Introduction to Sources of Business Finance
Finance required by the business to establish and run its operations is known as Business Finance. No business can function without an adequate amount of funds for undertaking various activities. To be able to produce goods or provide services, any business needs money. Longer goals of expansion and growth can only be achieved with the help of the required amount of funds. The financial needs of a business can be categorised into two parts-
1. Fixed Capital Requirement: To establish a business, a firm needs to invest money in the fixed nature of assets. Funds are required to purchase fixed assets like Plant & Machinery, Land & Building, Furniture and Fixtures etc. . The funds invested in fixed assets will remain invested for a long period.
2. Working Capital Requirement: The funds required for day to day business is known as working capital. It is used for holding current assets and paying off the current liabilities of the business.
The amount of Fixed or Working Capital requirement differs from business to business. A business involved in the day to day trading will require less fixed capital but more working capital whereas a business involved in manufacturing will always need to invest more in fixed capital and less in working capital.
Sources of Business Finance:
Unlike Partnership or Sole Proprietorship, a Company has many options from where it can arrange funds to operate a business. In Proprietorship and Partnership concerns, the funds may be raised either from friends and family or as a loan from a bank. But in the Company form of business, funds can be arranged from various sources. Various sources of Finance can be classified into three major categories, which are-
1. On the Basis of Period:
- Long-term: The long term sources fulfil the financial requirement of an enterprise for a period exceeding 5 years. It includes sources such as shares and debentures, long term borrowing and loans from a financial institution.
- Medium-term: When funds are required for more than 1 year but less than 5 years then the company opt for medium-term finance options. These sources include borrowings from commercial banks, public deposits etc.
- Short-term: Short-term funds are those which are required for a period not exceeding one year. Trade credits, loans from commercial banks and commercial papers are some examples of short-term funds.
2. On the Basis of Ownership:
- Owner’s Fund: Those funds which are provided by the owner of the enterprise are called Owner’s Fund. Shares and retained earnings are some examples of the Owner’s Fund.
- Borrowed Fund: Those funds which are borrowed from the outsiders as loans or borrowings are called Borrowed Funds.
3. On the Basis of Source of Generation:
- Internal Source: Those funds which are generated from inside the business are called Internal Sources of Fund. Collection of receivables, disposing of surplus inventories are some examples of internal sources.
- External Source: External Sources of funds include those sources that lie outside the organisation such as suppliers, lenders and investors.
There is not a single best source of funds for all organisations. Depending on the situation, purpose, cost and associated risk, a choice may be made about the source to be used. We will see them one by one:
1. Retained Earnings: A portion of profit or earnings which wasn’t distributed to the shareholders as dividends and retained in the business is called Retained Earnings. It is a source of internal financing or self-financing or ‘ploughing back of profits. The company can use its retained earnings as a source of finance.
2. Trade Credit: Trade Credit is a short-term finance option in which credit is extended by one trader to another for the purchase of goods and services. It facilitates the purchase of goods or services without immediate payment. The volume and period of credit are extended depending on factors such as the reputation of the purchasing firm, the financial position of the seller, volume of the purchase, record of the payment and degree of risk and competition prevailing in the market.
3. Factoring: Factoring is a financial service in which a business sells its account receivables to a third party(Factor) at a certain discount before the maturity date to meet its immediate and present cash needs. The factor provides the funds at that time and collects them from the firm’s debtors on the date of maturity.
4. Lease Financing: A contractual agreement in which the right to use any asset is given by one party i.e. the owner of the assets to the other party in return for a periodic payment. The owner of the assets is called the “lessor” and the user of the assets is called the “lessee”. It can also be called renting an asset for a specified period. Generally, fixed assets are leased.
5. Public Deposits: The money that is directly raised from the public is called Public Deposits. The interest rates offered on public deposits are generally higher than bank deposits. It can be used to raise the medium and short-term requirements of a business. Any person who is interested in depositing money in an organisation can do so by filling up a prescribed form. The organisation in return issues a deposit receipt as an acknowledgement of the receipt.
6. Commercial Paper: Commercial Paper is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. It can be issued by any firm to other business firms, insurance companies, pension funds and banks. The amount raised by Commercial Paper is generally very large. As the debt is unsecured, the firm having a good credit rating can only issue Commercial Paper.
7. Issue of Shares: The smallest unit of a firm’s capital is called a share. The firm’s capital is divided into small units and issued as shares to the public. The capital obtained by Issue of Shares is called ‘Share Capital’. It is a type of Owner’s Fund. Two types of shares can be issued:
- Equity Shares: Equity Shares are those types of shares in which there is no fixed dividend but have ownership and voting rights. The equity shareholders of the company are called Owner of the company. They do not get a fixed dividend but are paid based on the earnings of the company.
- Preference Shares: Preference shares are those types of shares that have a little preference over equity shares. Preference Shareholders get a fixed rate of dividend and have the right to get their capital before the equity shareholders at the time of liquidation. Although, they don’t have any voting right in the management of the company.
8. Debentures: Debenture is a type of financial instrument with a fixed rate of interest. It is a type of long term debt capital issued by a company as an acknowledgement that the company has borrowed a certain amount of money. Interest can be paid half-yearly or yearly on debentures.
9. Commercial Banks: Commercial Banks are very vital in providing funds as they provide funds for different purposes and different periods. Banks provide loans to firms in many ways, like, cash credits, overdrafts, term loans, discounting of bills and issue of letters of credit. The rate of interest charged on such credits varies from bank to bank as well as the nature, amount and period of that loan.
10. Financial Institutions: There are several financial institutions established by Government in the country to provide finance to business organisations. They provide both owned capital and loan capital for the long and medium-term requirements. As these institutions aim at promoting the industrial development of a country, these are also called ‘Development Banks’. In addition to providing financial assistance, these institutions also conduct surveys and provide technical assistance and managerial services to organisations.
With the opening up of the economy and the operations of the business organisation, apart from the sources mentioned above, organisations can raise funds internationally. Various international sources from which funds may be generated include;
1. Commercial Banks: Commercial Banks are all over the world, they extend foreign currency loans for a different purposes to organisations worldwide.
2. International Agencies and Development Banks: Several international agencies and development banks at national, regional and international levels have emerged over the years to finance international trade and business. These institutions provide long and medium-term loans and grants to promote the development of economically weaker countries as well as economically weaker areas.
3. International Capital Market: Just like the domestic capital market, companies can get funds from international capital markets as well. Prominent financial instruments used for this are Global Depository Receipts (GDRs) and American Depository Receipts (ADRs) and Foreign Currency Convertible Bonds (FCCBs)
Factors Affecting the Choice of the Source of Funds:
Different types of businesses have different types of financial needs. Therefore, business firms resort to different types of sources of funds. As no source of funds is free from risk and certain limitations, companies opt to use a combination of sources rather than relying on a single source. Several factors affect the choice of this combination, we will see them one by one:
1. Cost: The cost of procurement of funds as well as the cost of utilising the funds are taken into consideration while deciding about the choice of funds that will be used by an organisation.
2. Financial Strength and Stability of Operations: Company’s financial strength and position is key element to take into account. Funds need to be repaid to the source it has been generated from, so for this, a business should be financially stable. When the earning position of the business is not stable, fixed charged funds like preference share and debentures shouldn’t be taken.
3. Form of Organisation and Legal Status: The legal entity (i.e. sole proprietorship, partnership or company) of a business allows or prohibits to choose from various options of funds. Like only a public company can issue equity shares to raise money from the market, not the partnership business or even private company.
4. Purpose & Period: The purpose and period are important factors that affect the choice. Short-term use of funds has different sources where a company can choose from whereas Long-term use of funds has different sources.
5. Risk Profile: The risk factor associated with a different type of source of finance varies from each other. For example, there is the least risk inequity as the share capital has to be repaid only at the time of winding up and dividends need not be paid if there is no profit but in debentures are opposite in terms of payment of interest.
6. Control: If a company want to generate fund from issuing equity shares then it has to sacrifice a bit of ownership and control to the public whereas by issuing debt funds like debentures or taking a loan, a company doesn’t have to compromise with the ownership and control.
7. Effect on Credit Worthiness: Credit Worthiness is the company’s power or ability to repay the debts. Some source of funds affects the creditworthiness of a company negatively, a company may choose not to consider those options while selecting the source of finance.
8. Flexibility and Ease: Generally, those options which are more flexible and easy are preferable rather than those which have restrictive provisions, detailed investigation and documentation.
9. Tax Benefits: Various sources offer different tax benefits to the organisation, while the dividend on preference shares is not deductible, interest paid on debentures and loan is tax-deductible.