Sources of Finance: Overview
Sources of finance for the business are debt, equity, retained earnings, debentures, term loans, letters of credit, working capital loans, venture investment, etc. These sources of finance are applied in many contexts. Sources of finance are categorized according to their generation source, ownership and control, and historical period. It is best to assess the sources of finance before choosing one.
The most explorable finance area in finance is sources of finance, particularly for business owners launching a new venture. It is arguably the most challenging aspect of all the work. We can categorize different investment sources according to various criteria.
Every finance manager faces the difficult task of selecting the appropriate sources of finance. Analyzing all the sources of finance in-depth is necessary to choose the best one. It requires knowledge of all the characteristics of the financial sources to analyze and compare the sources. Numerous traits serve as the basis for identifying sources of finance.
Sources of finance are divided into three categories based on how long, medium, and short they will last. Sources of finance are divided into owned and borrowed money based on control and ownership. The two sources of capital generation are internal sources and external sources. All the sources of finance have unique qualities to meet various requirements. Let’s get a better understanding of them.
Sources of Finance Categories
In this read, we’ll explain to you details about long-term sources of finance, medium-term sources of finance, short-term sources of finance, owned capital, borrowed capital, internal sources, and external sources.
According to Time Period
Depending on how long the money will be needed, different sources of finance are categorized for different types of businesses. The following three categories are frequently used to group the time period:
- LONG-TERM SOURCES OF FINANCE
- MEDIUM-TERM SOURCES OF FINANCE
- SHORT-TERM SOURCES OF FINANCE
Long-Term Sources of Finance
Long-term sources of funding are used to finance capital investments in fixed assets such as land, buildings, machinery, and other equipment used in the company. Long-term sources of funding are also used to finance a portion of working capital permanently retained by the business.
Depending on other considerations, capital requirements for a period of more than five years to ten, fifteen, or even more years are referred to as long-term sources of finance.
Any of the following are possible long-term sources of finance:
- Shares of equity or capital
- Preference Shares or Preference Capital
- Internal Accruals or Retained Earnings
- Bonds and debentures
- Term Loans from Government Agencies, Commercial Banks, and Financial Institutions
- Securitization of Assets Financed by Venture
- international financing by issuing euros (USD to Euros), loans in other currencies, GDRs, ADRs, etc.
Medium Term Sources of Finance
Three to five-year financing sources are referred to as medium-term sources of finance and are typically utilized for two purposes. One, when long-term capital is temporarily unavailable; two, when deferred revenue expenses, such as advertisements, are made and must be written off over three to five years. One of the following could be a medium-term financial source:
- Preference Shares or Preference Capital
- Bonds and debentures
- Governmental and commercial banks may offer medium-term loans.
- Finance for medium-term notes, leases, and purchases
Short Term Sources of Finance
finance that is provided on a short-term basis—less than a year. To finance a business’s present assets, such as its inventory of raw materials and completed items, debtors, and minimum cash and bank balance, among other things, short-term financing is required. Working capital financing is another name for short-term lending. You can obtain short-term financing in the following ways:
- Market Credit
- Advances received from customers
- Fixed Deposits for one year or less
- Working capital loans from commercial banks
- Financial Services
- Short Term Loans like Working Capital Loans from Commercial Banks
- Discounting of bills, etc.
Ownership and Control-wise
Finances are categorized according to who owns and controls the company. These two criteria should be considered when choosing a funding source for the company. Every time we raise cash, there are two types of costs: interest and the cost of distributing ownership and control. While some business owners may prefer to retain full ownership of their company, others could favor risk sharing.
Equity is sometimes referred to as owned capital. When new equity shares are issued, it comes from the company’s promoters or the general public. Supporters bring in the necessary funding to launch the company. The sources of owned capital are as follows:
- Retained Profits
- Bonds that convert
- Private equity or venture capital
Additionally, when a firm expands and internal accruals like profits are insufficient to cover financing needs, the promoters can choose ownership or non-ownership capital. The supporters will decide on this. Still, let’s talk about a few benefits of equity capital:
It is a long-term capital, which means the business will always have access to it.
Unlike with borrowed money, there is no obligation to make interest or installment payments. So, there is a decreased chance of bankruptcy. Equity is preferred in early-stage businesses for this reason.
The financing obtained from external sources is called debt capital or borrowings. The following are some of these sources of debt financing:
- Financial institutions
- Commercial banks
The borrower has a charge over the firm’s assets in this type of capital, which suggests that in the case of a liquidation, the company will pay the borrower by selling the assets. Monthly payment of set interest and capital payback are additional features of the loaned funds. These are a few benefits of borrowing:
- There is no loss of ownership or control over the company.
- The cost of borrowing money is minimal since it can be deducted from income for tax purposes, saving the business money on taxes.
- It provides leverage for the benefit of the company.
Selected by Source of Generation
The internal and external sources of finance are listed below based on the source of generation:
- INTERNAL SOURCES
- EXTERNAL SOURCES
The business’s internal capital is known as an internal source of capital. These are listed below:
- Retained earnings
- Reduction or managing working capital
- Asset sales, etc.
The features of owned capital are also present in the internal source of finances. The business grows independently of outside parties, which is the best aspect of internal capital sourcing. This type of funding does not have the drawbacks of either debt or equity. Neither ownership is diluted, nor is there a possibility of insolvency or fixed obligation.
The money raised outside of the company is referred to as an external source of financing. All sources are external sources, excluding the internal sources of funding.
Top financial managers make a critical business decision when choosing the best source of funding. The incorrect source’s use raises the cost of finances, directly affecting the project’s viability in question. A poor fit between the type of capital and the firm’s needs could hinder efficient operation. For instance, financing fixed assets with short-term funds that only pay off after two years will result in a cash flow mismatch after one year, forcing the manager to hunt for new funding sources.
What is the source of finance definition?
A finance source is where a company obtains funds to carry out its operations.
What are the 2 types of financing sources?
The two most well-known forms of financing are: Money provided by an external lender, such as a credit union, a bank, and building society, is referred to as debt financing. Equity financing is paid for with funds from your company.
What are internal sources of finance?
Any money a company can raise on its own is considered an internal source of finance.
What is the best source of financing?
- Personal Investment or Personal Savings.
- Commercial Bank Loans and Overdraft.
- Business Angels.
- Venture Capital.
- Assistant of Government.
- Financial Bootstrapping.
- What is the most important source of finance?
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Riya Gote is the Founder of Scriberlee. A digital marketing firm features in Forbes 2020 for providing quality content to global clients. She is an enthusiastic writer who helps firms attract visitors with her writing style and marketing strategies. Having 4+ years in SEO-based content writing, Riya has worked with different content platforms for 18+ industry sectors. She was featured in more than 70+ global newspapers. She has expertise in academic writing as well. She is emerging motivational speaker and a tarot card reader.