that returns are not automatic, but only made when the small firm
has generated surpluses.
2) Working Capital
• It is short-term finance. Most small firms need working capital to
bridge the gap between when they get paid, and when they have to
pay their suppliers and their overhead costs.
• Requirements for this kind of short-term finance will vary
considerably by business type. For example, a manufacturer or small
firm selling to other businesses will have to offer credit terms, and the
resulting debtors will need to be financed; the faster the growth, the
more the debtors, and the larger the financial requirement.
3) Asset Finance
• It is medium to long term finance. The purchase of tangible assets is
usually financed on a longer-term basis, from 3 to 10 years, or more
depending on the useful life of the asset. Plant, machinery,
equipment, fixtures, and fittings, company vehicles and buildings may
all be financed by medium or long-term loans from a variety of
lending bodies.
 Sources of Financing
• Financial resources are essential for business, but particular requirements
change as an enterprise grows. Obtaining those resources in the amount
needed and at the time needed can be difficult for entrepreneurial ventures
because they are generally considered more risky than established
enterprises.
• As we shall see, financing means more than merely obtaining money; it is
very much a process of managing assets wisely to use capital efficiently. The
critical issue in financing is to assure sufficient cash flow for operations, as
well as to plan financing that coincides with changes in the enterprise.
Businesses obtain cash through two general sources, equity or debt, and
both can be obtained from literally hundreds of different sources. The
various sources of finance may be broadly be classified as follows:
1 Internal Sources
• Owner’s capital or owner’s equity represents the personal investment
of the owner in a business and it is sometimes called risk capital
because these investors assume the primary risk of losing their funds
if the business fails
• However, if the venture succeeds, they also share in the benefit
Sources of Equity Capital
• Personal saving: The first place entrepreneurs should take for startup
money is in their own
• Friends and relatives: After emptying their own pockets,
entrepreneurs should turn to friends and relatives who might be
willing to invest in the business
• Partners: An entrepreneur can choose to take on a partner to expand
the capital formation of the proposed business
• Public stock sale : In some case, entrepreneurs can go public by
selling share of stock in their corporation to outsiders
.• Savings are money or other assets kept over a period of time, usually
not to be consumed immediately but in the future. Savings can be
kept in a bank or any other safe place where there is no risk of loss,
spending, or making profit.
• Investments are monetary assets purchased in the hope that they will
generate income, reduce costs, or appreciate in the future.
• A personal budget is a finance plan that allocates future personal
income towards expenses, Savings and debt repayment.
2 External Sources (Debt capital)
• Borrowed capital or debt capital is the external financing that small
business owner has borrowed and must repay with interest.
• There are different sources as discussed here below
External Sources
• Commercial banks: Commercial banks are by far the most frequently used source
for short term debt by the entrepreneur. In most cases, commercial banks give
short term loans (repayable within one year or less) and medium term loan
(maturing in above one year but less than five years), long term loans (maturing
in more than five years).
• Bank Lending Decision:-The small business owner needs to be aware of the
criteria bankers use in evaluating the credit worthiness of loan applications. Most
bankers refer to the five C’s of credit in making lending decision. The five C’s are
capital, capacity, collateral, character, and conditions.
. • Capital: A small business must have a stable capital base before a bank will
grant a loan.
• Capacity: The bank must be convinced of the firm’s ability to meet its regular
financial obligations and to repay the bank loan.
• Collateral: The collateral includes any assets the owner pledges to the bank
as security for repayment of the loan.
• Character: Before approving a loan to a small business, the banker must be
satisfied with the owner’s character. The evaluation of character frequently is
based on intangible factors such as honesty, competence, willingness to
negotiate with the bank.
• Conditions: The conditions surrounding a loan request also affect the owner’s
chance of receiving funds. Banks consider the factors relating to the business
operation such as potential growth in the market, competition, location, and
loan purpose.
External Sources
• Micro Finances: provide financial services mainly to the poor ,micro and
small enterprises
• Trade Credit: It is credit given by suppliers who sell goods on account
• Equipment Suppliers: Most equipment vendors encourage business
owners to purchase their equipment by offering to finance the purchase
• Account receivable financing: It is a short term financing that involves
either the pledge of receivables as collateral for a loan
• Credit unions: Credit unions are non-profit cooperatives that promote
savings and provide credit to their members
Cont.
• Bonds: A bond is a long term contract in which the issuer, who is the borrower,
agrees to make principal and interest payments on specific date to the holder of
the bond. Bonds have always been a popular source of debt financing for large
companies in the western world.

• Traditional Sources of Finance: “Idir”, “equib”

Lease Financing
• Lease financing is one of the important sources of medium- and long-
term financing where the owner of an asset gives another person, the
right to use that asset against periodical payments.
• The owner of the asset is known as lessor and the user is called lessee.
The periodical payment made by the lessee to the lessor is known as
lease rental.
• Under lease financing, lessee is given the right to use the asset but the
ownership lies with the lessor and at the end of the lease contract, the
asset is returned to the lessor or an option is given to the lessee either
to purchase the asset or to renew the lease agreement.
Types of Lease
• Depending upon the transfer of risk and rewards to the lessee, the
period of lease and the number of parties to the transaction, lease
financing can be classified into two categories
• Finance lease and operating lease
1) Finance Lease
• Finance Lease is the lease where the lessor transfers substantially all
the risks and rewards of ownership of assets to the lessee for lease
rentals. In other words, it puts the lessee in the same condition as
he/she would have been if he/she had purchased the asset.
• Finance lease has two phases: The first one is called primary period.
This is non-cancellable period and in this period, the lessor recovers
his total investment through lease rental. The primary period may last
for indefinite period of time. The lease rental for the secondary period
is much smaller than that of primary period.
2) Operating Lease

• Lease other than finance lease is called operating lease. Here risks
and rewards incidental to the ownership of asset are not transferred by
the lessor to the lessee. The term of such lease is much less than the
economic life of the asset and thus the total investment of the lessor is
not recovered through lease rental during the primary period of lease.
• In case of operating lease, the lessor usually provides advice to the
lessee for repair, maintenance and technical knowhow of the leased
asset and that is why this type of lease is also known as service lease.
Traditional Financing in Ethiopian
• While Ethiopia has one of the least-developed formal financial sectors in the world, it
possessed a rich tradition in indigenous, community-based
groups such as savings and credit associations
and insurance like societies. These "iqub" and "idir" groups provide a source of credit
and insurance outside the formal sector but much rooted in Ethiopian society.
• The contributions of these groups, especially iqub, to economic growth is difficult to
quantify but can be assumed to play an important role. Iqub is a traditional means of
saving in Ethiopia and exists completely outside the formal financial system. An iqub is
a form of savings.
• People voluntarily join a group and make a mandatory contribution (every week, pay
period or month or example). The "pot" is distributed on a rotating basis determined
by a drawing at the beginning of the iqub. Amounts contributed vary according to the
ability of the participants.
Crowd Funding
• Crowd funding is a method of raising capital through the collective
effort of friends, family, customers, and individual investors or even
from the general public.
• This approach taps into the collective efforts of a large pool of
individuals primarily online via social media and crowd funding
platforms and leverages their networks for greater reach and
exposure.
Types of Crowd Funding
• Just like there are many different kinds of capital round raises for
businesses in all stages of growth, there are a variety of crowd
funding types
• Which crowd funding method you select depends on the type of
product or service you offer and your goals for growth
• The 3 primary types are donation-based, rewards-based, and equity
crow funding
1) Donation-Based Crowd Funding
• Broadly speaking, you can think of any crowd funding campaign in
which there is no financial return to the investors or contributors as
donation-based crowd funding.
• Common donation- based crowd funding initiatives include fund
raising for disaster relief, charities, nonprofits, and medical bills.
2) Rewards-Based Crowd Funding

• Rewards-based crowd funding involves individuals contributing to

your business in exchange for a “reward,” typically a form of the
product or service your company offers.
• Even though this method offers backers a reward, it’s still generally
considered a subset of donation-based crowd funding since there is
no financial or equity return.
 3. Equity-Based Crowd Funding
• Unlike the donation-based and rewards-based methods, equity-based
crowd funding allows contributors to become part-owners of your
company by trading capital for equity shares
• As equity owners, your contributors receive a financial return on their
investment and ultimately receive a share of the profits in the form of
a dividend or distribution
Micro Finances
What is Micro Finance?
• Microfinance is a term used to describe financial services, such as
loans, savings, insurance and fund transfers to entrepreneurs, small
businesses and individuals who lack access to banking services with
high collateral requirements.
• Essentially, it is providing loans, credit, access to savings accounts –
even insurance policies and money transfers to small business
owners, entrepreneurs (many of whom live in the developing world),
and those who would otherwise not have access to these resources.
Importance of MFIs
• Microfinance is important because it provides resources and access to
capital to the financially underserved, such as those who are unable
to get checking accounts, lines of credit, or loans from traditional
banks
• Without microfinance, these groups may have to resort to using loans
or payday advances with extremely high interest rates or even borrow
money from family and friends
• Microfinance helps them invest in their businesses, and as a result,
invest in themselves
Micro Finances in Ethiopia
• Micro-finance in Ethiopia has its origin in traditional informal method
used to accumulate saving and access credit by people who lacked
access to formal financial institutions
• Ethiopia has also more 38 MFIs and practice is one of the success
stories in Africa even though there are certain limitations
• The objective of the MFIs is basically poverty alleviation through the
provision of sustainable financial services to the poor who actually do
not have access to the financial support services of other formal
financial institutions
Types of Activities Carried Out by
Ethiopian MFIs
• According to Article 3 of the aforementioned proclamation, MFIs are
allowed to carry out the following activities:
• Accepting both voluntary and compulsory savings as well as demand
and time deposits
• Extending credit to rural and urban farmers and people engaged in
other similar activities as well as micro and small scale rural and
urban entrepreneurs
Types of Activities Carried Out by
Ethiopian MFIs
• Drawing and accepting drafts payable within Ethiopia Micro-insurance business as
prescribed by NBE,
• Purchasing such income generating financial instruments as treasury bill and other
income generating activities,
• Acquiring, maintaining and transferring any movable and immovable property including
premises for carrying out its business,
• Supporting income generating projects of urban and rural micro and small scale
operators,
• Rendering managerial, marketing, technical and administrative advice to customers and
assisting them to obtain services in those fields,
• managing funds for micro and small scale business, F Providing money transfer services,
• Providing financial leasing services