How entrepreneurs access internal and external sources of business finance

Business Finance

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:

Retained Profits

Commercial Banks

Finance Companies

Moneylenders

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:

Commercial Banks

Financial Institutions

Capital Market

Leasing Companies

Investment Trusts

Public Deposits

Retained Profits

Methods for Raising Short-Term Finance

There are different methods used for raising the short-term finance. These are:

1. Bank Credit

Loans

Cash credit

Discounting of bills

Bank overdraft

2. Trade Credit

3. Customer's advances

4. Factoring

5. Owner's Saving

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 from banks and financial institutions. The problem with taking loans in long-term is the high interest rates which increase the cost of the business. Another issue that banks and institutions require is security in the form of business assets which business might lose if it did not repay the money. And last but not the least problem that although banks do not control the business but they keep asking for regular updates.

Another common source used for raising long-term finance is the issuance of shares in the company. This way company stays away from external problems but then it has to pay dividends at the end of year in order reward investors for their investment. The shareholders also take risk by investing because the value of shares keeps fluctuating. This way company controls its own operations but shareholders become part of ownership and vote for changes.

Lease financing is another source in which the business company pays monthly installment for using the assets but does not own it afterwards. Interest is also charged in this case and assets can be taken back if installments are not paid on time.

Venture Capital businesses are very large companies who lend money to smaller businesses. They buy shares of the small business and help it in growing over 3-7 years, so the share prices increase and then they sell the shares to make good profit.

It can be concluded from above discussion that risk and costs is always involved in case of both short-term as well has long-term finance. This cost is sometimes in the form of money and sometimes in the form of wastage of time and effort. Keeping these points in mind, sole proprietors, partners and companies should carefully plan their finance and should look for sources that offer them best package.