Shares, debentures, bonds, and retained earnings are what we will consider in this guide or article
Long-term financing means capital requirements for a period of more than 5 years to 10, 15, 20 years, or maybe more depending on other factors.
SHARES, DEBENTURES, BONDS, AND RETAINED EARNINGS
Capital expenditures in tangible noncurrent assets like plant and machinery, land and building, etc. of a business are funded using long-term sources of finance.
Part of working capital which permanently stays with the business is also financed with long-term sources of finance.
In this session, we shall examine the different types of long-term financing such as shares, bonds, and debentures.
Objectives by the end of this session, you should be able to:
(a) explain security finance
(b) discuss shares as a source of finance for a business
(c) discuss debentures as a source of long-term funds
(d) explain bonds as a source of finance for a business
(e) describe the relevance of retained earnings as a source of business funds
Now read on …
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4.1 SOURCES OF LONG-TERM FINANCE
The sources of long-term finance refer to the institutions or agencies from which, or through which finance for a long period can be procured. In the case of sole traders and partnership firms, long-term funds are generally provided by the owners themselves and by retained profits.
But in companies whose financial requirements are rather large, the following are the sources from, or through which long-term funds are raised: shares, bonds, debentures, leasing,
4.2 LONG-TERM SECURITY FINANCE
If the finance is mobilized through the issue of securities such as shares, bonds, and debenture, it is called security finance. It is also called corporate securities. This type of finance plays a major role in the field of deciding the capital structure of the company.
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Security finance consists of the following important characteristics:
- Long-term sources of finance.
- It is also called corporate securities.
- Security finance includes both shares and debentures.
- It plays a major role in deciding the capital structure of the company.
- Repayment of finance is very limited.
- It is a major part of the company’s total capitalization. Types of Security Finance Security finance may be divided into two major types:
- Ownership securities or capital stock or equity finance; example shares
- Creditorship securities or debt capital; example bonds and debentures
The ownership securities also called capital stock or equity financing is commonly called shares.
Shares are the most universal method of raising finance for the business concern. Ownership capital consists of the following types of securities: Equity Shares and Preference Shares in Ghana. These shares are usually issued at no par value.
4.3.1 Equity Shares
Equity Shares also known as ordinary shares. Equity shareholders are the real owners of the company. They have control over the management of the company.
Read also: What Is A Running Finance and What Are Its Uses?
Equity shareholders are eligible to get dividends if the company earns a profit. Equity share capital cannot be redeemed during the lifetime of the company. The liability of the equity shareholders is the value of the unpaid value of shares.
Equity shares have the following important features:
- Maturity of the shares: Equity shares have permanent nature of capital, which means it has no maturity period. It cannot be redeemed during the lifetime of the company.
- Residual claim on income: Equity shareholders have the right to get income left after paying a fixed rate of dividend to preference shareholders. The earnings or the income available to the shareholders is equal to the profit after tax minus preference dividend.
- Residual claims on assets: If the company wounds up, the ordinary or equity shareholders have the right to get the claims on assets. These rights are only available to the equity shareholders.
- Right to control: Equity shareholders are the real owners of the company. Hence, they have the power to control the management of the company and they have the power to take any decision regarding the business operation.
- Voting rights: Equity shareholders have voting rights in the meeting of the company with the help of voting right power; they can change or remove any decision of the business concern. Equity shareholders only have voting rights in the company meeting and also, they can nominate a proxy to participate and vote in the meeting instead of the shareholder.
- Pre-emptive right: Equity shareholder pre-emptive rights. The pre-emptive right is the legal right of the existing shareholders. It is attested by the company in the first opportunity to purchase additional equity shares in proportion to their current holding capacity.
- Limited liability: Equity shareholders are having only limited liability to the value of shares they have purchased. If the shareholders are having fully paid up shares, they have no liability. We are fully aware you discussed this under Company and Partnership Law.
4.3.2 Preference Shares
Preference shares are part of the corporate securities of a firm. It is the shares, which have the preferential right to get dividends and get back the initial investment at the time of winding up of the company.
Preference shareholders are eligible to get a fixed rate of dividend and they have voting rights in accordance with the Companies Act of 2019, Act 992.
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It means a preference shareholder enjoys two rights over equity shareholders:
(a) right to receive a fixed rate of dividend and
(b) right to return of capital. After settling the claims of outsiders, preference shareholders are the first to get their dividend, and then the balance will go to the equity shareholders. However, the preference shareholders do not have any voting rights in the annual general meetings of the company.
Preference shares may be classified into the following major types in Ghana:
- Cumulative preference shares: Cumulative preference shares have the right to claim dividends for those years which have no profits. If the company is unable to earn profit in any one or more years, C.P. Shares are unable to get any dividend but they have the right to get the comparative dividend for the previous years if the company earned profit
- (ii) Non-cumulative preference shares: Non-cumulative preference shares have no right to enjoy the above benefits. They are eligible to get only dividends if the company earns profit during the years. Otherwise, they cannot claim any dividend.
- Redeemable preference shares: When the preference shares have a fixed maturity period it becomes redeemable preference shares. It can be redeemable during the lifetime of the company. The Companies Act of 2019, S.62 has provided certain restrictions on the return of the redeemable preference shares.
- Irredeemable Preference Shares: Irredeemable preference shares can be redeemed only when the company goes for the liquidator. There is no fixed maturity period for such kind of preference shares.
- Convertible Preference Shares: Convertible preference shareholders have the right to convert their holding into equity shares after a specific period. The constitution of the company must authorize the right of conversion.
- Non-convertible Preference Shares: These shares, cannot be converted into equity shares.
Creditorship Securities also known as debt finance which means the finance is mobilized from the creditors. Debenture and Bonds are the two major parts of the Creditorship Securities. The debenture is a document issued by the company. It is a certificate issued by the
company under its seal acknowledging a debt. Debentures are the loans taken by the company. It is a certificate or letter issued by the company under its common seal acknowledging the receipt of the loan. A debenture holder is the creditor of the company.
A debenture holder is entitled to a fixed rate of interest on the debenture amount. Payment of interest on debenture is the first charge against profits. Apart from the loans from financial institutions, a company may raise loans through debentures.
This is an additional source of long-term finance.
The payment of interest and principal amounts on these debentures is subject to the terms and conditions of the issue of debentures. Debentures may be divided into the following major types:
- Unsecured debentures: Unsecured debentures are not given any security on the assets of the company. It is also called simple or naked debentures. This type of debenture is traded as unsecured creditors at the time of winding up of the company.
- Secured debentures: Secured debentures are given security on the assets of the company. It is also called mortgaged debentures because these debentures are given against any mortgage of the assets of the company.
- Redeemable debentures: These debentures are to be redeemed on the expiry of a certain period. The interest is paid periodically and the initial investment is returned after the fixed maturity period.
- Irredeemable debentures: These kinds of debentures cannot be redeemable during the lifetime of the business concern. The Companies Act of 2019 called it perpetual debentures.
- Convertible debentures: Convertible debentures are the debentures whose holders have the option to get them converted wholly or partly into shares.
These debentures are usually converted into equity shares. Conversion of the debentures may be Nonconvertible debentures; Fully convertible debentures and Partly convertible debentures.
Bonds may be used to raise financing for a specific activity. They are a special type of debt financing because the debt instrument is issued by the company. Bonds are different from other debt financing instruments because the company specifies the interest rate and when the company will pay back the principal (maturity date).
Also, the company does not have to make any payments on the principal (and may not make any interest payments) until the specified maturity date. The price paid for the bond at the time it is issued is called its face value.
When a company issues a bond, it guarantees to pay back the principal (face value) plus interest. From a financing perspective, issuing a bond offers the company the opportunity to access financing without having to pay it back until it has successfully applied the funds.
The risk for the investor is that the company will default or go bankrupt before the maturity date. However, because bonds are a debt instrument, they are ahead of equity holders for company assets.
Earnings Retained earnings are another method of internal sources of finance. Actually, is not a method of raising finance, but it is called an accumulation of profits by a company for its expansion and diversification activities.
Retained earnings are called under different names such as; self-financed, inter finance, and plugging back of profits. According to the Companies
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Act of 2019, a certain amount of the net profits after tax of a financial year have to be compulsorily transferred to reserve by a company before declaring dividends for the year.
Under the retained earnings sources of finance, a part of the total profits is transferred to various reserves such as general reserve, replacement fund, reserve for repairs and renewals, reserve funds and secrete reserves, etc.
This session was centered on shares, bonds, debentures, and retained earnings as sources of finance for a business for a long period of time.
We explained the different types of shares businesses can issue. We want you to remember that under the topic valuation of financial securities, we shall revisit the topic on shares and bonds as the major financial securities used in Ghana and how they are valued.
So, when going for funding, there is the need to do the valuation and see how it will be beneficial for your business or company.
By: Eric Adjei
A professional with six (7) years of experience in finance and accounting. Demonstrating expertise in accounting procedures, computerized accounting system management, and financial operations. Financially astute with excellent analytical, problem-solving, management, people supervision, organizational, business administration, operation, and commercial management, and teaching skills.
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