Sources of Finance – Detailed Classification

Every business, whether starting out or expanding, requires funds to operate and grow. The ability to identify, select, and manage the right source of finance is a core competence for any business. Let's break down the sources of finance.

Classification of Sources of Finance

a. Internal Sources of Finance

Internal sources refer to funds generated from within the business. These are typically less risky and do not create additional obligations to external parties. The two primary internal sources are:

• Retained Earnings: Profits that a company keeps after paying dividends. These can be reinvested back into the business for expansion or modernization.
• Depreciation Funds: Non-cash charges accumulated over time, representing the reduction in value of assets. While not a direct cash flow, depreciation provisions can be used for asset replacement.

b. External Sources of Finance

External sources involve funds raised from outside the business. These can be further divided based on the time frame for which funds are required.

Time-Based Classification of External Finance

a. Long-Term Sources

• Equity Shares: Ownership capital issued to the public. Shareholders have voting rights and a share in profits, but returns are not fixed.
• Debentures: Long-term, fixed-interest debt instruments. Debenture holders are creditors, not owners, and receive interest irrespective of profits.
• Term Loans: Loans from banks or financial institutions for a fixed period (usually over five years) and used for capital expenditure such as land, buildings, or equipment.
• Venture Capital: Equity funding provided to startups and high-growth firms with innovative ideas but higher risk.

b. Medium-Term Sources

• Medium-Term Loans: Loans usually ranging from one to five years, often used for working capital or purchase of machinery.
• Lease Financing: Acquiring the right to use an asset for a specified period without owning it. The lessee pays regular lease rentals.
• Hire Purchase: Similar to leasing but with the option to own the asset after all payments are made.

c. Short-Term Sources

• Trade Credit: Suppliers allow the business to buy now and pay later, commonly used for inventory purchases.
• Bank Overdraft: The business is allowed to withdraw more than its account balance up to a limit. Interest is charged only on the overdrawn amount.
• Short-Term Loans: Loans for periods less than one year, often to finance immediate working capital needs.
• Commercial Paper: Unsecured, short-term promissory notes issued by firms with strong credit ratings.

Advantages, Disadvantages, and Suitability of Each Source

a. Internal Sources

• Retained Earnings
  Advantages: No dilution of control, no interest cost, signals confidence in business.
  Disadvantages: May not be sufficient for large projects, over-reliance can reduce dividend payouts and affect shareholder morale.
  Suitability: Ideal for established firms with consistent profits.
• Depreciation Funds
  Advantages: Provides for asset replacement without external borrowing.
  Disadvantages: Cannot be used for expansion, only for asset renewal.
  Suitability: Useful for asset-intensive industries.

b. Long-Term External Sources

• Equity Shares
  Advantages: No repayment obligation, enhances creditworthiness, raises large capital.
  Disadvantages: Dilutes ownership, cost of equity is high, dividend not tax-deductible.
  Suitability: Best for new ventures and expansions.
• Debentures
  Advantages: Fixed interest, no dilution of control, interest is tax-deductible.
  Disadvantages: Obligatory payment even if profits are low, increases financial risk.
  Suitability: Suitable for companies with stable cash flows.
• Term Loans
  Advantages: Flexible, quick to obtain, interest payments are tax-deductible.
  Disadvantages: Requires collateral, involves regular repayment, can strain liquidity.
  Suitability: Best for asset creation, modernization.
• Venture Capital
  Advantages: High-risk funding for innovation, provides managerial expertise.
  Disadvantages: Involves sharing ownership and strategic control.
  Suitability: Startups and high-growth companies.

c. Medium-Term Sources

• Lease Financing
  Advantages: No upfront capital needed, tax benefits.
  Disadvantages: No ownership until lease ends, can be expensive long-term.
  Suitability: Businesses needing assets without heavy investment.
• Hire Purchase
  Advantages: Asset use from day one, option to own.
  Disadvantages: Higher total cost, asset ownership only after final payment.
  Suitability: Small businesses acquiring machinery or vehicles.

d. Short-Term Sources

• Trade Credit
  Advantages: Simple, interest-free if paid within period.
  Disadvantages: Limited to supplier willingness, may affect relations if delayed.
  Suitability: Managing inventory and sales cycles.
• Bank Overdraft
  Advantages: Flexible, interest only on amount used.
  Disadvantages: Can be withdrawn anytime by bank, higher interest than loans.
  Suitability: Meeting short-term cash deficits.
• Commercial Paper
  Advantages: Low cost, no collateral needed.
  Disadvantages: Only for firms with strong credit ratings.
  Suitability: Large, financially sound companies.

Comparative Table: Sources of Finance

Example

Consider a business planning to launch a new product line. Let's walk through their financing decisions step by step:

1. The company first checks retained earnings sufficient funds allow them to avoid external borrowing.
2. They estimate the need for additional funds. For large capital investment, they issue equity shares to the public.
3. To meet urgent working capital needs, they arrange a bank overdraft facility.
4. For machinery, they consider lease financing to avoid blocking funds in asset purchases.

Notice how a mix of sources, each with its own advantages and constraints, is used to serve different financial needs and time horizons. That's the essence of strategic financial management.