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Sources of Finance

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Sources of Finance

Businesses aim to maximise their financial gains but they also need financial capital to operate. So where does their money come from? Well, there are a variety of sources of finance. Let's take a closer look at some of them.

Internal sources of finance

Sources of finance are the provision of finance for a business to fulfil its requirement for short-term working capital and fixed assets and other investments in the long term.

The internal sources of finance signify the money that comes from inside the organisation. There are various internal ways an organisation can utilise, for instance, owner’s capital, retained profit, and sale of assets. Internal finance can be considered as the cheapest type of finance, this is because an organisation will not have to pay any interest on the money.

Internal sources of finance examples

1. Capital brought by the owner

This is the investment that the entrepreneur brings into the business. This typically originates from their personal savings. This source of finance is the least expensive as there is no interest. It is generally the most significant source of finance for a startup business because the business will not have the assets or trading record which will help to get a bank loan.

2. Retained profit

It is when a business makes a profit, so it can reinvest it into the business if it decides to expand. Retained profit is also a good source of finance for the business as there is no interest charge, therefore, it is a desired type of finance.

3. Discount selling

Retail businesses have the choice to sell the unsold inventory in order to generate the much-required finance.

A retail store could sell the extra clothes from the last season at a lower price so that quick cash can be raised, this will also save the expense of storage.

4. Selling of fixed assets

This money is raised from the sale of fixed assets in the business which may not be required anymore. Several businesses have additional vehicles, equipment, or machinery that they can simply sell.

Advantages and disadvantages of internal sources of finance

Some of the advantages of internal sources of finance include:

  • Internal sources of finance let the business sustain complete control. When the business is utilizing its internal sources of finance, then it does not have any repayment obligations as it’s the case in external debt. There is no pressure to match the payment roster to the earnings roster.

  • It enhances the planning process. Businesses are more cautious with the use of internal finance when planning a project than in comparison to external finance. There is no misapprehension that the business has the cash to spare while using internal sources of finance. It is just spending the money that the business has generated or kept on a side for a project. This means that there is less spending on inessential things and therefore, presents positive spending habits over a period of time.

  • It lowers the overall cost of projects. When the business is using external sources of finance, then it will have to pay interest on it which makes it expensive to borrow. However, if it’s using internal sources of finance to purchase something, then it will pay just the expense of purchase without having to pay any interest charges on it.

  • It will improve the reputation and value of the business. A great deal of external debt borrowed by the business is not liked by the investors. Higher debt ratios show higher risk levels, hence reducing the value of the business as a whole.

Some of the disadvantages of internal sources of finance include:

  • There will be an adverse effect on the operating budget. Since the business is utilizing internal sources to finance its needs, that money should come from somewhere. For the majority of businesses, it means using cash from the capital or operating budget. Hence, there is not sufficient money available for managing daily expenses. That is why businesses use internal sources only to finance the short-run project.

  • It needs accurate estimations to be effective. If the business is using internal sources of finance for a project, then the project’s cost estimations should be considered accurate for it to be effective. Precise estimates are needed in order to calculate the forecasted return, which is essential for future needs to plan a budget.

  • It may take longer to finish projects. With external financing, the business will immediately get all the funding needed for the project and allow it to start the work right away. But with internal financing, access to money can at times be slow. The business might need to create funding levels prior to starting a project.

External sources of finance

External sources of finance can come from individuals or other sources which do not have direct trade with the organisation.

External sources of finance signify the money that comes from outside the organisation.

Long-term external sources of finance

Equity shares

They are a common source of financing for established businesses. All businesses can not utilize this form of financing as it is administered by several regulations. The main element is the division of ownership rights in equity shares; hence, the present shareholder rights are reduced to a certain extent.

Debentures

Debentures are a usual source of finance utilized by businesses who choose debt on equity. Debt is regarded as the cheapest form of finance in comparison to equity. There is no sharing of control with investors. This is due to the reason that the interest given to debenture holders is tax-deductible.

Term loan

The components of a term loan are identical to debentures apart from that it does not have a lot of cost of issuing as it is provided by a bank or other financial institutions. A thorough evaluation of the organisation’s financials and forthcoming plans is done by the bank to assess the debt servicing capability of the business. Such loans are assured by some assets.

Short-term external sources of finance

Bank overdraft

It is a simple form of short-term finance. At times a business may require money for daily expenses which may be because of a time gap amid the collection and payments. So, in order to fill this gap, a bank draft is a perfect short-term source of financing.

Trade credit

It is the credit that is provided to a company by its creditor or suppliers. This permits a company to postpone its payments for a certain period of time. This time of credit is subject to the credit terms among the company and the suppliers.

External sources of finance examples

1. Family and friends

A business can borrow money from family and friends and it is fast and cheap to arrange in comparison to a bank loan. There can be negotiations about flexible interest charges and repayment.

2. Share issues

Businesses can generate cash with the sale of shares to external investors. This is a long-run and comparatively tension-free way to raise funds because there are no repayments and interest to be paid on capital being raised. Nonetheless, this will give away some of the ownership stakes in the business. Profits will be divided as dividends are paid to shareholders and there will be no complete control of the business.

3. Business angels

Business angels are professionals and investors who offer finance to companies with increasing growth potential.

They also provide not just the cash but also their skills, experience, and networking that will be vital for a startup. The drawback is that shares in the business are given away and no complete control over how the business will run.

Advantages and disadvantages of an external source of finance

Some of the advantages of external sources of finance include:

  • Conserving the internal resources - External financing permits the business to utilize the internal financial resources for some other usage. If a business has an investment that has a high-interest rate in comparison to the bank loan, then it's logical that the business preserves its internal resources and places its money in that investment, and uses external sources of finance for business operations.
  • Growth - One of the reasons that businesses go for external financing is that it permits them to finance growth projects that the business can not finance on its own.
  • Guidance and expertise - Institutions that finance a business are usually valuable sources of expert assistance. Also, an investor may be willing to offer his expertise or direct towards suitable sources of advice.

A bank that might have funded several other small businesses can give advice on how to prevent traps that created difficulty for some.

Some of the disadvantages of external sources of finance:

  • Loss of ownership - Certain external sources of finance may require the business to share ownership in the company for their funding. The business may get a large amount of money it requires to launch or promote a new product but will also have to give the investor this right to vote on the company's decisions.
  • Interest charges - External sources of finance need a return on their investments. For example, a bank will have an interest charge on the loan and an investor will require a return on his investment. Typically, interest will add up to the cost of investment making it a greater burden than in the initial plan.

What are the factors of business financing?

Financial factors are the factors used to assess the different options concerning financial measures. Although each organisation is diverse, the general factors included in business financing are consistent and lasting.

1. Capability to repay

The most persistent factor is the ability to pay back is of utmost importance. Any business should be able to show this ability prior to considering other factors. The business should have proof that they have enough cash flow above operating expenses in order for the repayment of the loan.

2. History of repayment

The history of a business’s repayment records on time is a crucial factor. If the business has a clear record of paying the loans, then it should be able to obtain the finance it requires. But if the business previously had problems, then it will have to prepare a letter explaining the issues and indicate that the repayment issues have been resolved.

3. History of cash flows

Although very profitable businesses are always striking, consistent cash flow is a highly significant factor in commercial loans. Lenders are aware that cash flow shows the ability of the business to repay. Hence, even though the company shows historically decent profits- still close to the break-even point and the company shows consistently increasing cash flows, then lenders are not too sceptical to lend.

What are the factors that affect business financing?

The factors are as follows:

1. Nature of the business

If the nature of the company needs hefty equipment and machinery, then fixed capital will considerably be needed, or else a small amount of fixed capital will be needed. But if the nature of the business is to manufacture consumer goods, then higher levels of finance will be needed.

2. Size of the business

If a company is of huge size, then it will need more land and building, equipment and machinery, etc. In order to fulfil these needs, there is a higher volume of fixed and working capital needed.

3. Production method

If the production method is more labour-intensive, then low finance is required. But if there is more usage of machinery instead of labour with a complex production process, then high financing is needed.

4. Business cycle

If the business cycle is in the boom, then there is low capital needed, however, the need for working capital will increase.

What are the factors that influence the choice of business financing?

There are different factors that have an impact on the choice of sources of financing. Some of the are as follows:

Cost - Businesses have to assess the cost to mobilize and utilize the funds. For example, where the interest charges could be comparatively low in debentures, term loans, etc.

Sources of Finance - The choice of funding sources is based on the type of the company. The issuing of shares and debentures cannot be done by sole proprietors and partnership businesses. They have to rely on short-term sources, for example, hire purchase, leasing, bank finance, etc. Unlikely, businesses, government organisations, and cooperative organisations can get funds from long-term as well as short-term sources.

Time period - The time period for which the company needs finance ascertains the relevant source. For example, if funds are needed for the short-term then bank overdraft, cash credit, leasing, bill discounting, etc. are more appropriate. If funds are needed for the long term- then issuing shares, term loans, debentures, etc. are more appropriate.

The risk aspect - Funds owned by the business do not have any risk but borrowing funds involve a great deal of risk. This is because of the interest charges which may result in the liquidation of the business in addition to the damage to the reputation.

The phase of development - A newly launched business may find it difficult to mobilize business finance in comparison to a developed business. Hence, it might have to depend on the owned sources in the early stages. Once the business is developed it can then consider borrowing funds and will be in a position to keep its assets as a security.

Credit worth of the business - Certain sources of finance like debentures and creditors need the company to mortgage the assets. This will damage the creditworthiness of the business.

Sources of Finance - Key takeaways

  • Sources of finance are the provision of finance to an organisation to fulfil its requirement for short-term working capital and fixed assets and other investments in the long term.

  • The internal sources of finance signify the money that comes from inside the organisation. Examples: retained profit, capital brought by the owner, selling of fixed assets, discount selling, etc.

  • Some of the advantages of internal financing include that the business can sustain complete control, enhance the planning process, lower costs of a project.

  • Some of the disadvantages of internal financing include that there will be adverse effects on the operating budget, it requires accurate estimates, and may take longer to finish a project.

  • ­External sources of finance signify the money that comes from outside the organisation. Examples: friends and family, business angels, share issues, bank loans, new partners, etc.

  • Two types of external finance: Long-term external (equity shares, debentures, and term loans) and short-term (bank overdraft and trade credit)

  • The benefits of external financing are conserving the internal resources, growth, guidance, and expertise.

  • Drawbacks of external financing are loss of ownership and interest charges.

  • The most persistent factor in business financing, the ability to pay back is of utmost importance.

  • The history of a business’s repayment records on time is a crucial factor.

  • Factors that affect business financing include the nature and size of the business, production method, and business cycle.

  • Factors that influence the choice of source of financing include cost, type of organisation, time period, risk and control aspect, phase development, and credit worth of the business.

Frequently Asked Questions about Sources of Finance

Sources of finance are internal and external. 

Capital, retained profit, and discount selling are internal sources of finance. 

Equity shares, debentures etc. 

Internal(capital, retained profit) and external (term loans, debentures) are the sources of finance available to a business. 

No, trade credit is short-term source of finance. 

Final Sources of Finance Quiz

Question

Define sources of finance.


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Answer

Sources of finance are the provision of finance to an organization to fulfill its requirement for short-term working capital and fixed assets and other investments in the long-term.

Show question

Question

Define internal sources of finance.

Show answer

Answer

The internal sources of finance signify the money that comes from inside the organization.

Show question

Question

Are internal sources of finance the cheapest?


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Answer

Yes, Internal finance can be considered as the cheapest type of finance, this is because an organization will not have to pay any interest on the money.

Show question

Question

Is internal financing the most significant source of finance for startups?


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Answer

Yes, because the business will not have the assets or trading record which will help to get a bank loan.

Show question

Question

Why is the retained profit a desirable form of financing?


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Answer

This is because there is no interest charge.

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Question

Define external sources of finance.


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Answer

External sources of finance signify the money that comes from outside the organization.

Show question

Question

How can an organization benefit from its retained profit?


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Answer

The organization can decide to reinvest this profit into the business. This type of source of finance also does not have interest charges, therefore, it is a desired type of finance.

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Question

How are family and friends an external source of finance for an organization?


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Answer

An organization can get a loan or get the money that might not need to be given back or is paid back with low or no interest from family and friends.

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What are the types of external sources of finance?


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Short-term and long-term

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Is equity share a common source of external financing?


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Answer

It is a common source for established businesses, not all businesses can utilize this form of financing because of regulations.

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Question

List the benefits of external sources of finance.


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Answer

Conserving the internal resources, growth, guidance, and expertise from banks for instance.

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Question

What is the most consistent factor in business financing?


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Answer

The most persistent factor is the ability to pay back is of utmost importance.

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 Why is good cash flow history important?


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Answer

Lenders are aware that cash flow shows the ability of the business to repay.

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Question

Why is business financing difficult for startups?


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Answer

This is because they do not have a previous record of payments and they may not have additional assets to give as security.

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Question

List factors that affect business financing?


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Nature of the business, size, production method, business cycle.

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Does cost influence the choice of financing?


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Yes, businesses have to assess the cost to mobilize and utilize the funds and see which source of finance has a lower interest rate.

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Why should the risk aspect be considered?


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Risk should be considered because of the interest charges which may result in the liquidation of business in addition to the damage to the reputation.

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Does the form of business have an influence in choosing business financing?


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Answer

The choice of funding sources is based on the type of the company. For example, the issuing of shares and debentures cannot be done by sole proprietor and partnership businesses and they need short-term sources such as bank finance, hire purchase, etc.

Show question

Question

The internal sources of finance is the money that comes from...

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Answer

inside the organisation.

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Question

Which of these is not an external source of finance?

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Answer

Retained profit

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Which of these is an external source of finance?

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Term loan

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Which of these is an internal source of finance?

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Capital brought by the owner

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Family and friends is an internal source of finance.

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False

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A company with increasing growth potential found an investor who offers finance. What do we call this person?

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business angel

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This type of source of finance can lead to the loss of ownership. What type is it?

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Answer

An external source of finance

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What do we call a credit that is provided to a company by its creditor or suppliers?

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Answer

Trade credit

Show question

Question

A retail store could sell the extra clothes from the last season at a lower price so that quick cash can be raised, this will also save the expense of storage. What method of raising finance would they use?

Show answer

Answer

Discount selling

Show question

Question

This type of source of finance lowers the overall cost of projects. What is it?

Show answer

Answer

Internal source of finance

Show question

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What do we call a simple form of short-term finance?

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Answer

Bank overdraft

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Question

Which of these sources of finance is less expensive?

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Answer

Capital brought by the owner

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Can newly established businesses use retained profits to raise finance?

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Answer

No

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Question

These sources of finance let the business sustain complete control. What are they?

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Answer

Internal sources of finance

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