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Sources Of Finance – An Introduction

Sources Of Finance – An Introduction

No company can survive without finance; every company needs finance for its expansion or working capital requirements. Let us study the sources of finance in brief:

Sources of finance can be categorized into two heads:

A.   Internal Sources

B.   External Sources

INTERNAL SOURCES

When sources of finance are internally generated i.e. within the business they are known as internal sources of finance. In the early era of corporate finance these used to be the major sources of finance for a company. Broadly they can be categorized into following:

1. Reinvested profit

2. Working capital

3. Sale of assets

REINVESTED PROFIT

This is the most common and cheapest source of finance.  Reinvested profit refers to the retained profits of the company. Over the years, the profit the firm makes does not all need to be paid out to the owners i.e. shareholders through dividends.  Some profit is kept in the business to reinvest. No business whether company or otherwise can grow without ploughing back its profits in the business.

SALE OF ASSETS

Sale of fixed assets is also an alternative source of finance but this source is effectively can’t be termed as source of finance as the fixed assets are used for production and to generate revenue and their sale can affect the potential capacity of the business – the amount it can produce. A fixed asset is anything that is not used up in the production of the good or service concerned – land, buildings, fixtures and fittings, machinery, vehicles and so on. But at the time of slump and losses they may be an active source.

WORKING CAPITAL

It is the day-to-day finance for all businesses and consists of cash and those assets which can quickly be turned into money like stock, creditors etc. It is calculated as Current Assets less Current Liabilities and readily called as Net Current Assets. Firms can also ask for trade credit as a source of working capital, which is prevailing in all sorts of markets.  This is when they can delay payment for goods that have been delivered to them.  Another source of working capital is a bank overdraft that is short term borrowing from banks.

Simply, working capital = current assets – current liabilities

EXTERNAL SOURCES

This is finance that comes from outside the business. It may involve the business owing money to outside individuals or institutions. It is generally seen for a new start-up business has to get all of its finance from external sources of finance.

Broadly External Sources can be categorized into the following:

1. Owner’s Fund or Ownership Capital

2. Borrowed Funds or Non-Ownership Capital

OWNER’S FUND OR OWNERSHIP CAPITAL

The finance which is provided in the form of purchase of shares in company and normally can’t be paid back i.e. permanent source of capital (finance) is known as Owner’s Funds or Ownership Capital. In this context, ‘owners’ refers to those people/institutions who are shareholders. Shares are units of investment in an incorporated company, whether it be a public or private limited company. Shares are generally broken down into following two categories:

i. Equity Shares

ii. Preference shares

Equity Shares

This is a very important source of finance for companies. A share issue involves a business selling new shares that entitle the shareholders to share in the control of the business. Each share gives the shareholder a vote on the direction of the company. This usually means that the shareholder can elect the board of directors (the individuals who run the business of the company) of the company each year. If the shareholder doesn’t like the way the directors are running the business, they can elect new directors. An equity share gives the right to shareholders to share in the profits of the company in the form of dividends. Since the profits of companies can vary wildly from year to year, so can the dividends paid to ordinary shareholders.

Preference Shares

Preference shares are also treated as owner’s funds and earn their income in the form of dividend but they differ from equity shares in the following two ways:

  • Preference shareholders are often entitled to a fixed dividend even when equity shareholders are not.
  • Preference shareholders cannot normally vote at general meetings.

Preference Shares may be Cumulative or Non- Cumulative, Participating or Non-Participating, Convertible or Non- Convertible preference shares.

BORROWED FUNDS OR NON-OWNERSHIP CAPITAL

The funds which are not owner’s funds or generated from internal sources are fall under this category. Following are the main sources of borrowed funds:

  1. Debentures
  2. Term Loans
  3. Overdraft facilities
  4. External commercial Borrowings
  5. Hire purchase and Leasing
  6. Venture Capitalist
  7. Factoring

Debentures

This is a form of long term finance loan that can be taken out by a public limited company for a large sum and it will be paid back over several years. A debenture may be defined as an instrument of debt executed by the company acknowledging its obligation to repay the amount at a specified rate and alongwith interest. It is only one of the methods of raising the debt capital of the company. A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount with interest and although the money raised by the debentures becomes a part of the company’s capital structure, it does not become share capital. Debentures are loans that are usually secured and are said to have either fixed or floating charges with them. Debenture may be Secured or Unsecured or Convertible or Non-Convertible Debentures.

Term Loans

This is the most usual way of financing used by the companies. Term Loan may be defined as money advanced to a borrower, to be repaid at a fixed later date, usually with a fee called interest, is a percentage of the value of the loan. The long term loan generally from Financial Institutions (FI’s) or Banks are availed with the Fixed assets and stock-in-trade as collateral. The tern loan are usually availed for finance the projects to be taken up by the company. Term loans from FI’s or Banks are commonly used to buy fixed assets such as vehicles, building and machinery etc. The interest is charged on the amount borrowed, the rate depending upon the net-worth of the borrower, collateral issued etc. A business will pay the bank back the amount borrowed each month in installments generally through EMI.

The disadvantage of Loan is that the company has to pay back the loan even the company is making losses and in event of failure to pay back loan the lender may enforce winding up petition, however the loan is cheaper source of finance as compared to shares as the rate of interest is usually lower than the rate of dividend and the company has the option to pay it back. Also the Legal regime to raise Loan is relaxed in comparison to debentures.

Overdraft Facilities

If a business spends more money than it has in its bank account, we say that it has become overdrawn. Businesses will often have an arrangement with the bank whereby the bank will pay the extra money provided the business will pay them back in a fairly short period of time, with interest. This is a short term source of finance and is useful for small amounts. It is often used for buying supplies / inputs. Many companies have the need for external finance but not necessarily on a long-term basis and need finance not for their expansion or projects but for their routine activities like working capital requirement or to pay off short term creditors etc. The loan or issuing debenture will not be favorable for these transactions and are fulfilled through overdraft facilities with banks. Overdraft Facilities may be defined as a Loan arrangement under which a bank extends credit up to a maximum amount and for a charge or interest or both.  Overdraft Facilities are extensively used by companies to cater their temporary small cash flow problems from time to time.

External Commercial Borrowings

External Commercial Borrowings (ECB) refer to commercial loans [in the form of bank loans, buyers’ credit, suppliers’ credit, securitised instruments (e.g. floating rate notes and fixed rate bonds)] availed from non-resident lenders with minimum average maturity of 3 years.

ECB is nothing but a kind of Loan availed from the lender outside the country, i.e. the amount borrowed cross border. ECB includes Foreign Currency Convertible bonds (FCCBs) mean a bond issued by an Indian company expressed in foreign currency, and the principal and interest in respect of which is payable in foreign currency. ECB can be accessed under two routes, Automatic Route, in which no prior Government approval is required or Approval Route, if the specified borrowing do not fall into Automatic Route the approval from Government is required.

Hire Purchase and Leasing

Leasing involves business renting equipment that it may use for several years or months but never own. It will have a contract with a company who may come in to repair and service the product. The deal may also involve the product being replaced with a new model every so often. Leasing may be of two types Operating Lease and Finance Lease.

Hire Purchase is a method of acquiring assets without having to invest the full amount in buying them. Typically, a hire purchase agreement allows the hire purchaser sole use of an asset for a period after which they have the right to buy them, often for a small or nominal amount. The benefit of this system is that companies gain immediate use of the asset without having to pay a large amount for it or without having to borrow a large amount.

Venture Capital

Venture Capital has become a vital aspect of the source of finance market over the last 5 to 15 years. Venture Capital can be defined as capital contributed at an early stage in the development of a new enterprise, which may have a significant chance of failure but also a significant chance of providing above average returns and especially where the provider of the capital expects to have some influence over the direction of the enterprise. Venture Capital can be a high risk strategy. However, it is another form of owner’s capital only as funding through venture capital is generally done through issue of shares whether preference or equity.

Factoring

Factoring over a period of time has emerged as a handy tool of short term finance. In factoring the factor purchase all your pending bills for a charge so the company gets immediate realization of their pending invoices. Companies use factoring services because they do not have the resources to chase debts, and because they get immediate – if smaller – cash inflow when they sell the invoice.

Factoring allows you to raise finance based on the value of your outstanding invoices. Factoring also gives you the opportunity to outsource your sales ledger operations and to use more sophisticated credit rating systems.