Sources of Business Finance

Any company needs funds to purchase fixed assets, meet working capital needs, and implement corporate growth and expansion plans. This chapter explains the owner’s fund in detail and also talks about the various sources of finance and how they are categorised in the real world.

Owner’s funds refer to the funds that the owners of an enterprise provide. Also known as the company’s accumulated profit. The company has no liability to return these funds.

Classification of Sources of Funds

The Classification of sources of Funds is generally done using different basis, Period basis sources, Ownership basis sources, and Generation basis sources. A brief explanation of these classifications and the sources are provided as follows:

1. Period-based Sources

• Short-term Funds: These funds are required for a period not exceeding one year. This includes trade credits, commercial bank loans, and commercial paper.

• Medium-term Funds: These funds are required for a period of no less than 1 year and no more than 5 years. Borrowings from commercial banks, lease financing, and loans from financial institutions are the type of medium-term sources of finance.

• Long-term Funds: These funding sources cover the company's financial needs for over five years. It includes stocks, bonds, long-term loans, loans from financial institutions, etc.

2. Ownership-based Sources

• Owner’s Fund: Owner's funds mean funds provided by the owners of an enterprise.

• Borrowed Fund: Borrowed funds are raised through loans and borrowings. These sources provide funds for a specific period of time. Loans from commercial banks, public deposits, and trade credit are some examples of borrowed funds. 

3. Generation-based Sources 

• Internal Sources: Internal sources funds refer to those funds that are generated from within the business. A business can generate funds internally by disposing of surplus inventories and retained earnings. 

• External Sources: External sources include funding that is external to your organisation. The funds raised from external sources are considered costly compared to the internal source of funds. These include issues of debentures and borrowing from commercial banks and financial institutions.

What Do You Mean by Owner’s Fund?

• The financing required for a company to start and operate a business is known as Business finance. Therefore, it is said that finance is the lifeblood of any business. A business cannot function without sufficient funds available. The initial capital brought in by the entrepreneur is not always enough to cover all the company's financial needs. Entrepreneurs should therefore seek out a variety of other sources that can meet their funding needs. Funds can be raised from personal sources or by borrowing from banks, friends, etc.

• Owner’s funds mean funds provided by the owners of an enterprise, which may be sole traders, partners, or shareholders of a company. In addition to capital, this includes profits reinvested in the company. The owner's capital remains invested in the company for a long time and does not have to be repaid during the life of the company. This capital forms the basis for the owner to acquire the right to control the business. Issue of equity shares and retained earnings are the two essential sources from which the owner’s funds can be obtained.

Sources of Funds

Some of the sources of funds are discussed below:

1. Retained Earnings: Retained earning refers to a part of the profit which is not distributed among the shareholders as dividends but is retained in the business for use in the future. Also referred to as ploughing back of profits.

Advantages

• A continuous source of funding available to an organisation.

• It has no explicit cost in the form of interest, dividends, or floatation costs.

• The funds are generated internally; that is why there is greater operational freedom and flexibility.

• It improves the business's ability to absorb unexpected losses, and it may increase the market price of a company's equity shares.

Disadvantages

• Excessive ploughing back may cause shareholder dissatisfaction because it results in lower dividends.

• It is an uncertain source of funds because business profits fluctuate.

• Many firms do not recognise the opportunity cost associated with these funds. This may result in inefficient use of funds.

2. Trade Credit: Trade credit is credit extended by one trader to another to buy and sell goods and services. The buyer of goods' records appears as various creditors or accounts payable.

Advantages 

• Trade credit is an easy and consistent source of funds.

• Trade credit may be readily available if the seller knows the customers' creditworthiness.

• An organisation's sales must be promoted through trade credit.

• If a company wants to increase its inventory level to meet an expected increase in sales volume in the near future, it can use trade credit to finance it; it does not charge the company's assets while providing funds.

Disadvantages

• The availability of simple and flexible trade credit facilities may induce a firm to engage in overtrading, which may increase the firm's risks.

• Trade credit can only generate a limited amount of funds; it is generally a costly source of funds when compared to most other methods of raising funds.

2. Commercial Papers: Commercial papers (CP) are unsecured money market instruments that take the form of a promissory note. It was first introduced in India in 1990 to allow highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide investors with an additional instrument.

Advantages

• A commercial paper is sold unsecured and without any restrictive conditions; it has high liquidity because it is a freely transferable instrument, and it provides more funds than other sources.

• The cost of commercial paper to the issuing firm is generally lower than commercial bank loans; commercial paper provides a continuous source of funds.

• This is due to the fact that their maturity can be tailored to the needs of the issuing firm.

• Furthermore, maturing commercial paper can be repaid by selling new commercial paper; businesses can park excess funds in commercial paper, earning a good return on the money raised.

Disadvantages

• Commercial papers are only available to financially sound and highly rated companies.

• This method is ineffective for raising funds for new and moderately rated businesses.

• The amount of money that can be raised through commercial paper is limited by the excess liquidity available with fund suppliers at any given time.

Case Study

Jane saw her father watching the news on TV. She asked his father why he was so focused on the news today. Jane’s father told her that the news was about the stock market as he had invested in some shares. However, Jane could not understand anything that her father explained about shares. Can you explain to Jane what shares are? Also, clarify important types of shares.

Ans: A company's capital is divided into small units known as shares. Share capital is the capital obtained by the issue of shares. We can divide the shares into equity shares and preference shares.

• Equity Shares: These shares represent the ownership of the company. Such shareholders do not get a fixed dividend and are known as residual owners. After all other claims on the company’s income and assets have been settled, they are entitled to what is left.

• Preference Shares: Holders of these shares get priority over equity shareholders in two ways: 

• Receiving a fixed rate of dividend. 

• Receiving their capital after the claims of the company’s creditors have been settled at the time of winding up.

Summary  

Businesses are engaged in producing and distributing goods and services to meet the needs of society. You cannot operate a business without sufficient funds. Once the decision to start a business is made, the need for funding begins. Finance is said to be the lifeline of a company. Assessing your organisation's financial needs and identifying various sources of funds is critical.