Investment Banking |
June 16Sources 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.