Sources of Finance
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 in 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 the 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 a time period, sources are classified into long term, medium term, and short term. Ownership and control classify 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 is commonly classified into following three:
- Long Term Sources of Finance: 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. Capital expenditures in fixed 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. Long term financing sources can be in form of any of them:
- Share Capital or Equity Shares
- Preference Capital or Preference Shares
- Retained Earnings or Internal Accruals
- Debenture / Bonds
- Term Loans from Financial Institutes, Government, and Commercial Banks
- Venture Funding
- Asset Securitization
- International Financing by way of Euro Issue, Foreign Currency Loans, ADR, GDR etc.
- Medium Term Sources of Finance: Medium term financing means financing for a period of 3 to 5 years. Medium term financing is used generally for two reasons. One, when long-term capital is not available for the time being and second, when deferred revenue expenditures like advertisements are made which are to be written off over a period of 3 to 5 years. Medium term financing sources can in the form of one of them:
- Preference Capital or Preference Shares
- Debenture / Bonds
- Medium Term Loans from
- Financial Institutes
- Government, and
- Commercial Banks
- Lease Finance
- Hire Purchase Finance
- Short Term Sources of Finance: Short term financing means financing for a period of less than 1 year. Need for short term finance arises to finance the current assets of a business like an inventory of raw material and finished goods, debtors, minimum cash and bank balance etc. Short term financing is also named as working capital financing. Short term finances are available in the form of:
- Trade Credit
- Short Term Loans like Working Capital Loans from Commercial Banks
- Fixed Deposits for a period of 1 year or less
- Advances received from customers
- Factoring Services
- Bill Discounting etc.
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.
- Owned Capital: Owned capital is also referred as equity capital. It is sourced from promoters of the company or from the general public by issuing new equity shares. Business is started by the promoters by bringing in the required capital for a startup. Owners capital is sourced from following sources:
- Equity Capital
- Preference Capital
- Retained Earnings
- Convertible Debentures
- Venture Fund or Private Equity
Further, when the business grows and internal accruals like profits of the company are not enough to satisfy financing requirements, the promoters have a 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:
- It is a long term capital which means it stays permanently with the business.
- There is no burden of paying interest or installments like borrowed capital. So, the risk of bankruptcy also reduces. Businesses in infancy stages prefer equity capital for this reason.
- Borrowed Capital: Borrowed capital is the capital arranged from outside sources. These include the following:
- Financial institutions,
- Commercial banks or
- The general public in case of debentures.
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:
- There is no dilution in ownership and control of business.
- The cost of borrowed funds is low since it is a deductible expense for taxation purpose which ends up saving on taxes for the company.
- It gives the business a leverage benefit.
ACCORDING TO SOURCE OF GENERATION:
- Internal Sources: Internal source of capital is the capital which is generated internally from the business. Internal sources are as follows:
- Retained profits
- Reduction or controlling of working capital
- Sale of assets etc.
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.
- External Sources: An External source of finance is the capital which is generated from outside the business. Apart from the internal sources finance, all the sources are external sources of capital.
Deciding the right source of finance is a crucial business decision taken by top-level finance managers. The wrong source of finance increases the cost of funds which in turn would have a direct impact on the feasibility of project under concern. Improper match of the type of capital with business requirements may go against the 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.What’s your view on this? Share it in comments below.