Long Term Finance
Long term financing is a form of financing that is provided for a period of more than a year which may extends up to 30 years. Long term financing are provided to those business entities that face a shortage of capital.
This type of financing may be needed to fund expansion projects, purchase fixed assets, develop a new product, R&D, Mergers and acquisitions etc. The methods of financing these types of projects will generally be quite complex.
Table of Contents
- 1 Long Term Finance
- 2 Long Term Financing Needs of a Business
- 3 Advantages of long term financing
- 4 Sources of Long Term Financing
- 5 Internal Sources of finance
Long Term Financing Needs of a Business
Finance is needed for all kind of business irrespective of their size and nature of activities. Financing requirement of a business can be classified into two categories namely; long term and short term. Long term finance is needed for the acquisition of fixed assets like plant, machinery and other long term assets.
The main reasons a business needs finance are to:
- To start a business: Depending on the type of a business, money is needed to finance the purchase of assets, materials and employing people. Money is also needed to cover the running costs. It may be required before the business generates enough cash from sales to pay for these costs.
- To finance expansions activities: As a business grows in size, it needs higher capacity and new improved technology to cut product costs and keep up with competitors. New technology can be relatively expensive to the business and investment of this type is of long term nature, because the costs will outweigh the money saved or generated for a considerable period of time.
- To develop and market new products: In a fast moving markets, where competitors are constantly updating their products, a business needs to spend money on developing and marketing new products e.g. to do marketing research and test new products in “pilot” markets. These costs are not normally covered by sales of the products for some time (if at all), so money needs to be raised to pay for the research.
- To enter new markets: When a business seeks to expand, it may look to sell their products into new markets. These can be new geographical areas to sell to (e.g. export markets) or new types of customers. This costs money in terms of research and marketing e.g. advertising campaigns and setting up retail outlets.
- Takeovers or acquisitions: When a business buys another business, it will need money to pay for the acquisition as it involves significant investment. Business need to arrange the money either by borrowing from banks, financial institutions or raising money from equity shares.
Advantages of long term financing
- Stability: Long-term financing provides businesses with a more stable debt management instrument than short-term loans. Long-term financing allows borrowers to have more security when budgeting for costs and expenses as the time period of financing is fairly long and there is no need to repay back at a shorter period.
- Flexibility: There is a wide variety of long-term debt financing options available to borrowers, such as mortgages, leases, reverse mortgages, and loan refinancing, which can be fine-tuned to meet the borrower’s needs. This allows more flexibility and control overspending.
For example, a lease is a special type of long-term debt-financing instrument that allows lessor to benefit from the use of an asset in exchange for rental payments without having to purchase the asset.
- Linked to company’s productivity: Unlike short-term loans, which are used as a quick source of cash to tide over short-term liquidity problems, long-term debt financing is used for capital investments.
Capital investments, such a real estate, machinery, vehicles, furniture and leases, provide real benefits to a company by either increasing its productivity or expanding its operating capacity.
For example, a successful restaurant can use a mortgage – a classic example of long-term debt financing – to open a new location and increase its profit potential.
Sources of Long Term Financing
A business can use a wide range of sources of fund to finance their expansion plan and long term requirements of business. These sources can broadly be categories as (a) Internal sources of finance and (b) External sources of finance. Detailed classification of these sources is presented in the below figure
External sources of finance
- Equity Shares
- Preference Shares
- Debentures and Bonds
- Venture capital
- Term Loans
- Lease financing
Every company has a statutory right to issue shares to raise funds. Also known as ordinary shares are issued to the owners of a company. Ordinary share have a nominal or face value.
Dividend on these shares is paid after the fixed rate of dividend has been paid on preference shares, if any amount is left. The rate of dividend on equity shares is not fixed and depends upon the profits available and the intention of the board to distribute dividend among shareholders.
Preference shares as those shares which carry preferential rights as the payment of dividend at a fixed rate and as to repayment of capital in case of winding up of the company.
Thus, both the preferential rights viz.
- Preference in payment of dividend and
- Preference in repayment of capital in case of winding up of the company must attach to preference shares.
The rate of dividend on these shares is fixed and the dividend on these shares must be paid before any dividend is paid to ordinary shares
Debentures and Bonds
Debentures and Bonds are a fixed-interest, fixed term investment. They are offered by finance and industrial companies which are referred to as issuers.
They usually offer a higher return than is available from other fixed interest investments. Returns are based on a combination of official interest rates and loan rates depending on the issuer’s lending practices. They are not risk-free investments.
The term ‘venture capital’ represents financial investment in a highly risky project with the objective of earning a high rate of return. Venture capital (VC) is financial capital provided to early-stage, high-potential, high risk, growth start-up companies.
The venture capital fund makes money by owning equity in the companies it invests in, which usually have a novel technology or business model in high technology industries, such as biotechnology, IT, and software.
Term loans are provided to the industrial sector by commercial banks, development financial institutions, state level financial institutions and investment institutions.
Terms loans are secured or unsecured loans obtained by the company. The company has to pay interest on these term loans. The shareholders do not lose ownership control of the company by obtaining term loans.
Term loans represent long- term debt with a maturity of more than one year. Term loan is one of the most common methods of financing by companies in India.
A lease is a contract granting use or occupation of property during a specified period in exchange for a specified rent. A lease is a method of obtaining the use of assets for the business without using debt or equity financing.
It is a legal agreement between two parties that specifies the terms and conditions for the rental use of a tangible resource such as a building and equipment. Lease payments are often due annually.
The agreement is usually between the company and leasing or Financing organization and not directly between the company and the organization providing the assets. When the lease ends, the asset is returned to the owner, the lease is renewed, or the asset is purchased.
Internal Sources of finance
It is regarded as the most dependable source of longterm finance. Retained earnings are an easy source of internal financing to use because they are readily available (provided company have profits).
Retained earnings are the portion of net income (profit after tax) that have retained in the company and not paid out to the shareholders as dividends. Instead of paying out retained earnings, shareholders can reinvest them into the company. In other words, retained earnings refer to the undistributed profits of companies which are usually kept in the form of general reserve.
The retained profits can be used for expansion and modernization plans by the companies. The amount of retained earnings is determined by the quantum of profits, the dividend payout policy followed by the management, the legal provisions for dividend payment, and the rate of corporate taxes etc.
It is an internal source, which does not involve any cost of floatation and the uncertainties of external financing. It also strengthens the firm’s equity base, which enables to borrow at better terms and conditions.
The main drawbacks of this source are (a) it is fully dependent on the accuracy of profits; and (b) possibility of reckless use of funds by the management.
Advantages of Retained Earnings
- Ready Availability: Being an internal source, these earnings are readily available to the management and directors don’t have to ask outsiders for finance.
- Cheaper than External Equity: Retained earnings are cheaper than external equity because the floatation costs, brokerage costs, underwriting commission are other issue expenses are eliminated.
- No Ownership Dilution: Relying on retained earnings eliminates the fear of ownership dilution and loss of control by the existing shareholders.
- Positive Connotation: Retained earnings carry a positive connotation as compared to equity issue as far as stock market is concerned.
Sale of assets
As firms grow in size they build up various fixed assets. These assets could be in the form of property, machinery, equipment, other companies or even logos. In some cases it may be appropriate for a business to sell off some of these assets to finance other projects.
So, sale of assets is another source of internal finance for financing new projects. Although a convenient method of financing some business requirements but has certain limitations like not available to all companies, no ready market for buying the assets of the companies, etc.