BUSINESS FINANCE NOTES
TOPIC ONE
FORMS OF BUSINESS ORGANISATIONS
Business – is an organization established by a person or a group of persons to produce goods or services in order to earn profit.
Factors to consider when establishing a new business
1. Nature of business;- There are so many types of businesses and a businessman should first decide what type of business to start.
2. Form of business ownership:- A business can be a sole proprietorship, partnership or limited company. Each has its own advantages & disadvantages.
3. Finance;- Its suitability determines the scale at which the business can be started.
4. Location of the business;- This is place where the business shall be carried on and the site where business establishment should be located. It should be suitably selected by taking into consideration various factors like the availability of raw materials, power, water, skilled labour, nearness to the market and existence of transport and communication facilities.
Forms of Business Organisation
SOLE PROPRIETORSHIPS (SOLE TRADERSHIP)
It is the oldest & simplest form of business. It is that type of business where an individual introduces his own capital, uses his own skills, and intelligence in management of its affairs, assumes all the risk of business and is solely responsible for the result of its operations. The bakery, hardware store, barber shop, beauty parlous are examples of sole proprietorship.
Characteristics
• Ownership;- the ownership of the business unit is by one person
• Management;- the owner is the active manager of the business unit. He may delegate some of the powers to his trusted employees in case the business is large.
• Finance;- the necessary capital is usually provided by the owner himself. However if additional capital is needed it can be increased by borrowing.
• Size of the business unit;- it is usually small but it is not necessarily so.
• Risk;- as the trade operate the business for his sole personal interest he assumes all risks of business
• Unlimited liability;- it is unlimited and in the event of insolvency of the business, how will be responsible for making good the deficiency from his personal wealth.
• Entity;- the business is not a separate legal entity from the sole trader
• Freedom of action;- the sole trader can take prompt and immediate action within a legal framework
• Continuity;- the continuity of the firm is based on good health of the owner.
• No legal formalities;- there are no legal formalities to set up the business. There may be legal restrictions on the setting up of particular type of business.
• Profit;- as the owner bears full risks of the business, he therefore retains all profit with him.
Sources of Finance for the Sole Proprietor
• Savings;- this is done in advance to accumulate the required capital by the trader
• Assistance from friends or relatives;- it is either agreed to be returned or given as donation
• Proceeds from sale of assets
• Bank loan up on application and meeting the requirements
• Funding by the NGO’S
• Trade credit from big companies producing certain goods
• Government agencies e.g. women and youth development funds
Advantages
• Simplicity of formation
• Personal incentive;- the trade takes personal interest for the success of a business
• Sole trade usually skilled in the business (good for competition)
• Profits motivates owners
• High supervision of employees
• Need for small capital
• Independence;- the trader can put his own plans into action quickly since he does not have to consult any other person
• Direct contact with the customers hence personal attention, cater for their personal complaints & understand their needs better.
• Sole claim on profit ;- no sharing profits
• flexible management
• Easy & low cost organisation
• Secrecy
• Low bureaucracy (less time wasted)
Disadvantages
1. Short economic life therefore does not attract long-term finance, therefore, limited expansion and growth.
2. Unlimited liability
3. Success depends on ability or judgement of owner
4. limited managerial ability
5. Difficulties of expansion
6. Lack of continuity
7. over worked
8. unable to carry out research
Note
• Most sole traders do not employ professional advice which implies less growth and stagnation.
• Limited sources of finance.
• Limited accounts knowledge.
PARTNERSHIPS
Definitions
“The relationship, which exists between persons carrying on a business in common with a view of profit.”
Formation of a partnership
1. Orally
2. Actions of the person concerned
3. Agreement in writing.
4. By a deed i.e. an agreement under seal.
Note
In case the partners want to run their business under a name which does not disclose true surname of all partners, such a firm must be registered under the registration of Business Names Act.
Types of Partners
1. General Partners – Unlimited liability and active in participation in partnership activities.
2. Limited partners – Limited liability and does not participate in the management of partnerships.
3. Sleeping partners – has no active role, nevertheless, such a partner will have contributed to the capital of the partnership business and will thus share in the profits although at a lower proportion in most cases.
A partnership deed constitutes a legal contract among the partners. The articles of partnerships must contain eleven clauses.
a. Nature of business.
b. Profit sharing ratio
c. Capital contribution
d. Rates of interest on both capital and drawings
e. The provision for proper accounts and their audit.
f. Powers of each partner.
g. Grounds of dissolution.
h. Determination of Goodwill
i. Determination of amount payable to outgoing partners.
j. Expulsion procedures.
k. The arbitration clause.
Advantages
• Simplicity of formation
• Favourable credit standing
• Large capital
• Greater management ability
• Combined judgement
• Prompt decisions
• Secrecy
• Specialization
• Freedom of action
• Retention of skilled workers
• Ease of dissolution
Disadvantages
• Unlimited liability
• Limited life business
• Less capital
• Less freedom of action
• Joint investments
• Profits are shared
Source of finance for partnerships
• Capital contributions by the partners
• Loans advanced by the partners
• Loans from friends and relatives
• Loans and overdraft facilities from the banks
• Trade credit
• Hire purchase
• Lease finance
Limited Companies/Joint Stock Companies
A voluntary association of different persons created by law as a separate body for specific purposes. It is a legal entity separate and distinct from its members. It possesses a common capital contributed by its members. Such capital being divided into transferable shares.
Initiators contribute to the capital base of such companies through the purchase of shares of such companies. These companies are governed by the Companies Act (Cap. 486) of 1948.
Such must be registered with the Registrar of Companies after which it is issued with a certificate of incorporation which indicates the Birth of the company. A company may be formed either by registration, charter or legislation (statutory).
Basic Characteristics of a Company
1. Legal personality;- it is an artificial person created by law having an entity separate from its members. The persons contributing capital are known as shareholders. It can own property or transfer the title of property, enter into contracts under its own name, sue & be sued in a court of law.
2. Capital divided into transferable shares;- a shareholder can sell his interest in the company to another person without getting the consent of other shareholders. But not in private companies.
3. Common seal;- this is a signature embodied in the common seal of the company.
4. Perpetual succession;- it enjoys continued existence. The death or retirement of any member cannot affect the running life of the company. The business continues until it is liquidated since its life is separate from its members.
5. Limited liability;- each shareholder is liable only to the amount of capital contributed by him and to the unpaid value of the shares he holds. Private assets of the members are not liable to settle the debts incurred and other business obligations of the company.
Types of Companies
1. Company by charter;- This is a company incorporated by royal order. Its powers, rights and functions are governed by the charter issued at the time of formation e.g. University.
2. Statutory (legislation) company;- This type of company is formed by order of the president or by the special act of legislature. It is organized for the purpose of carrying on some business of national importance. Each company can exercise its particular powers which are governed by the terms of its special act. In Kenya, such companies are known as parastatals e.g. Basin Development Authority, Kenya Ports Authority etc.
3. Registered company;- Incorporated under the company Act prevailing in a country. Once formed it becomes a separate legal entity apart from its members. It may be divided into;-
a) Unlimited Company;- These are ordinary large partnership where shareholders have unlimited liability. They are liable to pay debts and other obligations of the business as in an ordinary partnership. They are very rare in East Africa.
b) Company limited by Guarantee;- Each member guarantees (promises) to contribute a fixed sum of money towards the liabilities of the company to the fixed sum of money guaranteed. If such a company has share capital, the amount must be mentioned in the charter of the company. It is normally formed to promote social, cultural and scientific activities such as sports clubs, chamber of commerce, welfare, professional and educational associations.
c) Company limited by Shares;- These are the most common types these days in which liability of each shareholder is restricted to the value of the shares held by him. If he pays the full value of the shares, his liability will be nil. Such companies are either private or public.
i. Private limited company
– It may consist of a minimum of two members but the maximum may not exceed fifty.
– A private company is not allowed to call upon the public for funds in the form of shares or debentures
– Any transfer of shares is restricted. it must be approved by the Board of Directors
– It must use ‘Limited’ as the last words of its name.
ii. Public limited company
– This is one whose membership is not less than seven and there are no restriction for;-
• Maximum members
• Transferring of shares
• Expansion through the sale of shares to the public.
– The owners or members of the company are the people who hold shares. Such people are called shareholders
– The day to day affairs of the company are managed by people called ‘Directors’ who are elected by shareholders from among themselves.
Formation of a Limited Company
There should be some people who come up with an idea of forming a company and setting it in operations. These are the founder member of the company and are known as promoters. It requires a minimum of 2 and seven members for private and public company subsequently. The process may be summarized as follows;-
A. Search for Name;- A small fee is paid to the registrar of company to search and approve the chosen name by the promoters. This is done to find out whether another company has already been registered with the same name or not. If the name is identical to the name of an existing company then the promoters choose another name.
B. Once the name is approved, they go ahead and prepare certain necessary legal documents. These are as follows.
1. Memorandum of association;- This is an application to the registrar signed by the promoters of a company that they need to be formed into a company. This document states;-
i. The name of the company with the word limited as the last word in the name
ii. The city and country in which the registered office is situated
iii. A statement that the liability of the members is limited
iv. The objectives of the company outlining the aims and purposes for which the company is being formed. The company cannot act beyond the objectives stated in its memorandum of association.
v. A statement of the nominal authorized capital with which the company wants to be registered. The Registration fee is calculated according to this capital.
vi. Declaration: this confirms that the promoters want to form themselves into a limited company. It is signed by a minimum of seven persons in case of public company and at least two in case of private company.
2. Article of association;- Second most important document to be prepared signed & delivered to the registrar by the promoters. It includes regulations governing the internal management & administration of the company. It is very essential in the case of a private company but a public company may, if it wishes, adopt the standard set of articles known as ‘TABLE’. It contains the following points;-
i. Classes & rights of shareholders
ii. The issue & transfer of shares
iii. Methods of dealing with any alterations on the capital
iv. Procedures of general meetings and voting rights
v. Qualifications, duties and powers of directors
vi. Borrowing, dividend and reserve policies
vii. Auditing of the books, etc.
3. Registered office;- notice of the situation of the company’s registered office.
4. List of directors;- list of persons along with their particulars who have agreed to act as directors.
5. Statutory declaration;- It is signed by the company secretary or a director whose name explicitly named in the Articles of Association or an advocate of the high court of Kenya.
C. All the documents are taken for stamp duty to the collector of stamp duties at the ministry of Lands Office. For MOA is Ksh. 2,000/= and for the statement of share capital is 2% of the authorized share capital. After paying, the documents are stamped. Then the documents are retrieved from the collector of stamp duties and then lodged for incorporation with the registrar of companies.
D. Certificate of incorporation;- It is issued by the registrar of companies upon satisfaction that the all the legal & technical requirements for registration have been met. it means:-
i. The company has been registered
ii. The company has come into existence
iii. The company has processed a legal entity apart from its members.
E. Trading License:- This is a document issued by the authority in an area to carry out a particular business in a specific area. After acquiring a trading license, a private company can then begin business but a public cannot do so until a certain minimum amount of shares capital has been raised. A public company will take the following further steps before it starts business.
1. Issue of prospectus;- This is the document advertising company shares or inviting the public to subscribe for the shares. Usually it is printed in the newspaper or sent to people who are likely to be interested.
2. Allot shares;- this is done by the directors after the application have been received from the public. An allotment is the acceptance of the offer of the applicant, and such constitutes a binding contract with the applicant.
3. Certificate of commencement of business;- The following documents should be submitted to the registrar before commencement of business by the public company;-
a) Minimum subscription;- A statutory declaration on the prescribed form that the shares have been allotted to an amount not less in the whole than the minimum subscription
b) Payment of shares;- Every director of the company has paid for the company’s qualification shares
c) Submission of prospectus;- the company has filed a prospectus or statement in lieu of prospectus with the registrar
d) Declaration regarding conditions;- A statutory declaration by the secretary or one of the directors on the prescribed form that all the conditions have been complied with.
After verifying these foregoing documents, the registrar issues a certificate of commencement of business to Public Company. The company is entitled to commence its business from the date of obtaining this certificate.
The capital structure of company
it refers to different categories under which the authorized capital of a company are divided up. This is because the company does not normally invite subscriptions for all of its nominal or authorized capital at one time. Payment is usually by periodic amounts known as installments or calls.
Capital of company is described in a number of ways. If we look at from the legal and accounting view, the capital of a company is classified on the basis of the amount mentioned in the capital clause of the MOA. The capital is fixed after making carefully analysis of the present and future requirements of the company. The capital of the company is generally divided into the following categories.
Classes of Capital
1. Authorized or registered capital. This is the maximum amount of capital the company expects to raise from its shares and stated in the capital clause of its MOA.
Example;- A company’s share capital is made up of 100, 000 ordinary shares of Sh. 10/= each. Then the nominal or authorized capital of the company is Ksh. 100, 000 x Shs. 10/=. Once Registered the registrar of companies expects such firm to operate with this amount. The authorized capital of the company is also called nominal or registered capital. it is the amount of capital with which a company is registered.
2. Issued & Unissued Capital. A company issues shares according to its requirements. Issued capital is that part of authorized capital which is example, out of the company’s authorized capital which is actually offered to the public for subscription in the form of shares.
For example out of the company’s authorized share capital, the directors may decide to put some of it to the public so as to start subscribing for the purpose they issue only 50,000 shares then the issued capital is;-
50,000 x Sh. 10 = Sh. 500,000. The reminder is what is known as unissued capital.
3. Called-Up Capital. Once the shares have been put to the public so as to start applying for, then the shareholders are called upon to subscribe or pay. They may call upon to pay for all the shares issued or only a fraction of what was issued. Assume that each shareholder is asked to pay Shs. 5 first to every share he has taken up. Since 50,000 shares were issued the amount of called up capital is 50,000 x SHs. 5, = SHs 250,000. The remainder is known as uncalled – up capital. The amount unpaid is known as uncalled-up capital i.e. What the shareholders are asked to reserve for sometimes.
4. Paid-up capital. The paid up capital is the amount of capital which has been paid up by the shareholders on application of each share. In other words, this is actual amount received from the subscribers by the company out of the called-up capital. The amount unpaid is known as calls in arrears.
5. Reserve capital;- A public company may create a special category of capital known as Reserve Capital in respect of the called-up capital of the company. Reserve capital is the amount which is not callable by the company except in the case of company being wound up. reserve capital is created by means of a special resolution passed by the company in the general meetings
Classes of Shares
A share is a unit into which the capital of a company is divided. The face value or nominal value of the shares is kept at a small amount to encourage more people to buy them. A share means “a share in the capital of a company.” A public company generally issues various classes of shares as laid down in the AOA and Prospectus of the company.
Types of shares
1. Ordinary shares: Also called equity shares. The holders are the real owners of the company. They have voting rights in the meetings of the company but have no special rights in regard to dividend. They are paid dividend (profits which are distributed to shareholders) as declared by the BOD. They do not carry any fixed rate of return out of the company’s profits.
Characteristics
i. Most important & popular type of shares – venture capital of a company
ii. No burden on company’s resource – the dividend is to be paid out of the profit of the company hence impose no burden on the resources of the company.
iii. Provide log term finance to the company
iv. Do not create any charge to the assets of the company
v. OSH are paid profit after all other claims are met by the company
vi. The rate of dividend depend upon the profit of the company
But the greatest risk of business falls upon them because;-
i. They have no fixed rate of dividend
ii. There is no special security for such investments other than the soundness of the company
iii. In good years they may receive high rates of dividends than the other shareholders but in bad years there may be no return at all
iv. when the company is winding up, the shareholders are repaid money after the other shareholders and creditors
2. Preference Shares: – As their name suggests they have certain preferential rights or privileges in respect of the payment of dividend or repayment of capital as compared to other types of shares. The main features of such shares are;-
i. They earn a fixed rate of dividend; say 5% or 10% preference shares
ii. These too are held by the owners of the company and form part of the company capital with a fixed rate of dividend
iii. The first preference is for payment of dividend
iv. In case of winding up the company, the preference shareholders have prior right in regard to repayment of capital
v. The preference shareholders therefore assume a proportionately lesser risk than the ordinary shareholders but also earn a lower rate of return.
The preference shares are sub-divided into;-
i. Cumulative Preference Shares; – In addition to the above rights, these shares have additional privileges in regard to payment of dividend. If a company makes no profit in a particular year and the directors decide to declare no dividend in that particular year, these shares will get two years dividend in the following year. In other words, these shares have the right to have arrears of dividend carried forward to subsequent years until it is paid
ii. Non-Cumulative Preference Shares; – arrears of dividends in years with no profits are not carried forward to the subsequent years. They are entitled to a fixed rate of dividend but are paid only if a company earns profits.
iii. Participating Preference Shares; – These have an addition to fixed rate of dividend, a share in the surplus profit remaining after the ordinary shares have been paid.
iv. Redeemable Preference Shares; – A public company may issue these shares if so authorized by its Articles. Such shares are fully paid up before redemptions. They are bought back (Redeemed) by a company after a stated period. The repayment of these shares is made by creating a Reserve fund.
v. Guaranteed Preference Shares: These shares are guaranteed for a fixed rate of dividend by a third party. If the profits of any one year are not sufficient to pay such dividend, the guarantor(s) have to pay the same off their private resources.
vi. Convertible Preference;- They are those which the holder can convert into equity (ordinary) shares at specified period of time. The right of conversion is to be authorized by the Articles of Association of the company.
3. Deferred Shares;- These shares are issued to promoters who take initiative in the formation of a joint stock Company. So these are also called ‘Founders’ shares’.
They are usually valuable shares as these may have entitlement to participate in all profits remaining after payment of dividend to all of the other classes of shares.
Winding up of a Company
This means the end of the life of a company. In simple words it’s the closing down of the business. A company having been created by law it cannot die a natural death like a human being. The termination of its existence is affected by law. Thus winding up of the company is a legal procedure. When a company ceases to exist and its property is administered for the benefits of its creditors and members, it is called winding up or liquidation.
Methods of modes of winding up of a limited company
i. Compulsory winding up by court
ii. Voluntary winding up by shareholders
iii. Winding up under supervisor of the court
These are further explained below
1. By court;- The main reasons for winding up by the court are as under;-
i. By special resolution;- a special resolution has been passed by the company to be wound up by the court
ii. Failure to commence business:- If public company does not commence business within one year of the date of its incorporation or suspends business for a certain period, the court may order its winding up.
iii. Statutory report or delay in meeting;- Where default is made not submitting the statutory report to the registrar’s (of companies) office or not in holding the statutory meeting within prescribed time or has not held two consecutive annual general meetings
iv. Members reduced below minimum; – A public company may be wound up by the court if its members are reduced below seven (less than two in case of private limited company),
v. Inability to pay its debts
2. Voluntary winding up;- the voluntary winding up of the company is of two kinds
Members voluntary winding up;- If the members wish to liquidate the company, the directors are required to file a declaration of solvency. This can take place if the majority of directors file in a special board meeting resolves to wind up the company and submit a declaration (verified by the company’s auditors) to the registrar of companies that the company either has no debts or is able to pay its debts in full within a certain period for the commencement of winding up.
3. Winding up under supervision of court;-A court can also order the winding up of the company under the following conditions.
4. If the court is satisfied that the com
Advantages
– Limited liability.
– Perpetual existence (or going concern) which allows the company to make strategic plans to raise finance in Capital Markets more easily.
– The company can own assets and incur liabilities on its own accord.
– Title to share is freely transferable which makes these shares more of an investment.
– Exception – Private limited companies whose transfer of shares needs the consent of its members.
– Shares may be used as securities.
– Large sources of finance.
– Large scale production
– Expert management
Disadvantages
– Loss of secrecy – poor competition
– Many formalities in forming the company
– Heavy initial capital outlay.
– Difficult to reconstruct the capital
– Bureaucracies especially in decision making processes.
– Inflexibility and thus low adaptability.
– Difficulties in control
– Poor workers relationships
– Operational expenses
– corruption
– growth of monopolies
– heavy taxes
Sources of finance for limited companies (especially to a public limited company)
– Ordinary share capital
– Preference share capital
– Retained earnings and provisions
– Loan capital e.g. Debentures
– Loans from banks
– Trade credit
– Hire purchase financing
– Lease financing
– Factoring and invoice discounting
Difference between a public and a private company can be analyzed under;-
1. Number of shares
2. Transfer of shares
3. Methods of raising funds from the public
4. Number of directors
5. Quotation
6. AGM’s
7. Retirement age of directors.
Cooperative Societies
A form of business where members strive to achieve any common objective on voluntary and democratic basis. The main rule of a co-operative society is “each for all and all for each”
It is established by the voluntary association of a certain number of persons with a spirit of service in order to achieve self help through mutual help, and managed in a democratic manner.
Features of co-operative society
1. A voluntary association;- The membership is at all time opened to all people who may joint it at their own accord for the satisfaction of their common economic need.
2. Service motto;- This is the basic principle; to serve members. A combination of business and spirit of service which evokes loyalty, fellowship and corporate feeling.
3. One for all and all for one;-Self help through mutual help. Each member endevours his maximum to help others and each member in turn will get the maximum help from others
4. Democratic movement;- Its management is democratic. The managing committee is elected from among the members constituting the society. An important point to be noted in this connection is that every member has one vote irrespective of the number of shares held by him.
5. Division of profits;- The profits are divided on the basis of the services rendered by each member for the common benefit of the society.
6. State control;- The state exercise a close control over co-operative organizations. This is to avoid any malpractices on the part of some members.
Differences between co-operative and stock companies
ITEM CO-OPERATIVES COMPANIES
Registration Are registered under Co-operative Societies Act Are registered under the Companies
Membership Minimum of ten people are required to form a primary co-operative society Private – Minimum of two not exceeding fifty.
Public – Minimum of seven & no maximum limit imposed
Joining Anybody can join Apply through the BOD
People serve Members General public not shareholders
Control Democratic as members have equal shares Controlled by directors & voting rights depend on the number of shares held
Share capital One type of share capital with fixed rate of interest Capital structure consists of different types of shares with varying rate of interest
Operating capital May issue as many shares as it may wish- has no limit Shares limited to the authorized or nominal value
Voting rights Each member has one vote Each share held entitles to a vote
Issue of shares Not quoted on the stock exchange & do not fluctuate in value Public Companies shares are quoted on the stock exchange & fluctuate in value
Payment of shares Members pay for their shares as they wish Shareholders pay for their shares as the company states
Repayment of capital Can repay on demand & thus withdraw from the society A member has to apply through the BOD
Management controlled by an elected committee of management A company is controlled by an elected Board of Directors
Forms of cooperative societies
Main forms of co-operative societies are;-
i. Consumer Co-Operative Society
ii. Wholesaler Co-Operative Society
iii. Producer Co-Operative Society
iv. Savings And Credit Societies