Medium Term Sources of Finance
Medium-term sources are the sources where the funds are required for a period of more than one year but less than five years. The sources of the medium term include borrowings from commercial banks, public deposits, lease financing and loans from financial institutions. Medium-term sources of finance are generally needed for the purchase of capital assets, repair and/or modernisation of equipment, renovation of the plant/building, implementation of new production methods, large-scale ad campaigns in print or broadcast media, expansion, etc.
Table of Content
- 1 Medium Term Sources of Finance
- 2 Lease Finance – Meaning, Advantages and Limitations
- 3 Hire Purchase – Meaning, Advantages and Limitations
- 4 Venture Capital Finance – Meaning, Advantages and Limitations
- 5 Public Deposits – Meaning, Advantages and Limitations
- 6 Preference Capital or Preference Shares – Meaning, Advantages and Limitations
- 7 Debenture/Bonds – Meaning, Advantages and Limitations
- 8 Medium-term Loans From Government or Financial Institutions – Meaning, Advantages and Limitations
Medium term is required to fill up the gap between long term and short term. They come with the advantage of both short-term and long-term sources of finance, however with their own inherent limitations. Medium-term sources of finance are those sources of funds that a company pays back in 1 to 5 years.
There are four factors that play an important role in deciding on a source that will be most appropriate for a business as depicted in Figure:
These factors are explained as follows:
- Risk: Risk is an important factor when deciding which source of finance to choose. It is essential to think of how a business might be endangered or become vulnerable in case of inability in meeting financial commitments of a particular source of finance.
- Cost: The cost of finance is important to consider when deciding a source of finance because it will directly impact the earnings.
- Control: Control plays an important role when deciding on a source of finance because certain sources of finance result in a dilution of control amongst existing shareholders and/or owners.
- Flexibility: It also plays an important role in deciding a source of finance. Medium-term sources have more flexibility than longterm sources and will be more appropriate to meet demands that are not long-term and also if interest rates are currently high but predicted to go down in the future.
Lease Finance – Meaning, Advantages and Limitations
Lease finance is a source of finance where the funds are obtained not in cash, but in the form of machinery, equipment and other capital assets. That is, in lease finance, the company seeking funds contacts a leasing company, which provides the desired capital assets to the former for use during the specified period.
The leasing company purchases the assets from the market and the user company pays rent for use of the assets. The complete ownership of the asset is with the leasing company. This source transfers nearly all the risks and rewards of ownership of assets to the lessee for the duration of the lease. The lessee is responsible for the maintenance of the asset and the lessor’s investment is assured because the lease cannot be cancelled.
Advantages of Lease Finance
- Beneficial to both parties: Lease finance eases the financial burden on the lessee and provides benefits to the lessor such as the recovery of investment on the asset.
- Easy: Lease finance is the easiest solution to the funding problem of entrepreneurs.
- Quick: This source provides quick funds because the procedure is not as complicated and lengthy as with financial institutions.
- No interference: There is no interference in the management of the company and it is free to take its decisions.
- Tax benefits: Lease payments can be deducted as a business expense and provide tax benefits.
- Unaffected by inflation: The lessee is not affected by inflation since lease rent remains unchanged during the specified period.
- Flexible: The payment schedule for lease financing is more flexible than loan contracts.
- Easier to budget: Since lease rent is decided in advance, the business can budget it easily.
Disadvantages of Lease Finance
- Expensive: Lease is generally kept high, which makes lease finance an expensive source of finance.
- Loss in case of obsolescence: There are losses to the lessee in case the equipment, and other capital assets become obsolete before the specified period.
- Unprofitable to the lessor in case of inflation: The lease amount is fixed in the contract and cannot be increased even if the cost of the asset goes up during the specified period.
- Possibility of double taxation: The lessor may be doubly taxed, once at the time of purchase of an asset and second at the time of leasing.
- Chance of damage to the asset: The lessee might cause damage to the asset and since ownership is still with the lessor after the expiry of the lease period, he will suffer a huge loss.
- Non-cancellable: A finance lease contract cannot be cancelled so the lessee is required to pay the lease for the whole duration even he does not need the asset anymore.
Hire Purchase – Meaning, Advantages and Limitations
Hire purchase is a method of financing the purchase of a fixed asset by paying for the asset in instalments over an agreed period of time. In this source, the purchase price of the asset is paid in instalments and ownership is transferred after the payment of the last instalment.
The key features of hire purchase are:
- Each instalment is considered to be a hire charge for using the asset.
- A hire purchaser can use the asset immediately after signing the contract agreement with the hire vendor.
- In case of problems in obtaining instalments, the hire vendor has the right to repossess the asset.
Advantages of Hire Purchase
- Easy: Hire purchase is an extremely easy source of finance.
- Ownership: The hire purchaser gets the ownership of the asset in the future.
- Payments are spread over time: The hire purchaser does not feel the burden of paying for an expensive asset because the instalments are spread over time.
- Benefit of depreciation: The hire purchaser obtains the benefit of depreciation on the hired asset.
- Tax benefit: There is a tax benefit on the interest payable by the hire purchaser.
Disadvantages of Hire Purchase
- Ownership takes long: Since payments are spread over time, the ownership of the asset is transferred only after the payment of the last instalment. Failure to complete the full payment may prevent ownership even if most instalments have been paid.
- Usually suited for only small assets: Hire purchase involves funds on a very small to small scale suited only for small assets such as office equipment or automobiles.
- Expensive: The hire purchaser ends up paying more than the actual cost of the asset because interest is added to the payments.
Venture Capital Finance – Meaning, Advantages and Limitations
Venture capital finance is a private or institutional investment made into early-stage/ start-up companies. By definition, a venture is a new activity that involves risk or uncertainty in the expectation of a substantial gain. Venture capital finance is money invested in businesses that are small or in their initial stages but have considerable potential to grow. A team of financial experts or an individual who professionally invests venture capital is called a venture capitalist.
A venture capital investment is made when a venture capitalist provides funding to a small or growing business despite the risks associated with the company’s future profits and cash flow. The venture capitalist risks losing money if the venture does not succeed or takes a long time to return profits.
Rather than being given out as a loan, venture capital is invested in exchange for an equity stake in the business. Venture capital is the most appropriate for financing for businesses with large initial capital requirements without cheap alternatives and limited operating history, such as start-ups in the field of technology, software and biotechnology.
Advantages of Venture Capital Financing
- Expansion opportunity without obligation for repayment: Venture capital provides a business with an opportunity to expand without the issues of collateral and obligation to repay the loan, unlike bank loans.
- Support: Venture capital is often a source of useful guidance, expertise and counselling from members of the venture capitalist firm which supports the start-up company.
- Builds networks and connections: Venture capitalists are experienced and generally boast a huge network of connections in the business community. These connections can be very useful for the start-up company.
- Better regulations: Venture capitalists are strictly controlled by regulatory bodies, hence there is less risk of them being involved in corruption.
Disadvantages of Venture Capital
- Dilution of ownership and control: Venture capitalists invest huge capital in the start-ups in exchange for a stake in the equity of the company. In case the start-up is successful, they not only earn huge profits but also become a part of the Board of Directors of the company. They actively participate in the decision-making process of the start-up, diluting the ownership and control of the entrepreneur.
- Early redemption: Venture capitalists may decide on early redemption of the investment as their main focus is to earn capital gains. For entrepreneurs whose business plan will take a longer time to provide liquidity, this might not work.
- Complicated and lengthy process: Since, venture capital finance involves a lot of risk and uncertainty, the process of availing these funds is not easy. The start-up has to provide a detailed business plan to the venture capitalist which the latter reviews. There might be one or more meetings to discuss the business plan in detail. The venture capitalist then verifies these details and offers a term sheet only if he finds everything satisfactory.
- Grabbing the attention of a venture capitalist is tough: It is usually hard for a start-up to get the attention of venture capitalists who get proposals from many entrepreneurs.
- Funds might not be released all at once: Even though the startup would like to get all the requested finance at once, it is a huge risk for the venture capitalist who may decide to release funds in instalments only when the start-up reaches certain milestones.
- Under-valuation of start-up company: If a venture capitalist wants to sell off their equity stake, they may force the owner of the company to list the company. An untimely listing may lead to an undervaluation of the company’s shares.
Public Deposits – Meaning, Advantages and Limitations
Public deposits refer to the system of the general public depositing its funds with companies at a specified rate of interest for a specified period, and the latter accepting it for meeting its medium-term requirement of funds. Public deposits are a popular form of finance because this system is simpler and cheaper than bank credit.
The Key Advantages of Public Deposits as a Source of Business Finance
- Easy: The system of financing through public deposits is quite easy. Unlike the issue of shares or debentures, there are no legal formalities involved.
- Higher interest rate for depositors: Public deposits appeal to the public because of the higher interest rates paid by companies as compared with banks.
- Tax benefits: Interest paid on public deposits is a tax-deductible expenditure.
- Lower administrative costs: Issuing public deposits needs lower administrative costs than those involved in issuing shares or debentures. There are fewer formalities and the procedure is simple.
- Trading on equity: Since, the rate of interest and the period of deposits are fixed, the company can benefit by trading on equity if the company is earning more than the rate of interest paid on the deposits.
- No loss of control and ownership: This source of financing does not dilute the control of shareholders.
- Does not affect borrowing capacity: Public deposits are generally unsecured and the company does not create any charge against its assets for raising funds through it. The borrowing capacity is therefore not affected.
- Flexibility: Public deposits provide flexibility in financial planning and help to avoid overcapitalisation because the deposits can be paid back at any time when it is not necessary to retain the fund.
Limitations to Public Deposits
- Not available for longer durations: Regulations prevent public deposits to go beyond 3 years.
- Risk of misuse: The management may misuse the deposit as these deposits are unsecured. In the event of the failure of the company, there is no guarantee the depositors will get back their money.
- Not dependable: There might be a sudden withdrawal of deposits by the depositors leading to a financial crisis for the company. It is also difficult to formulate a financial plan based on public deposits.
Preference capital or shares involve the following two preferential rights:
- A right to a fixed rate of dividend before any dividend is paid to the equity.
- A right to return of capital before any capital is returned to the equity.
Note that preference shares enjoy these preferential rights only over the equity and not over debentures or bonds. Preference shares are issued by companies wanting to raise capital and combine the characteristics of debt and equity investments, hence they are classified as hybrid securities. Preference shareholders can collect dividend payments before equity shareholders but they do not have voting rights.
- Preference shareholders receive fixed dividends: Preference shareholders receive fixed dividends as they are entitled to a fixed quarterly (or yearly) return. Hence, preference shares are a lowrisk investment for investors.
- Preference shareholders have prior claim on company assets: In the event that a business experiences bankruptcy or liquidation, preferred shareholders have a prior claim on company assets than equity shareholders (because they are supposed to be repaid on a high priority basis).
- No loss of control for the company: A lack of voting rights for preference shareholders prevents interference from preference shareholders in company management and lets the company retain more control.
- Repurchase of shares: Companies can issue redeemable preference shares which confer on them the right to repurchase shares depending on market conditions. For example, say the redeemable shares had been issued at a dividend rate which is now higher than interest rates, the company can redeem any outstanding shares, then refinance by a fresh issue of preference shares with a lower dividend rate.
- Financial burden to the company: Since preference shares require payment of a fixed dividend, they involve a financial burden on the company.
- No tax benefits to the company: Preference dividend is payable only after payment of tax, hence, preference shares do not provide any tax advantages to the company.
- Preference shareholders have no voting rights: Investors in this source of finance do not have the same voting rights as equity shareholders. Furthermore, their preferential rights are limited as they have no preferential rights over debenture holders.
Debenture/Bonds – Meaning, Advantages and Limitations
In case a company requires funds but does not want to increase its share capital, it can borrow from the general public by issuing certificates for a specified period at a fixed rate of interest. These certificates issued by a company making an acknowledgement of debt are known as debentures. Debentures are issued to the public for subscription similar to the issue of equity shares. Debentures are issued under the common seal of the company acknowledging the receipt of money.
Different Forms of Debentures
- Simple debentures: This type is issued without mortgaging any asset, i.e., this is unsecured.
- Mortgage debentures: A debenture is a corporate bond or promissory note issued by many publicly traded corporations or well-capitalised private corporations. When a company uses its fixed assets to secure the loan or note and pledges its property as collateral, the debenture becomes a mortgage debenture.
- Non-convertible debentures: These debentures have no option for being converted into equity shares. They are to be redeemed at maturity.
- Partly convertible debentures: These debenture holders have an option to convert part of their debentures so that they can enjoy the benefits of both debenture and equity shareholders.
- Fully convertible debentures: These debentures can be fully converted into a specified number of equity shares after a fixed period at the debenture holders’ discretion.
- Redeemable debentures: These debentures can be redeemed/ repaid on a predetermined date and at a predetermined price.
- Irredeemable/Perpetual debentures: These debentures cannot be redeemed during the lifetime of the company and are only repaid at the time of liquidation of the company.
- Registered debentures: These debentures are recorded in the company’s register book and cannot be easily transferred to another person.
- Unregistered debentures: These debentures are not recorded in the company’s register book can be easily transferred to the bearer.
Advantages of Debentures
- No loss of control for the company: A lack of voter rights for debenture holders prevents their interference in company management and lets the company retain more control.
- Tax advantage: Interest payable on debenture is a charge against profit, and hence a tax-deductible expenditure.
- Lower cost: The rate of interest payable on debenture is generally lower than that of dividend on preference shares and equity shares.
- Facilitates trade on equity: By combining debentures in its capital structure, a corporation can trade on equity and boost revenue per share.
- Flexibility: Debentures provide flexibility in the capital structure as the company can redeem them at its discretion when it has surplus funds.
- Easy: It is easy to raise funds using this source because of the certainty of income and low risk to investors.
- Low risk for debenture holders: Interest on debentures is payable even in case of a loss, so it is a low-risk investment.
- No dilution of interests of equity shareholders: Debenture holders do not have any voting rights, therefore, the interests of equity shareholders are not diluted.
Limitations of Debentures
- Financial burden to the company: Payment of interest on debenture is obligatory even if there is a loss, hence, it becomes a burden to the company.
- Increase risk: Debentures are issued to trade on equity but high dependence on debentures raises the financial risk of the company.
- Larger cash outflow: Redemption of debentures involves a larger amount of cash outflow.
Medium-term Loans From Government or Financial Institutions – Meaning, Advantages and Limitations
A medium-term source financed by the government and financial institutions is generally used for funding the expansion, diversification and modernisation of the business. This type of financing is also known as project financing. These are secured loans since the assets financed with term loans serve as primary security, while the company’s other assets serve as collateral security.
It is obligatory on part of the borrower to pay the interest and repay the principal even if the firm is not earning a profit. Medium-term loans are repayable in periodic instalments. The rate of interest on a medium-term loan is fixed but can be negotiated between the concerned parties at the time of loan disbursal. Term loans may have the option to be converted into equity, subject to the terms and conditions of the lending institutions.
Advantages of Medium-term Loans
- Cheaper: Medium-term loans are a relatively cheaper source of medium-term financing.
- Fixed payments: Payments are fixed and regular which helps businesses budget for fixed costs.
- Tax benefit: Interest payable on a term loan is a tax-deductible expenditure.
- Flexibility: The conditions of term loans are negotiable between the borrowers and lending institutions which makes them more flexible. Moreover, medium-term loans can be used for a variety of business purposes.
- Fixed interest rates: Interest rates are fixed at the time of loan disbursal which helps the borrower to know the exact loan costs and budget them.
- Improved credit score: The borrowers’ credit score can improve when they pay off a medium-term loan. This will make it easier for them to get additional loans in the future.
- No dilution of interest: The interests of the equity shareholders are not diluted by medium-term loans.
- Security: Medium-term loans are provided against security, hence they are secured.
- Source of income to lender: The borrower is obligated to pay the interest and repay the principal giving a regular and steady income to the lender.
Disadvantages to Term Loans
- Obligation to borrower: Failure to make interest payments and principal repayment may be penalised by the lender and also raises the risk of liquidation for the borrower.
- Increased financial risk: Medium-term loans increase the financial risk of the company.
- Interference: The lending institution can impose restrictive covenants on the borrowing company which might interfere with the functioning of the concern.
- Interest of lenders can be affected: The negotiability in terms and conditions of term loans may affect the interest of lenders.
- No control to lenders: Like other sources of debt financing, the lenders of term loans have no right to control the proceedings of the company.
- Hard to qualify: These loans require good credit score or cash flow, plus collateral to qualify.
Leverage ratios are a financial measurement to understand the capital structure of the company and find the amount of debt loan a business has taken on the assets or equity of the business. A high ratio implies that the company has taken a large amount of debt as compared with its capacity and it will not be possible for it to fulfil the obligations with the current cash flows. The most commonly used leverage ratio is the debt-equity (DE) ratio.
The formula of this ratio is:
Debt / Equity Ratio = Total Debt / Total Equity
Typically, a D/E ratio greater than 2.0 indicates a risky scenario for an investor though it does depend on the industry.