Finance is the most crucial aspect of any business, and it becomes difficult to survive when the sources get drained out for them. Have you ever wondered how companies like Apple, Google, Wipro, TCS, L&T, and other major companies are functioning for so long despite having highs and lows in their business tenure?
Whether you are just starting up or have been in business for several years, managing funds for a business or start up is the most significant part of entrepreneurial skill. Businesses always require funds to operate, expand or taking ahead to the next level.
In this article, We will provide you detailed information on different sources of finance for a business.
Table of Contents
Sources of funds – Classification
Before we go ahead, we need to understand the classification of funds. The businesses primarily require funds for their fixed capital requirements and working capital requirements.
The source of funds can be classified based on following perspectives.
- Time Period – According to the duration of financing, the sources of finance are classified.
- Ownership – According to ownership/ control.
- Source of Generation – As per source of generation of funds for businesses.
1) Time Period:
Since time duration plays a crucial role in deciding the various significant factors such as interest rate, repayment period, the purpose of finances, and others. A business cannot make a foreign investment despite the availability of required funds for short-term periods. All the purpose of finances gets nullified when the time factors are not appropriately considered.
- Long-term sources of finance –
- Equity Shares/ Share capital
- Preference Shares
- Venture Capital
- Business Loans
- Extermnal Sources
- Medium-term Sources of finance –
- Term Loans
- Public deposits
- Lease financing
- Short-term sources of finance –
- Trade Credit
- Bill Discounting
- Customer’s Advance
- Commercial Paper
Long-term Sources of Finance –
The long term varies from business to business, but in the general scenario, finance takes five years, and more are considered long-term sources. Businesses use that sources for expansion, purchase of fixed assets, and reinvestment into R&D and others.
This is ideally the best way to attract a good amount in the short term if the business prospects are bright. Here a business launches its Initial public offer (IPO) or FPO in the stock markets and invites people to invest money to get some shares or equities in the company.
You might have heard the name of Sensex, NIFTY, Bombay stock exchange, and other terms related to share markets. In India, more than 20 shares markets are available, out of which the Bombay stock exchange (BSE) and the National stock exchange (NSE) are relatively more popular. A business launches its IPO to accumulate long-term finance for its working, expansion, interest payment, capital expenditure, and others spending.
This is another category of stock market listing where the share is allotted to some preferential investors with a fixed dividend. Those investors enjoy preferential rights and get the benefits of profits in the form of dividend. Experts put this category between the equity and debt category of finances. Fixed dividend category, preference over equity, and preferential shares without voting rights are significant categories.
Here, small companies get finance from big organizations or wealthy and reputed investors. An ordinary public can’t invest money through these options. Experts call these options a business financing another business model.
A business reserves portions of its profits or earnings for its day-to-day functioning and other purposes. Whenever the business feels the need for some additional finance source, they use their internal accruals. In simple words, it can be called saving for the business that becomes useful when it is needed.
It is a type of written documents where the business promise to provide some benefits like a higher rate of interest, the percentage in their profits, preferential treatment for the share purchase, and others. Business issues these bonds at a specific cost for the general public to purchase with predefined terms and conditions. Based on a certain period, the bond gets mature, and an investor gets the benefits. Business issues different types of bonds such as zero-coupon, plain vanilla, deferred coupons, step-downs, inverse floaters, participatory, and more.
There are slight differences between bonds and debentures. It is issued mainly during the course of the business, and companies back it by promise rather than any collateral or security like bonds. In the financial market, debentures are considered riskier than bonds as business requires paying more interest on the investment.
Finances taken for a long term varying between 5 to 10 years are regarded as term loans. Based on the business prospects, financial institutions such as banks, government, international institutions, etc., provide loans to businesses for the long term. A business pays the taken amount to the lender based on terms and conditions agreed upon when signing the deal.
External financing source:
Big businesses also get the opportunity to attract finance from internal financing sources such as foreign currency loans, Global Depository Receipt (GDR), American Depository Receipt (ADR), Euro issue, etc. This option is very beneficial for businesses when there are devaluations of the Indian currency as they get more finance when the loan is converted into Indian currency. However, when the business needs to pay the loan back, they require to pay more.
Medium-term Source of finance –
Medium-term finance refers to the way of financing where the business requires paying back the amount within 3 to 5 years. Businesses prefer to choose medium-term financial courses when the long-term source is unavailable or when there is a need to fulfill some financial obligations.
In general parlance, all long-term sources are also available for business for the medium term. They get finances through the share market, preferential share placement, bonds issuance, Debentures issuance, financial institutions, internal accruals, and others.
Short-term Sources of Funds
As the name itself denotes, businesses require such types of funds, especially when they need cash for less time, mainly less than one year. The companies utilize it to maintain inventory, pay salaries, interest payments, other working capital requirements, etc.
Short-term loans –
All major commercial banks offer short-term loans or working capital loans to the business. A business requires submitting the relevant document for financing. These types of loans attract high interest due to high risk and the short repayment period.
This way, businesses generate the credit source from other firms or organizations, such as suppliers, contractors, creditors, and others. It is also called delay of payment as based on credit; the business gets an exemption to pay the due amount or any liabilities after some time. Competitions, buyers’ credibility, business prospects, liquidity positions, pay payment records, profit-making ability, etc., determines the trade credit possibility.
Here, a business sells its bill receivables to another party with some discount in order to get finances. It is like internal management between businesses to raise funds for the short term. Factoring reduces the credit risk and helps in maintaining a healthy working capital cycle for the business.
Bill discounting –
This is applicable for a business that sells goods or provides services in the market. Here, the business recovers some proportion of invoice from the financial intermediaries, buyers, etc., before it is due. Invoice discounting is a good practice in the case of high-value transactions. Financial intermediates like banks provide short-term finance to businesses and reduce the risk of default involved in the business cycles.
This is the easiest and most important way to get short-term finance for the business. It means the business gets the goods or services without making the immediate cash payment to suppliers or sellers. In simple terms, a business gets the raw materials now with terms and conditions of paying the amount after the agreed time frame.
Creditors can be any individual, business entity, financial institution, etc. Businesses take short-term loans from anyone with excess amounts or intend to earn some extra money through interest. A business also takes credit from other businessmen and pays the principal amount with interest through EMI or a one-time payment.
Customer’s Advances –
Big customers give the advance payment in order to get the goods/services at an agreed time. This way of financing is very prevalent where high investment is required for a business to formulate products or deliver services. The business also gets advances if the supply is scarce and demand is high for the product. For example, when the reputed car maker launches the new car variant, customers make the advance payment for booking the car with the delivery promise in the future.
Sources of finance – Control and Ownership
Businesses raise funds either by diluting the ownership or by paying the interest to the creditors in general parlance. The second option, where a business needs to pay interests, the financing becomes a costly affair for them many times. In that case, some entrepreneurs dilute the ownership with the creditors and get long-term to short-term funds. Here, the source of finance can be classified into two categories-
Owned capital –
As the name itself denotes, businesses own the capital until they cannot pay the agreed amount or choose to let go of their holdings. Equity, convertible debentures, earnings, venture fund, etc. are an example of owned capital. A business issues the shares and gets money for their requirement.
Later, the equity trades on the share market and go up & down based on various conditions. In the later stage, when the equity value is high, the business still has an option to buy back the equity or share the ownership from the investors.
In owned capital, a business does not require to pay interests, as well as it reduces the various risk associated with running a business.
Borrowed capital –
Business borrows capital from financial institutions, commercial banks, the general public, and others to meet their cash requirement. Here business pays the interests on agreed terms for keeping the money when themselves.
Final Words –
Hopefully, you have got some idea about the financial sources of business. A business is like a combined entity of individuals with great power, flexibility, and growth prospects. They use all the internal as external sources for finances and get that as and when required.
It is a simple give-and-take relationship where the other person/institutions give the money to a business in anticipation of earning interests or getting some control.