Finding sources of Business finance is the most critical part for a businessperson or entrepreneur when beginning a new firm. It requires the greatest amount of work and attention. The sources of business finance are classified according to ownership, time, duration, and control, among other factors, and are evaluated and employed in various scenarios.
Business Finance Meaning
Business finance is the management of money and funds within a business entity. It involves activities related to planning, procuring, and utilizing financial resources to achieve business goals and sustain operations. Business finance ensures the availability of necessary funds for various activities such as investments, operations, and expansions, thereby enabling the company to thrive and grow.
Classification of Sources of Business Finance
Business Finance sources are often classified using multiple criteria, such as time basis sources, ownership basis sources, and generation basis sources. The following is a quick explanation of these categories and their sources:
Period-based Sources:
Short-term Funds (up to 1 year):
Trade credits, commercial bank loans, commercial paper.
Medium-term Funds (1-5 years):
Borrowings from banks, lease financing, loans from financial institutions.
Long-term Funds (over 5 years):
Stocks, bonds, long-term loans, and loans from financial institutions.
Ownership-based Sources:
Owner's Fund:
Funds provided by owners.
Borrowed Fund:
Funds raised through loans and borrowings, including loans from banks, public deposits, and trade credit.
Generation-based Sources:
Internal Sources:
Funds generated within the business, like selling surplus inventories and retained earnings.
External Sources:
Funds from external sources, which are usually more expensive, including debenture issues, and loans from banks and financial institutions.
Sources of Business Finance
The choice of funding depends on factors such as purpose, cost, and associated risks. For instance, long-term funds might be needed for fixed capital requirements, while short-term sources can meet daily business needs. A few of the sources of Business finance are given below:
1. Retained Earnings:
Firms often keep a portion of their earnings for future use, known as retained earnings. It provides internal financing, offering operational freedom and flexibility.
Merits:
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A permanent source of funds for the organization.
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No explicit costs like interest or dividends.
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Offers operational flexibility and capacity to absorb losses.
May boost the market price of equity shares.
Limitations:
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Excessive retention may dissatisfied shareholders.
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Uncertain source due to fluctuating profits.
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Fails to account for opportunity costs, potentially leading to suboptimal fund utilization.
2. Trade Credit:
Trade credit, where one trader extends credit to another for purchasing goods, is a convenient short-term funding source. It's continuous and doesn't create charges on assets.
Merits:
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Convenient and continuous source of funds.
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Accessible when customer creditworthiness is known.
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Promotes sales and inventory expansion.
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Does not create charges on the firm's assets.
Limitations:
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Easy access may encourage overtrading, increasing risks.
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Limited funds can be generated through trade credit.
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Typically more costly than other funding sources.
3. Factoring:
Factoring involves selling receivables to a factor and providing cash flow and credit control services. While it accelerates cash flow and offers flexibility, it can be costly for numerous small invoices.
Merits:
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Cost-effective compared to traditional bank credit.
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Accelerates cash flow, enabling prompt liability payments.
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Offers a flexible and secure cash inflow pattern.
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Does not create asset charges.
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Relieves the client of credit control responsibilities.
Limitations:
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Becomes expensive with numerous small invoices.
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Higher interest costs for advanced finance.
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The involvement of a third-party factor may be uncomfortable for the customer.
4. Lease Financing:
Lease agreements allow businesses to use assets without a large initial investment. It's suitable for assets prone to quick obsolescence.
Merits:
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Enables acquiring assets with lower upfront investment.
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Simple documentation eases asset financing.
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Lease rentals are tax-deductible.
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Provides finance without diluting ownership.
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Does not affect the debt-raising capacity.
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Shifts obsolescence risk to the lessor.
Limitations:
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May impose restrictions on asset use.
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Non-renewal may disrupt business operations.
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Premature lease termination can lead to higher payouts.
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Lessee never becomes the owner, missing out on residual asset value.
5. Public Deposits:
Public deposits refer to funds raised directly from the public. These deposits pay out greater interest rates than bank deposits.
Merits:
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Simple procedure without stringent conditions compared to loans.
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Cost-effective compared to borrowing from banks.
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There is no charge placed on the assets of the firm.
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No voting rights for depositors, maintaining control of the company.
Limitations:
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New companies might struggle to attract public deposits.
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Unreliable sources as public response can be uncertain.
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Collection may be difficult, especially for large deposits.
6. Commercial Paper:
Commercial Paper (CP) is a promissory note that is an unsecured money market item.
Merits:
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Unsecured and easily transferable, ensuring high liquidity.
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Provides substantial funds at a lower cost compared to other sources.
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Offers continuous funds with flexible maturity.
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Allows companies to invest excess funds for additional returns.
Limitations:
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Limited to financially sound firms; new or moderately rated ones face challenges.
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Amount raised is restricted by available excess liquidity.
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Impersonal method; non-renewal could cause issues if the firm can't be redeemed.
7. Issue of Shares:
Share capital is raised by issuing shares, divided into equity shares and preference shares.
Merits:
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Equity shares are suitable for risk-taking investors.
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Dividend payment to equity shareholders is not mandatory, reducing company burden.
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Equity capital is permanent, safeguarding creditors in case of liquidation.
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Enhances company creditworthiness without asset charges.
Limitations:
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Investors seeking stable income might avoid equity shares due to fluctuating returns.
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Costlier than other funding sources.
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Dilutes voting power and earnings of existing equity shareholders.
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Involves formalities and procedural delays in fundraising.
8. Debentures
Debentures are instruments for raising long-term debt, promising fixed interest payments.
Merits:
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Attracts investors desiring fixed income with lower risk.
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Debentures are fixed charge funds, not linked to company profits.
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Suitable for stable sales and earnings situations.
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Does not dilute control of equity shareholders, as debentures lack voting rights.
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Cost-effective due to tax-deductible interest payments.
Limitations:
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Debentures create a constant financial burden due to fixed interest.
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Companies must allocate funds for redeemable debenture repayment.
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Debenture issuance reduces a company's borrowing capacity.
