Chapter Six

Business Financing
 Chapter Objectives:
After completing, students will be able to;
 Definition of Finance
 sources of finance to start a business venture
 Understand lease financing
 Learn micro finances
 Understand crowd funding
 Learn about traditional financing in Ethiopia
 The Concept of Financing

 Four basic questions must be answered during initial

financial planning:
 What types of capital do I need in my new
business?
 How can I estimate the amounts needed?
 Where can I obtain the required funds?
 What should my financing proposal include?
 Financial Requirements
 All businesses need money to finance a host of
different requirements.
 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.
 Ideally, 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.
 Cont.…
 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.
 Asset Finance:- It is medium to long term finance.
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
 Internal Sources (Equity capital):- Owner’s capital or
owner’s equity represents the personal investment of
the owner(s) 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.
 Internal Sources (Equity capital) are as follows;
1. Personal saving
2. Friends and relatives
3. Partners
4. Public stock sale (going public)
5. Angels
6. Venture capital companies
 Cont.…
 Personal saving: Entrepreneurs should take for
startup money is in their own pockets.
 Friends and relatives: After emptying their own
pockets, entrepreneurs should turn to friends and
relatives who 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 (going public): In some case,
entrepreneurs can go public by selling share of stock
in their corporation to outsiders.
 Cont.…
 Angels:- These are private investors (or angles) who
are wealthy individuals, often entrepreneurs, who
invest in the startup business in exchange for equity
stake in these businesses.
 Venture capital companies:- Are private, for profit
organizations that purchase equity positions in
young business expecting high return and high
growth potential opportunity.
 They provide start -up capital, development funds or
expansion funds.
Comparison of Angles and Venture Capitalist
 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:
 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).
 External Sources (Debt capital)…
 To secure a bank loan, an entrepreneur typically will
have to answer a number of questions, together
with descriptive commentaries.
 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?
 External Sources (Debt capital)
 Bank Lending Decision:-The small business owner
needs to be aware of the criteria bankers use in
evaluating the credit worthiness of loan applications.
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: includes any assets the owner pledges to
the bank as security for repayment of the loan.

 External Sources (Debt capital)…
 Character: Before approving a loan to a small
business, the banker must be satisfied with the
owner’s character.
 Conditions: The conditions surrounding a loan
request also affect the owner’s chance of receiving
funds.
 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.
 External Sources (Debt capital)…
 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.
 Bonds: It 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.
 External Sources (Debt capital)…
 Traditional Sources of Finance: “Idir”, “equib”
 Lease Financing:-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.
 lessee is given the right to use the asset but the
ownership lies with the lessor and at the end of the
lease contract.
 Types of Lease
 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.
 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.
 Advantages and Disadvantages of Lease Financing
 Assured Regular Income: Lessor gets lease rental by leasing
an asset during the period of lease which is an assured and
regular income.
 Preservation of Ownership: In case of finance lease, the
lessor transfers all the risk and rewards incidental to
ownership to the lessee without the transfer of ownership of
asset.
 Benefit of Tax: As ownership lies with the lessor, tax benefit is
enjoyed by the lessor by way of depreciation in respect of
leased asset.
 High Profitability: The business of leasing is highly profitable
since the rate of return based on lease rental, is much higher
than the interest payable on financing the asset.
 Advantages and Disadvantages of Lease Financing
 High Potentiality of Growth: The demand for leasing
is steadily increasing because it is one of the cost
efficient forms of financing.
 Recovery of Investment: In case of finance lease, the
lessor can recover the total investment through
lease rentals.
 Lessor suffers from certain limitations:
 Unprofitable in Case of Inflation
 Double Taxation
 Greater Chance of Damage of Asset
 Traditional Financing in Ethiopian (Equib/Edir...)
 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.
 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.
 Crowd funding is essentially the opposite of the
mainstream approach to business finance.
 The Benefits of Crowd funding
 Reach: By using a crowd funding platform can access
to thousands of accredited investors who can see,
interact with, and share your fund raising campaign.
 Presentation: By creating a crowd funding campaign,
go through the invaluable process of looking at your
business from the top level its history, offerings,
addressable market, value proposition, and boiling it
down into a polished, easily digestible package.
 PR & Marketing: From launch to close, you can share
and promote your campaign through social media,
email newsletters, and other online marketing
tactics.
 The Benefits of Crowd funding…
 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.
 Types of Crowd Funding
 Donation-Based Crowd Funding:-Common
donation-based crowd funding initiatives include
fund raising for disaster relief, charities, nonprofits
medical bills.
 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.
 Equity-Based Crowd Funding:-allows contributors to
become part-owners of your company by trading
capital for equity shares.
 Micro Finances
 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.
 Some of the importance of MFIs
 it provides resources and access to capital to the
financially underserved
 helps them invest in their businesses, and as a result,
invest in themselves.
 serve as an important resource for those in the
developing world.
 Decrease unemployment, increase earning power,
and aid the financially marginalized
 Micro Finance in Ethiopia
End of chapter six