Sources of Finance

Finance is the lifeblood of a business. Adequacy of finance is a fundamental requirement for the survival, growth, and profitability of a company. The financing needs of a company are satisfied through an entire ecosystem of institutions engaged in providing money to them in some manner or the other. Choosing the finance for the company is equally important as it determines the associated obligations.

The need for raising money can arise because of a variety of factors such as the expansion of business financing of an acquisition, increasing cost of production etc. However, there are also many avenues from which a business can raise funds. However, the availability of the funds from a particular source along with the terms and conditions for fundraising differ significantly as per the profile of the business. The primary sources of business finance include debt, equity, internal accruals, or a combination thereof.

We classify these sources of business finance based on

(a) time,

(b) ownership, and

(c) source of funds.

(a) Time: The sources of business finance involve a threefold classification exists based on the time period such as,

1. Long Term

This type of financing fulfills the fund requirements of a company for an interminable period ranging from an upward of at least ten years. Long-term financing looks at facilitating the growth and expansion plans of a company. It may also invest in businesses that have a lengthy gestation period. It can be in the form of either debt or equity capital. The debt capital can comprise bonds, debentures, term loans, venture debt, etc. and the equity capital may constitute equity shares, preference shares, warrants or other convertible securities. A careful analysis of the interest and principal repayment obligations in case of debt financing must be done. With equity financing, the extent of dilution of shareholding of existing shareholders has to be considered.

2. Medium Term

Medium-term entails financing for a period between three to five years. Medium-term financing assumes importance when a company cannot raise funds on a long-term basis or wants to write off deferred expenditures. The modes of raising money under this head include debentures or bonds for a fixed medium duration, lease financing, medium-term loans, and hire purchase finance.

3. Short Term

The short term encompasses all the financing facilities available for a period of less than one year. This bridges the mismatch between current assets and current liabilities in a particular financial year. It also helps to satisfy working capital requirements. Examples include short term working capital loans, trade credit, discounting of bills of exchange, advance payment from customers, etc.

(a)     Ownership: based on ownership and control a particular mode of financing provides it can be divided into two owned capital and borrowed capital.

ü  Owned Capital

Owned capital involves infusion of funds in the company by existing shareholders or by bringing in new shareholders. Hence, either the promoters of the company may provide the needed funds or funds that may be obtained from the public by shares. This expands the capital base of the company and results in the dilution of equity and control. It is comparatively cheaper to the alternative that is borrowed capital as there are no repayment obligations. Equity shares, preference shares, warrants, convertible debentures, convertible preference shares, etc. fall under this category. 

ü  Borrowed Capital

Borrowed capital is also referred to as debt capital, it involves receiving funds from designated institutions like commercial banks and financial institutions. Such type of financing is usually secured by creating a charge on the assets of the company. The charge can be fixed or floating. There is no dilution of ownership or control and the interest paid is a tax-deductible expense. Fixed period interest payment obligations are also attached to borrowed capital. Any default relating to payment adversely affects the credit profile of the company and the future fund-raising capability. 

(a)     Sources: based on point of generation we can classify the sources of funds into:

ü  Internal Sources

Internal sources refer to the use of funds generated by a business in its day-to-day operations in financing the capital needs of a company. The advantage of utilizing the internal sources is that they do not result in the creations of any leverage on the company. However, the funds so generated may prove insufficient in satisfying the requirements of the company. These sources comprise retained earnings, reduction of working capital requirements, and sale of assets. 

ü  External Sources

External sources refer to raising funds from sources outside that of the business. As a general rule, all sources except internal sources are deemed to fall under this head. Examples include raising money from investors, venture capitalists, angel investors, etc. A significant aspect of this financing is that it comes with a set of restrictions and obligations, the impact of which must be carefully analyzed before accepting it.

The aforementioned list is not exhaustive. There are multiple mechanisms that a company may use with subtle variations to raise funds. A company may also use a combination of different sources of funds to ensure the diversifications of risk. A thorough analysis of each of the methods is imperative to determine the right mix of funds because it has far-reaching ramifications towards the running of a company. The availability of funds to a business depends on not only the company but also the market conditions. Hence, it becomes important to assess the market too before proceeding with the decision to raise funds.