Sources and Uses of Short Term and Long Term Funds

Sources of financing are divided into Two major categories:

1. Debt Financing
 Debt financing can be in the form of borrowing from banks or other lending institutions
or issuance of debt securities like commercial papers and bonds. For· some companies, it
can also be in the form of advances from stockholders to expedite the process of raising
funds.
 Debt financing creates a contractual obligation for the borrower to pay the interest and
the principal.
o Advantages:
 Interest expense is tax-deductible.
 Interest expense provides a tax shield.
 It allows company to grow without diluting the interest of the controlling
stockholders.
 Creditor generally do not intervene in the decision of the management.

o Disadvantages:
 Payments have to be made on time because unpaid interest and principal
lead to penalties and more interest
 Too much debt can expose the company to a bankruptcy risk
 Suppliers may stop the delivery of the goods or merchandise if not
handled very well and;
 Managers’ executive time will be focus on how to fix the debt problem
instead of the operation of the company.

2. Equity Financing
 Equity financing refers to issuance of new shares of stocks and retained earnings plowed
back into operations of the company.
o Advantages:
  Safest source of financing for a company
 It does not require any mandatory payment of dividends
 With enough shares, you can control the operation and financing decision
 Will provide the company a financial flexibility
 If a company is 100% financed by equity; it will be attractive to creditors
 It can easily raise funds through debt financing or equity financing or a
combination of both.
o Disadvantages:
 Cash dividends are not tax-deductible
 Offering new shares to other investors may dilute the ownership stake in
terms of percentage of the existing stockholders.
 It is the most expensive source of financing.

The following are the reasons to figure out that equity is more expensive than debt financing

 Most companies opt to have debt financing.

 Under Philippine laws, a company which is in the process of liquidation cannot
distribute anything to the stockholders unless the claims of the creditors have been
satisfied first. This provision in the law implies that the stockholders are taking the
biggest risk in the company. In finance, there is this popular statement "high risk, high
return" which means that for somebody to take more risk, he has to be compensated
by an expected higher return. If this is not the case, then why take additional risk?
 Unlike loans where interest and-principal payments by borrowers are more assured,
cash dividends are not guaranteed.
 If a company does not perform-well, the stockholders absorb the losses. Based on
the reasons presented, it is clear that stockholders bear the most risk in a company,
and therefore should demand higher return.
Pecking Order Hypothesis

 The pecking order hypothesis in corporate finance was developed based on repeated " observations
of how companies fund their financing requirement. According to this hypothesis, this is how
companies fund their requirements:
1. Internally generated funds. These are the funds that come from operating cash flows.
2. Debt. When internally generated funds have been exhausted, debt financing is the
next alternative.
3. Equity. The last in the priority list of financing is equity financing. This is not surprising
given that it is more difficult to issue new shares of stocks.

Sources and Uses of Short-Term Funds

 Short-term funds are normally used to finance the day-to-day operations of the company. It
is used for working capital requirements such as accounts receivable and inventories. It can
also be used for bridge financing where a company has some maturing obligations and does
not have enough cash to pay such maturing obligations. There are occasions when the
management of a company decides to borrow short-term loan to address this problem.

The following can be sources of short-term funds:

1. Suppliers' credit. Suppliers of raw materials and merchandise are the best sources of short-term
working capital. This is the reason why a good relationship has to be nurtured with suppliers. As
much as possible, honor the credit terms.
2. Advances from stockholders. If you have enough personal assets and you control the company,
advancing funds to the company when there are financial requirements is an easy way for the
company to raise funds. Interest on these advances can be charged by the stockholder.
3. Credit cooperatives. To borrow from credit cooperatives, you have to be a member. Credit
cooperatives can lend as much as five times of your equity or contributions. If you own a company
which is in need of funds and you are at the same time a member of this credit cooperative, then
you can, borrow in your personal capacity from the cooperative and advance the proceeds from
 the loan to your company. This practice, however, should not be encouraged because your
company must be able to raise ·money on its own merits.
4. Bank loans. Banks can provide both short-term and long-term loans. Some banks also provide
credit facilities, not just to big corporations, but also to small and medium enterprises.
Government banks, the Development Bank of the Philippines (DBP) and Land Bank of the
Philippines (LBP), offer short-term credit facilities to small and medium enterprises. Private banks
such as BPI and BDO also provide working capital loans to small and medium enterprises. Securing
loans from these credit institutions may take some time as they have to do credit investigation.
They also have to evaluate the loanable values of the collateral that may be mortgaged to support
a loan. Among the collaterals that can be acceptable to banks include real estate, transportation
vehicles, and even inventories. The mortgaged properties like house and lot may have to be
insured as well. Thus, the transaction costs involved in banks’ lending may be high.
5. Lending companies. These are small lending companies which cater normally to small and
medium enterprises. The lending process is much faster as compared to banks but they charge
higher interests, higher than the banks but lower compared to a more informal lending, popularly
known as, "5-6." These lending companies can finance working capital requirements. Some of
them may require some documents such as purchase order to support a loan application. This
purchase order may become the basis of a loan release.
6. Informal lending sources such as "5-6”. This is a very expensive source of financing and should be
avoided. It is called such because for every P5 that you borrow you have to return P6. This 20%
interest is just for a month. Without interest compounding, this translates into an annual interest
rate of 240%. Therefore, this source of financing should never be considered because you will end
up working for the creditor.

Sources and Uses of Long-Term Funds

 Long-term funds are used for long-term investments or sometimes called capital investments:
This includes expansion, buying new equipment, or buying a piece of land which will be the
site of future expansion. Long-term funds can also be used to finance permanent working
capital requirements.
 Long-term investments have to be financed by long-term sources of funds to minimize default
risk or the risk that you may not be able to pay maturing obligations. The returns on long-
 term investments may not be realized immediately, and therefore require more patient
sources of financing.

The following are the different sources of long-term funds:

1. Equity investors. Equity investors can be issued common stocks. This is the most patient source of
capital. As far as the company is concerned, this is the safest source of financing. Unfortunately, it is
not always available when the company needs it. Even big corporations have to identify a correct
timing or opportunity for them to issue more shares. Big companies normally wait for a bullish market
in issuing new shares of stock. During bull market, companies can afford to set a higher price for each
share allowing them to maximize the amount that they can generate from public offering.
2. Internally generated funds; Instead of declaring cash dividends, the company can use internally
generated funds for expansion or to finance other types of capital investments; Based on the
Corporation Code of the Philippines, there is a limit regarding the amount of retained, earnings that
the company can keep in its statement of financial position. Retained earnings cannot exceed 100%
of the value of common stocks or sometimes called paid-in capital. However, if the board can make a
resolution, setting aside a specific amount of retained earnings for expansion, then this is acceptable.
There are other approaches on how to go about this provision in the law, but this topic may be
reserved for a more advanced subject in finance.
3. Banks. Banks are sources of different types of financing from short-term to long term. They provide
lower interest rates as compared to other financial institutions but they have a lot of requirements
and a borrower goes through a process, normally taking a month before a loan gets approved.
4. Bond market This market is gaining more popularity among our big publicly listed companies for their
fundraising activities. Philippine bonds are now traded through the electronic platform provided by
the Philippine Dealing System Holdings Corporation (PDS Group). To issue bonds, the services of an
investment bank are also needed to underwrite the issue. The bonds that will be issued have to be
registered with the Securities and Exchange Commission and they have to be credit rated. Moody's
and PhilRatings are among the credit rating agencies in the Philippines. The credit rating given by
these credit rating agencies is important because it will dictate the interest rate that the issuer can
charge to the buyers of the bonds. A high credit rating means that the bond issuer can afford to charge
lower interest rates which in turn will minimize its financing cost. Just like in an IPO, roadshows are
 also conducted in a bond offering to have a feel of the market's perception of the issue and the
interest rate bond, investors are willing to take.
5. Lending companies: Some of the lending companies also provide long-term loans ranging from two
to five years. These lending companies can process loans faster but they charge higher interest rates.

Problems Faced by SMEs in Financing

While there seems to be an abundance of funds available for SMEs, the reality is that SMEs are not
able to avail of most of these facilities for many reasons. A survey was conducted by Rafaelita M.
Aldaba of the Philippine Institute for Development studies (PIDS). This study which became part of
PIDS' discussion series of 2012 cited the following reasons for the inability of SMEs to take advantage
of available financing:

1. Limited track record

2. Limited acceptable collateral
3. Inadequate financial statements
4. Lack of business plans

The potential creditors of these SMEs cited the following reason for rejecting the loan applications

1. Poor credit history

2. Insufficient collateral
3. Insufficient sales, income, and cash flows
4. Unstable business type,
5. Poor business plans

Duties of the Borrower to Creditors

1. Pay the creditors based on the payment schedule agreed upon. One way of establishing
credibility is paying obligations oil time. If you cannot pay-on time, notify the creditors
ahead of time. But as much as possible, pay on time. Coming up with different reasons
for not paying on time creates bad impression.
2. Provide the collaterals as agreed upon in the loan negotiation with proper
documentation, if necessary and if applicable (e.g., annotation of the Transfer
Certificate of Title (TCT) or Condominium Certificate of Title (CCT). Ensure that these
collaterals are in the physical condition perceived by the creditors during the
determination of the loanable value of the loans. It pays to be in good faith.
3. Comply with the provisions of the loan covenant such as maintaining certain liquidity
and leverage ratios. These conditions are supposed to benefit the borrower so that his
company will not be over-exposed to borrowing and he will be tasked to monitor the
liquidity position of the company on a more regular basis.
4. Notify the creditor if the company is acquiring another company or the company is now
the subject of acquisition. The interest of creditors may be jeopardized if new owners
take over the company or if the company is going to acquire another company.
5. Do not default on the loans as much as possible. Aside from the creditors, there may be
other parties such as the guarantors of the loan who will be put at a disadvantage if the
borrower default.