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Sources of Finance
Sources of Business Finance
Finance is the life blood of every business as all types of businesses need money at every stage of their operation. It is of vital importance particularly for the modern businesses which require huge capitals. Finance is actually the determinant of the firm formation and it not only influences the ability of any firm to enter in the market but also affects its performance after the entry. Empirical studies have shown that sufficient size of initial capital play an important role in boosting the ability of the new firms to survive in the market (Bruderl et al. 1992, p.227), make higher profits and expand further (Bamford et al. 1999, p.253).
Now, the question is that how can businessmen and entrepreneurs gather these huge amounts of money? Do they have enough money that they can do business with their own money; which is obviously difficult in cases of large businesses? Therefore, entrepreneurs and businessmen utilize the various options available in the internal and external environment along with their own equity in order to arrange the required amount of capital or funds. Finance is required in different amounts by different businesses and for different periods. Therefore, business finance is classified into two broad categories depending upon the period for which it is required, these are; Short-term Finance and Long-term Finance. Short-term finance is taken for less than a year and the long-term finance is acquired for a period of more than five years.
Sources of Finance
In broad terms, finance can be gathered by the businessmen for their businesses by the two main categories of sources; internal sources and external sources. The businessman will have to either invest his own capital or borrow from outside or can use both sources for meeting the finance needs. Many businessmen invest their own capital, 'owner's capital', and retain the profits they have earned. This is a cost effective source of getting capital and very important part of every organization but has its own limitations. Therefore the business organzaitions have to use the other internal and external sources of finance in order to meet their needs.
There are different external sources from which businessmen can get finance, these can be; banks, financial institutions, capital markets, money lenders, producers, manufacturers, foreign financial institutions and agencies, friends and relatives etc. However, the scope of raising fund also depends on the form of business organization. For instance, the sole proprietorship and partnership form of business organizations have limited internal and external resources for arranging funds. These forms of organizations usually gather the long-term capital from the owners themselves while the short-term finance is gathered from different sources which include:
Manufacturers and Suppliers
Friends and Relatives
The above sources are not only used by sole proprietors but are also used in case of partnership firms. However, in case of companies, the finance is usually gathered through the following sources:
Methods for Raising Short-Term Finance
There are different methods used for raising the short-term finance. These are:
1. Bank Credit
Discounting of bills
2. Trade Credit
3. Customer's advances
5. Owner's Saving
Implication of Short-Term Finance Sources
Different short-term finance sources have different conditions and features due to which the implication of these sources also differs. For instance an overdraft is a flexible source of finance and can be used when the need arises and it can be repayable on demand. Another short-term finance source, "short-term loan" is borrowed from bank with its repayment to be made within one year. The company has to pay interest on this loan, which can be fixed or floating at regular intervals, like half yearly or quarterly and sometimes also monthly. If compared with the over draft, this short-term loan taken from banks is less flexible as the full amount of loan has to be taken by the company over the loan period and company also make a commitment to pay interest on this amount. Contrary to that in case of overdraft, interest is paid by the company only on the amount they have borrowed and not on the agreed overdraft limit. Security from the company is also required by the bank in order to grant this short-term loan.
Another common source of short-term finance "Trade Credit" is used by the companies in which it is agreed to take payment of goods and services at a later date on which the goods and services were supplied to the consuming company. Usually one, two or three-month's credit is offered on the commercial transactions and this source is considered by the companies as one of the major source of the short-term finance.
Banks also provide advance money to the companies by discounting the bill of exchange. When this bill is given to the bank for encashment, the bank credits the amount from the account of the company and also deducts some discount. This amount varies depending upon the interest of the period of bill. The payment is received from the drawee through bank on the maturity of that bill.
As listed above, another method for raising short-term financing is factoring. In factoring the company takes money in advance from the bank against the amount that it has to receive from its debtors. The company pays a specified charge to the bank for collecting the amount from its debtors and collects its money in advance without even waiting for the due date to come. By factoring the company also stays away from the efforts of collecting its money from the debtors.
Sometimes the company asks for advance payment from its client before delivering goods and services. This usually happens in the case of big and costly orders for which the company needs finance to start working on them. Clients agree to pay this advance payment to the company for the goods that are either not easily available in the market or the company is giving them a very cheap or ideal offer. This way the company gets money in hand and meets its requirement of short-term finance without paying any interest.
Another source through which business can save its self from paying any interest is the owner's savings. This also helps owner is keeping his control on the business. However, if the business fails, the owners lose everything and is left empty hands, secondly owners have a limited amount of money so they need some other source as well.
No matter what type of short-term source businesses use, is always more flexible and cheaper as compared to the long-term sources of finance. For instance, the short-term interest rates are lower than the long-term interest rates. Similarly an overdraft is flexible than a long-term loan in which the company must have to pay a fixed amount of interest annually.
However, one problem with the short-term finance resources is that these are riskier than the long-term resources, in terms of the business that is borrowing, because these cannot be renewed or can be renewed on less favorable terms. Another risk associated with short-term finance is that the interest rates keep hanging as compared to the long-term finance in which risk is compounded if the floating rate short-term debt is used. Therefore businesses should seriously decide on whether they need short-term finances or long-term finances for meeting their business needs.
Methods for Raising Long-Term Finance
In small organizations the long-term finance is invested by the owner while in large organizations like the joint stock companies, long-term finance is collected through the following different options that are available for raising funds.
1. Share Capital
2. Preference Shares
3. Issuing Debentures/Bonds of Different Types
4. Loans from Financial Institutions
5. Loans from Commercial Banks
6. Retaining Profits
7. Foreign Investment
8. Lease Financing
9. Public Deposits
10. Venture Capital Funding
Implication of Long-Term Finance Sources
Since long-term finance is taken for a period of more than five years and involves huge amounts of money so the sources of gathering it are also complex. Looking at the complexities, firms usually don't use just one source of finance but look for multiple sources; this is also because it is difficult to get huge amounts of money from only one source.
Same like short-term financing sources, long-term financing sources also have different characteristics and conditions apply on the borrower. Each source has advantages and disadvantages. For instance, retained profit which is the amount that company saved in the past years, is one of the sources of long-term finance. Its positive point is that there is no cost for interest and business itself controls everything. Its disadvantage on the other side is that company will be left empty hand if the project failed which obviously company would not like to face by taking risks.
A common source of long-term source utilized by most of the business companies is taking loan…[continue]
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