Exploring Sources of Finance
Sources of finance refer to the provision of funding to an organization for fulfilling short term and long term requirements.
In this article on sources of finance, we will be discussing the most important sources that facilitate funding.
Table of Content
What is Finance?
Finance is a huge domain with a significant and practical impact on humans in modern civilization. Be it maintaining a modern lifestyle, be it starting a business or be it maintaining a business, finance is inevitable. The main aim of any business is smooth operation to achieve its final goal. Be it a non-profit or a for-profit organization, every business needs financial sources for funding its operations and projects. This is why sources of finances are required.
Such sources help businesses in fulfilling operational requirements, including fixed assets, working capital and other types of investments. By leveraging sources of finance, one can invest capital in processes and projects that are important for business and financial growth.
The choice of source of funds depends on the specific needs of the company and the availability of different financing options. For example, a company that is looking to finance a new product launch may choose to raise debt financing, while a company that is looking to expand into a new market may choose to raise equity financing.
Classification of Sources of Finance
Sources of funds can be classified into two main categories: internal and external.
Internal Sources of Funds
- Retained earnings: Profits that are not distributed to shareholders as dividends but are reinvested in the business.
- Accumulated depreciation: The cumulative amount of depreciation expense that has been recorded over the life of a fixed asset. Depreciation expense is a non-cash expense, so accumulated depreciation represents a source of cash that can be used to finance new investments or pay down debt.
- Sale of assets: The sale of fixed assets, such as land, buildings, or equipment, can generate cash that can be used to finance new investments or pay down debt.
External Sources of Funds
- Debt financing: The borrowing of money from lenders, such as banks or bondholders. Debt financing can be used to finance new investments, working capital needs, or acquisitions.
- Equity financing: The issuance of new shares of stock to investors. Equity financing is used for raising capital for new investments, working capital needs, or acquisitions.
- Government grants and subsidies: Grants and subsidies from government agencies can be used to finance specific projects or initiatives.
Hybrid Sources of Funds
- Venture capital: This is a type of equity financing that is for early-stage companies with high growth potential. Venture capitalists invest in companies that have not become profitable but have the potential to become major players in their industry.
- Private equity: Private equity is a form of equity financing that is provided to established companies. Private equity firms typically acquire controlling stakes in companies and then work with management to improve the company's performance and profitability.
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Different Sources of Finance
The following are the sources of finance:
1. Lease Financing
It represents a contractual agreement between the asset owner (lessor) and asset user (lessee). This is a long-term financing option where the asset owner grants the right to another person to use the asset in lieu of a periodic payment.
A contract containing all terms and conditions of the lease is prepared. The periodic payment made by lessee to lessor is known as lease rental. Once the contract gets over, the asset is handed back to its owner. If the owner wants, an agreement for further lending or purchase of asset is offered.
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2. Trade Credit
Trade credit is one of the sources of finance offered by one trader to another for purchase of products and services. This facilitates the purchase of goods without making immediate payment. The credit shows in the buyer of goods’ records as ‘accounts payable’ or ‘sundry creditors’. Businesses use trade credit when they need a short-term source of finance.
Anyone with strong financial status and reputation is granted trade credit. The term and amount of trade credit is determined by the financial status, number of purchases, firm’s reputation, payment history and market’s competition level.
3. Venture Capital
It is a type of private equity and a financing option that is offered by investors to startups and small businesses having long-term potential. Well-known investors, investment banks and other financial institutions provide venture capital as a source of finance. Other than monetary aid, venture capitalists help with technical and managerial expertise.
Most venture capitalists invest in early-stage companies in lieu of equity or ownership. Investing in such companies is done with the aim of gaining ROI when the company becomes successful. Most venture capital investments occur after the initial ‘seed funding’ round. The first round of institutional venture capital for funding growth is known as the Series A round.
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4. Debenture
A debenture is a bond or debt instrument which is not secured by collateral. Such debt instruments must rely on the creditworthiness and reputation of the issuer. Government, as well as organizations, issue debentures for raising funds.
Corporation use debentures as long-term loans, even if these are unsecured. These are the debt instruments that pay an interest rate and are redeemable or repayable on a fixed date. Debentures come with the backing of the financial viability and creditworthiness of an underlying company.
5. Preferred Stocks
It is a percentage of stock that refers to an ownership or equity in the firm. Preferred stock is a special stock that pays a set schedule of dividends. It has limited rights which do not include voting. Preferred stock is the source of finance that combines the features of both common stocks and bonds into one security.
It combines stable and consistent income payments of bonds with the equity ownership advantage of common stocks. This includes the potential for shares to rise in value over time. Such a share provides the holder with a priority over common stock holders for claiming the company assets on liquidation. It also offers dividend payments to shareholders.
6. Crowdfunding
It refers to the use of the small amount of capital from multiple individuals as a source of finance for business ventures. Here, many people are invited from social media and crowdfunding websites to bring together investors and entrepreneurs. Through crowdfunding, entrepreneurs can raise money for investment purposes. Crowdfunding is a great source for ensuring that both businesses and individuals receive the required funding.
7. Term Loan
A term loan offers borrowers with a lump sum of cash upfront on following borrowing funds. The borrowers agree to pay certain repayment schedules with fixed or floating rates of interest. It requires a substantial down payment to reduce payment amounts and total loan costs.
Here, the borrower agrees to pay the lender with fixed amount over a certain repayment schedule with fixed or floating rate of interest. These are usually granted to small businesses that require cash for purchasing equipment, fixed assets and buildings for production processes. Many businesses borrow cash when they need to operate on a month-to-month basis.
8. Angel Investors
These are the high-net-worth individuals that provide financial backing to entrepreneurs and startups. For angel investment, these investors ask for ownership equity in the company. The financial support provided by angel investors may be one-time investment or be ongoing support for carrying out company operations. These investors aim for startups with the capability of a higher return on investments than focusing on traditional investment opportunities.
9. Retained Earnings
It refers to the amount of profit available with the company once it has paid direct and indirect costs, income taxes and dividends to shareholders. When retained earnings are accumulated over years, it is known as ‘accumulated profits’.
It represents the portion of the company’s equity for investing in research, marketing and purchasing new equipment. These are reflected in the equity section of balance sheet. For smaller businesses, retained earnings are reflected on the income statement.
Conclusion
Every business requires sources of finance for starting, smoothly running and managing a business. Only when there are sufficient funds the organization runs properly. These sources of finance are classified on the basis of time, source of generation and ownership and control. Based on the prerequisites of the business model, the organization can choose the source of funds.
FAQs
What is the main principle of finance?
Time value of money is the fundamental principle of finance. According to this principle, the value of money increases with time.
Which are internal sources of finance?
When the money comes in from a business, it is known as the internal source of finance. Retained profit, assets and owner's capital is the internal source of finance.
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