There are various sources of finance such as equity, debt, debentures, retained earnings, term loans, working capital loans, letter of credit, euro issue, venture funding etc. These sources are useful under different situations. They are classified based on time period, ownership and control, and their source of generation.
Sources of finance are the most explored area especially for the entrepreneurs about to start a new business. It is perhaps the toughest part of all the efforts. There are various sources of finance classified based on time period, ownership and control, and source of generation of finance.
Having known that there are many alternatives of finance or capital, a company can choose from. Choosing right source and right mix of finance is a key challenge for every finance manager. The process of selecting right source of finance involves in-depth analysis of each and every source of finance. For analyzing and comparing the sources of finance, it is required to understand all characteristics of the financing sources. There are many characteristics on the basis of which sources of finance are classified.
On the basis of time period, sources are classified into long term, medium term, and short term. Ownership and control classifies sources of finance into owned capital and borrowed capital. Internal sources and external sources are the two sources of generation of capital. All the sources of capital have different characteristics to suit different types of requirements. Let’s understand them in a little depth.
ACCORDING TO TIME-PERIOD:
Sources of financing a business are classified based on the time period for which the money is required. Time period are commonly classified into following three:
ACCORDING TO OWNERSHIP AND CONTROL:
Sources of finances are classified based on ownership and control over the business. These two parameters are an important consideration while selecting a source of finance for the business. Whenever we bring in capital, there are two types of costs – one is interest and another is sharing of ownership and control. Some entrepreneurs may not like to dilute their ownership rights in the business and others may believe in sharing the risk.
Further, when the business grows and internal accruals like profits of the company are not enough to satisfy financing requirements, the promoters have choice of selecting ownership capital or non-ownership capital. This decision is up to the promoters. Still, to discuss, certain advantages of equity capital are as follows:
In this type of capital, the borrower has a charge on the assets of the business which means the borrower would be paid by selling the assets in case of liquidation. Another feature of borrowed capital is regular payment of fixed interest and repayment of capital. Certain advantages of borrowing capital are as follows:
ACCORDING TO SOURCE OF GENERATION:
The internal source has the same characteristics of owned capital. The best part of the internal sourcing of capital is that the business grows by itself and does not depend on outside parties. Disadvantages of both equity capital and debt capital are not present in this form of financing. Neither ownership is diluted nor fixed obligation / bankruptcy risk arises.
Deciding the right source of finance is a crucial business decision taken by top level finance managers. Wrong source of finance increase the cost of funds which in turn would have direct impact on the feasibility of project under concern. Improper match of type of capital with business requirements may go against smooth functioning of the business. For instance, if fixed assets, which derive benefits after 2 years, are financed through short term finances will create cash flow mismatch after one year and the manager will again have to look for finances and pay the fee for raising capital again.