Sources of Finance

Sources of finance for business are equity, debt, debentures, retained earnings, term loans,
working capital loans, letter of credit, euro issue, venture funding, etc. These sources of funds
are used in different situations. They are classified based on time period, ownership and
control, and their source of generation. It is ideal to evaluate each source of capital before
opting for it.

Table of Contents
1. Long-Term Sources of Finance
2. Medium Term Sources of Finance
3. Short Term Sources of Finance
4. Owned Capital
5. Borrowed Capital
6. Internal Sources
7. External Sources
On the basis of a time period, sources are classified as long-term, medium-term, and short-
term. Ownership and control classify sources of finance into owned and borrowed capital.
Internal sources and external sources are the two sources of generation of capital. All the
sources have different characteristics to suit different types of requirements. Let’s understand
them in a bit of depth.
According to Time Period

Sources of financing a business are classified based on the time period for which the money
is required. The time period is commonly classified into the following three:

MEDIUM TERM
LONG TERM
SOURCES OF
SOURCES OF SHORT TERM SOURCES OF FINANCE / FUNDS
FINANCE /
FINANCE / FUNDS
FUNDS

Share Capital or Equity Preference Capital

Trade Credit
Shares or Preference Shares

Preference Capital or
Debenture / Bonds Factoring Services
Preference Shares

Retained Earnings or
Lease Finance Bill Discounting etc.
Internal Accruals

Hire Purchase
Debenture / Bonds Advances received from customers
Finance

Medium Term
Term Loans from
Loans from
Financial Institutes, Short Term Loans like Working Capital Loans from Com
Financial Institutes,
Government, and Banks
Government, and
Commercial Banks
Commercial Banks

Venture Funding Fixed Deposits (<1 Year)

Asset Securitization Receivables and Payables

International Financing
by way of Euro
Issues, Euro Equity,
Foreign Currency
Loans, ADR, GDR etc.
Long-Term Sources of Finance
Long-term financing means capital requirements for a period of more than 5 years to 10, 15,
20 years or maybe more depending on other factors. Capital expenditures in fixed assets like
plant and machinery, land and building, etc of business are funded using long-term sources of
finance. Part of working capital which permanently stays with the business is also financed
with long-term sources of funds. Long-term financing sources can be in the form of any of
them:

• Issue of shares is the main source of long term finance. Shares are issued by joint stock
companies to the public. A company divides its capital into units of a definite face value, say
of Rs. 10 each or Rs. 100 each. Each unit is called a share. A person holding shares is called a
shareholder.

 Share Capital or Equity Shares

 Preference Capital or Preference Shares
 Retained Earnings or Internal Accruals
 Debenture / Bonds
 Term Loans from Financial Institutes, Government, and Commercial Banks
 Venture Funding
 Asset Securitization
 International Financing by way of Euro Issue, Foreign Currency Loans, ADR, GDR,
etc.

EQUITY SHARES • Equity shares are shares which do not enjoy any preferential right in the
matter of payment of dividend or repayment of capital. The equity shareholder gets dividend
only after the payment of dividends to the preference shares. • Equity shareholders are the
real owners of the company. They have a control over the management of the company.
Equity shareholders are eligible to get dividend if the company earns profit
PREFERENCE SHARES • Preference Shares are the shares which carry preferential rights
over the equity shares. These rights are (a) receiving dividends at a fixed rate, (b) getting
back the capital in case the company is wound-up. Investment in these shares are safe, and a
preference shareholder also gets dividend regularly.
CREDITORSHIP SECURITIES • Creditorship Securities also known as debt finance which
means the finance is mobilized from the creditors. Debenture and Bonds are the two major
parts of the Creditorship Securities.
• Debentures • A Debenture is a document issued by the company. It is a certificate issued by
the company under its seal acknowledging a debt. According to the Companies Act 1956,
“debenture includes debenture stock, bonds and any other securities of a company whether
constituting a charge of the assets of the company or not.”
DEBENDTURES • Whenever a company wants to borrow a large amount of fund for a long
but fixed period, it can borrow from the general public by issuing loan certificates called
Debentures. • These are offered to the public to subscribe in the same manner as is done in
the case of shares. A debenture is issued under the common seal of the company. It is a
written acknowledgement of money borrowed. It specifies the terms and conditions, such as
rate of interest, time repayment, security offered, etc.
Types of Debentures : • Debentures may be classified as: • a) Redeemable Debentures and
Irredeemable Debentures • b) Convertible Debentures and Non-convertible Debentures.
Short Term Sources of Finance
Short term financing means financing for a period of less than 1 year. The need for short-term
finance arises to finance the current assets of a business like an inventory of raw material and
finished goods, debtors, minimum cash and bank balance etc. Short-term financing is also
named as working capital financing. Short term finances are available in the form of:

 Trade Credit
 Short Term Loans like Working Capital Loans from Commercial Banks
 Fixed Deposits for a period of 1 year or less
 Advances received from customers
 Creditors
 Payables
 Factoring Services
 Bill Discounting etc.

According to Ownership and Control:

Sources of finances are classified based on ownership and control over the business. These
two parameters are an important consideration while selecting a source of funds for the
business. Whenever we bring in capital, there are two types of costs – one is the interest and
another is sharing ownership and control. Some entrepreneurs may not like to dilute their
ownership rights in the business and others may believe in sharing the risk.

OWNED CAPITAL BORROWED CAPITAL

Equity Financial institutions,

Preference Commercial banks or

Retained Earnings The general public in case of debentures.

Convertible Debentures

Venture Fund or Private

Equity
Owned Capital
Owned capital also refers to equity. It is sourced from promoters of the company or from the
general public by issuing new equity shares. Promoters start the business by bringing in the
required money for a startup. Following are the sources of Owned Capital:

 Equity
 Preference
 Retained Earnings
 Convertible Debentures
 Venture Fund or Private Equity
Further, when the business grows and internal accruals like profits of the company are not
enough to satisfy financing requirements, the promoters have a choice of selecting ownership
capital or non-ownership capital. This decision is up to the promoters. Still, to discuss, certain
advantages of equity capital are as follows:

 It is a long-term capital which means it stays permanently with the business.

 There is no burden of paying interest or installments like borrowed capital. So, the
risk of bankruptcy also reduces. Businesses in infancy stages prefer equity for this
reason.
Borrowed Capital
Borrowed or debt capital is the finance arranged from outside sources. These sources of debt
financing include the following:

 Financial institutions,
 Commercial banks or
 The general public in case of debentures
In this type of capital, the borrower has a charge on the assets of the business which means
the company will pay the borrower by selling the assets in case of liquidation. Another
feature of the borrowed fund is a regular payment of fixed interest and repayment of capital.
Certain advantages of borrowing are as follows:

 There is no dilution in ownership and control of the business.

 The cost of borrowed funds is low since it is a deductible expense for taxation
purpose which ends up saving on taxes for the company.
 It gives the business the benefit of leverage.

ACCORDING TO SOURCE OF GENERATION: Based on the source of generation, the

following are the internal and external sources of finance:

INTERNAL SOURCES EXTERNAL SOURCES

 Retained profits Equity

Reduction or controlling of
Debt or Debt from Banks
working capital

Sale of assets etc. All others except mentioned in Internal Sources

Internal Sources
The internal source of capital is the one which is generated internally by the business. These
are as follows:

 Retained profits
 Reduction or controlling of working capital
 Sale of assets etc.
The internal source of funds has the same characteristics of owned capital. The best part of
the internal sourcing of capital is that the business grows by itself and does not depend on
outside parties. Disadvantages of both equity and debt are not present in this form of
financing. Neither ownership dilutes nor fixed obligation/bankruptcy risk arises.

External Sources
An external source of finance is the capital generated from outside the business. Apart from
the internal sources of funds, all the sources are external sources.

Deciding the right source of funds is a crucial business decision taken by top-level finance
managers. The usage of the wrong source increases the cost of funds which in turn would
have a direct impact on the feasibility of the project under concern. Improper match of the
type of capital with business requirements may go against the smooth functioning of the
business. For instance, if fixed assets, which derive benefits after 2 years, are financed
through short-term finances will create cash flow mismatch after one year and the manager
will again have to look for finances and pay the fee for raising capital again.

Retained Earnings (Internal source of finance) • Like an individual, companies also set aside
a part of their profits to meet future requirements of capital. • The portion of the profits which
is not distributed among the shareholders but is retained and is used in business is called
retained earnings or ploughing back of profits. As per Indian Companies Act., companies are
required to transfer a part of their profits in reserves. The amount so kept in reserve may be
used to buy fixed assets.This is called internal financing
Public Deposits • It is a very old source of finance in India. When modern banks were not
there, people used to deposit their savings with business concerns of good repute. Even today
it is a very popular and convenient method of raising medium term finance. The period for
which business undertakings accept public deposits ranges between six months to three years

Any member of the public can fill up the prescribed form and deposit the money with the
company. The company in return issues a deposit receipt. This receipt is an
acknowledgement of debt by the company. The terms and conditions of the deposit are
printed on the back of the receipt.

Borrowing From Commercial Banks : • Traditionally, commercial banks in India do not grant
long term loans. They grant loans only for short period not extending one year. But recently
they have started giving loans for a long period. Commercial banks give term loans i.e. for
more than one year. • Commercial banks give loans to organizations in either cash credits,
overdrafts, term loans, purchase/discounting of bills, or issue of letter of credit. Banks help
enterprises by providing loans to produce goods and contribute towards industrial growth and
generate employment opportunities.

Financial Institutions • The economic development of any country depends on the growth of
the business sector. The well developed financial system helps the business to achieve growth
by making funds available to them. For which, the government has established financial
institutions all over the country to provide finance to businesses.

Special Financial Institutions • 1. Industrial Finance Corporation of India (IFCI) •

2. State Financial Corporations (SFC) •

3. Industrial Credit and Investment Corporation of India (ICICI)

Short-term Financial Requirements or Working Capital Requirement

• Apart from the capital expenditure of the firms, the firms should need certain expenditure
like procurement of raw materials, payment of wages, day-to-day expenditures, etc.

• This kind of expenditure is to meet with the help of short-term financial requirements which
will meet the operational expenditure of the firms. Short-term financial requirements are
popularly known as working capital.

• Short-term source of finance include: •

● Bank Credit

● Customer Advances ●
Trade Credit ● Factoring

● Public Deposits

● Money Market Instruments

• Trade Credit

• Trade credit refers to the credit extended by the supplier of goods or services to his/her
customer in the normal course of business. Trade credit occupies a very important position in
short term sources financing due to the competition. Almost all the traders and manufacturers
are required to extend credit facility (a portion), without which there is no possibility of
staying back in the business. • Trade credit is a spontaneous source of finance that arises in
the normal business transactions of the firm without specific negotiations (automatic source
of finance). In order to get this source of finance, the buyer should have acceptable and
dependable creditworthiness and reputation in the market.

• Factoring • Cash lubricates the wheels of trade, business and industry. Cash flow is
necessary to meet commitments – statutory or otherwise. But, unfortunately for the sellers of
goods and services, credit sale is the order of the day, worldwide. The most vulnerable
segments are the small and medium sector enterprises. Delayed realisation of the sales
receivables elongates their working capital cycles. Poor bookkeeping and collection
mechanisms along with inadequate and delayed institutional credit hasten their untimely
sickness.

• Public Deposits • Public deposits or term deposits are in the nature of unsecured deposits,
have been solicited by the firms (both large and small) from general public primarily for the
purpose of financing their working capital requirements.

• Commercial Papers (CPs) • Commercial paper represents a short term sources unsecured
promissory note issued by firms that have a fairly high credit (standing) rating. It was first
introduced in the USA and it was an important money market instruments. In India, Reserve
Bank of India introduced CP on the recommendations of the Vaghul Working Group on the
money market. CP is a source of short term sources finance to only large firms with sound
financial position. CAPITALIZATION

• Capitalization refers to the valuation of the total business.

• It is the sum total of owned capital and bor-rowed capital. Thus it is nothing but the
valuation of long-term funds invested in the business.

• It refers to the way in which its long-term obligations are distributed between different
classes of both owners and creditors.

TYPES OF CAPITALIZATION • Over Capitalisation:

 • Many have confused the term ‘over-capitalisation’ with abundance of capital and ‘under-
capitalisation’ with shortage of capital. An enterprise becomes overcapitalised when its
earning capacity does not justify the amount of capitalisation.

• Over-capitalisation has nothing to do with redundance of capital in an enterprise.

• Overcapitalization occurs when a company has issued more debt and equity than its assets
are worth. The market value of the company is less than the total capitalized value of the
company. An overcapitalized company might be paying more in interest and dividend
payments than it has the ability to sustain long-term.

Causes of over-capitalization:

• Acquiring assets at inflated prices:

• Over-issue of capital:

 Formation during the boom period:

• Over estimation of earnings:

 Shortage of capital

• Liberal Dividend Policy

Under-Capitalisation:

• Generally, under-capitalisation is regarded equivalent to the inadequacy of capital but it

should be considered as the reverse of over-capitalisation i.e. it is a condition when the real
value of the corporation is more than the book value.

• A company is said to be under-capitalised when it is earning exceptionally higher profits as

compared to other companies or the value of its assets is significantly higher than the capital
raised.

The following are the causes for under-capitalization:

• Acquisition of Assets during Recession

• Underestimation of earnings

• Unforeseeable increase in earnings

• Conservative dividend policy

• Efficient Management