CHAPTER 6

BUSINESS FINANCING
Chapter Objectives

By the end of this chapter , students will be able to:

 Learn about the cost of starting an enterprise

 Know the different sources of finance to start a business venture

 Understand lease financing

 Learn micro finances

 Understand crowd funding

 Learn about traditional financing in Ethiopia

6.2 Financial Requirements
 All businesses need money to finance a host of different requirements

 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.

Cont.
 permanent capital is only serviced when the firm can afford it; investment in equity

is rewarded by dividends from profits, or a capital gain when shares are sold.

 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.

2) Working Capital

 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.
Cont.
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.

6.3 Sources of Financing

 financing means more than merely obtaining money; it is very much a process of

managing assets wisely to use capital efficiently.

 Cash is the most important asset to manage, and to generate cash, business must

generate sales.
 Cont.
 In order to generate sales, most businesses must have inventory and

facilities.
 Service enterprises need offices and staff, and manufacturers face

more extensive requirements, including plant and equipment.

 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:
Cont.
6.3.1 Internal Sources (Equity capital)
Personal saving

Friends and relatives

Partners

Public stock sale (going public)

Angels( private investors )

Venture capital companies
Comparison of Angles and Venture Capitalist

Angels Venture Capitalists (VCs)

• Individuals who wish to assist others • Finance, small scale new technology
in their business venture, and any risky idea.
• Usually found through networks, • Funds are more specialized versus
• Reasonable expectations on equity homogeneous
position and ROI, • High expectations of equity position
• Often passive, but realistic and ROI,
perspective about business venture,
Exit strategy is important,
 SAVING
WHAT ARE SAVINGS?
 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.

Savings can be done through

 Small but regular deposits – this happen when someone has decided to

sacrifice current consumption (use of assets, e.g. of money and goods) in

order to increase the availability of assets for future consumption.
 Automatic deductions from salaries, wages or income - this type of

saving is not voluntary. It is a system used by most employers under the

Cont.
Advantage of saving
 To provide for specific needs in the future

 To have access to monetary or other assets whenever needed

 To ensure financial independence

 To make one’s own resources inaccessible for others without one’s

approval
 To safely store surplus

 To acquire skills for proper money management and self-discipline

 To qualify for certain types of loans

Investments
 These are monetary assets purchased in the hope that they will

generate income, reduce costs, or appreciate in the future. In short,

investment means the use of money to make more profit in the
future.

Personal Budget
 A personal budget is a finance plan that allocates future personal

income towards expenses,

 Savings and debt repayment.

 How to prepare a personal budget for saving purposes?

 Identify your sources of income and how much you earn from each

source
 Add up to get total income per month.
Cont.
 Track all your expenses daily, weekly or monthly

 Then divide them by categories

 For daily expenses, multiply each by four to get monthly expenses

and add them to get a monthly total for daily expenses

 Take the total income per month and subtract the monthly total for

daily expenses. The difference can be taken as savings. If the

difference is negative or the expenses exceed the income then:
 Cut back your expenses

 Adjust your expenses

6.3.2 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:

1. 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).

 To secure a bank loan, an entrepreneur typically will have to answer a

number of questions
Cont.
 What do you plan to do with the money?

 When do you need it?

 How much do you need?

 For how long do you need it?

 How will you repay the loan?

Bank Lending Decision

 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.

Cont.
 Collateral: The collateral includes any assets the owner pledges to the bank

as security for repayment of the loan.

 Character: 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.
Cont.
2. Micro Finances: provide financial services mainly to the poor ,micro and
small enterprises.

3. Trade Credit: It is credit given by suppliers who sell goods on account.

This credit is reflected on the entrepreneur’s balance sheet as account payable
and in most cases it must be paid in 30 to 90 or more days.

4. Equipment Suppliers: Most equipment vendors encourage business

owners to purchase their equipment by offering to finance the purchase.

5. Account receivable financing: It is a short term financing that involves

either the pledge of receivables as collateral for a loan.

6. Credit unions: Credit unions are non-profit cooperatives that promote

savings and provide credit to their members.
Cont.
7. 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.

8. Traditional Sources of Finance: “Idir”, “equib”

LOCAL CASE
THE STORY OF ABDELA’S FAMILY
Dear students form a group and discuss on the
case then come up with a decision with its
advantage and dis advantage.
6.4 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.
 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.

6.4.1 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.
Cont.
1. Finance Lease
 It is the lease where the lessor transfers substantially all the risks and

rewards of ownership of assets to the lessee for lease rentals.

 Finance lease has two phases:

1. primary period: 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.

2. secondary period: is much smaller than that of primary period. often

known as peppercorn rental.
Cont.
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.
Advantages and Disadvantages of Lease Financing

Advantages of lease financing from the lessor point of view

 Assured Regular Income

 Preservation of Ownership

 Benefit of Tax

 High Profitability

 High Potentiality of Growth

 Recovery of Investment

Lessor suffers from certain limitations such as

 Unprofitable in Case of Inflation

 Double Taxation


 6.5 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.
 Iqub is a traditional means of saving in Ethiopia and exists completely

outside the formal financial system.

 People voluntarily join a group and make a mandatory contribution

(every week, pay period or monthly).

 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. Iqub is widespread, especially in urban areas.
Cont.
 Most formal banks require a high level of collateral and/or a guarantor for loans,

which discourages start-up borrowers and does not allow for borrowing for personal
needs.
 In the absence of loans from formal banks, Ethiopians also turn to loan sharks (Arata

Abedari in Amharic) who require guarantors and charge as much as 120% per year
interest.
 Iqub can be a driver of economic growth and development. It is filling a vital role

in providing capital for physical infrastructure expansion.

 "Idirs" are burial societies that provide a traditional form of insurance. Idir

contributions are used to pay for expenses in the event of the death of a family
member. Idir is the only means, other than personal savings, to pay for
Cont.

 Idir contributions are generally small compared to Iqub, usually around

Br.10-25 per month. Some idirs provide additional coverage, for example, in
cases of illness, destruction of a member's house or death of livestock.

6.6 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.
6.6.1 How is Crowd Funding Different?
• A single platform to build, showcase, and share your pitch resources
 it’s much easier for you to get your opportunity in front of more interested parties

and give them more ways to help grow your business, from investing thousands
in exchange for equity to contributing Br.500 in exchange for a first-run product
or other reward.

6.6.2 The Benefits of Crowd funding

 Reach: you have access to thousands of accredited investors who can see,

interact with, and share your fund raising campaign.

 Presentation: you go through the invaluable process of looking at your business

from the top level its history, traction, offerings, addressable market, value
proposition and more.
Cont.
 PR & Marketing: From launch to close, you can share and promote your campaign

through social media, email newsletters, and other online marketing tactics.
 Validation of Concept: Presenting your concept or business to the masses affords an

excellent opportunity to validate and refine your offering.

 Efficiency: One of the best things about online crowd funding is its ability to

centralize and streamline your fund raising efforts.

6.6.3 Types of Crowd Funding

1. Donation-Based Crowd Funding: 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. include fund raising for disaster relief, charities, nonprofits, and
medical bills.
Cont.
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.

3. Equity-Based Crowd Funding: 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.

6.7 Micro Finances

6.7.1 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
Cont.
Dear students, who was the inventor of micro finance ?

6.7.2 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.
 In fact, women are major microfinance borrowers, making up 84 percent of loans

in 2016, according to the 2017 Microfinance Barometer. Most of these women –

around 60 percent – live in rural areas.
 The microfinance industry is also growing rapidly. In 2016, there were

123 million microfinance borrowers, for a total of $102 billion in loans.

Cont.
 some have lauded microfinance as a way to end the cycle of poverty, decrease

unemployment, increase earning power, and aid the financially marginalized, some
experts say that it may not work as well as it should, even going so far as to say
it’s lost its mission.
 Others argue that microfinance simply makes poverty worse since many borrowers

use microloans to pay for basic necessities, or their businesses fail, which only
plunges them further into debt.
 . However, other experts say that microfinance can serve as a valuable tool for the

financially underserved when used it properly.

6.7.3 Micro Finances in Ethiopia

 Ethiopia has also more 38 MFIs (in 2018) and practice is one of the success stories

in Africa even though there are certain limitations.

Cont.
 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.
 The known micro finance institutions in different regions of Ethiopia with

more than 90% market share are:

 Amhara Credit and Savings Ins. (ACSI) S.C.

 Dedebit Credit and Savings Ins. (DECSI) S.C.

 Oromiya Credit and Savings Ins. S.C (OCSCO).

 Omo Credit and Savings Ins. S.C.

 Addis Credit and Savings Institution S.C.(ADCSI)

Cont. .
Reading assignment on Activities carried out
by Ethiopian MFI