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Sources of Finance

Sources of finance refers to where a business gets money from. There are two main sources: internal sources like owner's capital and retained profits, and external sources like short, medium, and long term funds from commercial banks, shareholders, and financial institutions. A business must consider factors like cost of capital and balance of equity vs debt when deciding on its capital structure.

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119 views13 pages

Sources of Finance

Sources of finance refers to where a business gets money from. There are two main sources: internal sources like owner's capital and retained profits, and external sources like short, medium, and long term funds from commercial banks, shareholders, and financial institutions. A business must consider factors like cost of capital and balance of equity vs debt when deciding on its capital structure.

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Mahathi
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© © All Rights Reserved
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FINANCE

SOURCES OF FINANCE
SOURCES OF FINANCE

Sources of finance refers to where


a business gets money from to
fund their business activities.

Entrepreneurs needs funds to


establish a business, operate
business activities and to expand
the business in future.
There are two main sources of finance:

• Internal sources of finance:


Internal sources of finance refers to the finance generated within the
business.

• External sources of finance:


External sources of finance refers to the cash flow generated outside of
the business.
Internal sources of finance:
•Owner’s capital
The entrepreneur invests their own money into the business, usually in the form of personal savings or selling personal assets. Owner can invest capital at any stage of business life.

•Retention of profit
The business may retain a part of the profits and utilise it as capital.

•Sale of assets
Whenever business sell off its assets and the cash generated is used for financing the capital needs.
External sources of finance are of three types:
• Short term funds.
Short term funds which arise for a short period of time often not exceeding
one year

• Medium term funds


Medium term funds which are required for a period exceeding one year but
not exceeding five years.

• Long term funds


Long term funds which are for a period exceeding five to ten years.
External sources of finance

SHORT TERM FUNDS MEDIUM TERM FUNDS LONG TERM FUNDS

1. Commercial bank 1. Hire purchase 1. Shares


2. Leasing 2. Debentures
2. public deposits
3. Financial institutions
3. Trade credits 4. Commercial banks
4. Factoring 5. Public deposits
5. Bill discounting
6. Bank overdraft
SHORT TERM FINANCE
• Commercial banks
Banks provide short term loans which are repaid within a year.

• Trade credit
A business sets up an account with their suppliers and agrees payment terms, then pay for
goods or services on later date.

• Factoring
Factoring is a financial transaction between a business owner and a third party that provides
instant cash to the former in exchange for the account receivables of the business.

• Bill discounting
Bill Discounting is a trade-related activity in which a companys unpaid invoices which are
due to be paid at a future date are sold to a financier.
• Bank overdraft
Bank overdraft is where the business is allowed to be overdrawn on its account. This
means they can still write cheques, even if they do not have enough money in the account.

MEDIUM TERM FUNDS


• Hire purchase
Hire purchase is a method of financing of the fixed asset to be purchased on future date. Under
this method of financing, the purchase price is paid in installments.

• Leasing
Leasing is one of the important sources of medium term financing where the owner of an asset
gives another person, the right to use that asset against periodical payments.
LONG TERM FUNDS
• Shares
Business may sell more of their shares to raise money. These are issued to the general public.
These may be of two type : Equity share & Preference shares.

• Debentures
Debentures is a type of debt instrument issued by a company.

• Financial institutions
Financial institutions established by the Central and State governments which give long term
loans at reasonable rates of interest.

• Public deposits
public deposits refers to any money received by a company through the deposits or loans from the
public.
COST OF CAPITAL
Cost of Capital is the rate of return the firm expects to earn from its investment in
order to increase the value of the firm in the market.

It is the rate of return that the suppliers of capital require as compensation for their
contribution of capital.

Classification of cost of capital:


1. Historical cost and future cost
2. Specific cost and composite cost
3. Average cost and marginal cost
4. Explicit and implicit cost
Entrepreneurs has to take a few critical decisions regarding the sources of finance:

1. Out of the available sources,from whom should he borrow?


2. How much should he borrow?
3. Should he borrow from one source or have multiple sources for borrowings?

A investment decisions for new projects should always generate a return that exceeds the
firm’s cost of the capital used to finance the project. Otherwise, the project will not generate a
return for investors.
CAPITAL STRUCTURE
Capital structure is defined as the combination of equity and debt that is put into use by a company
in order to finance the overall operations of the company and for its growth.

Equity capital is the money owned by the


shareholders or owners. It consists of two different
types:
1. Contributed capital
2. Retained earning

Debt capital is referred to as the borrowed money


that is utilised in business. It consists of two types:
3. Long term - Bonds
4. Short term - Commercial paper
BASIS FOR COMPARISON CAPITAL STRUCTURE FINANCIAL STRUCTURE
Definition Capital Structure is a Financial Structure is a
combination of different types of combination of different types of
long term sources of funds. long term as well as short term
sources of funds.
Scope Capital Structure has a narrower Financial Structure has a broader
scope compared to Financial scope compared to Capital
Structure. Structure.
Includes Equity capital, preference Equity capital, preference
capital, retained earnings, capital, retained earnings,
debentures, long term debentures, long term & short
borrowings etc. term borrowings etc.
Balance sheet The Capital Structure is a part of The Financial Structure includes
the Liabilities section of the all the items in the Liabilities
Balance Sheet. section of the Balance Sheet.

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