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.

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:

LONG TERM SOURCES OF MEDIUM TERM SOURCES SHORT TERM

FINANCE / FUNDS OF FINANCE / FUNDS SOURCES OF
FINANCE / FUNDS

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.

Medium term financing means financing for a period of 3 to 5 years and is used
generally for two reasons. One, when long-term capital is not available for the
time being and second when deferred revenue expenditures like advertisements
are made which are to be written off over a period of 3 to 5 years.

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.

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.

OWNED CAPITAL BORROWED 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.
 Borrowed or debt capital is the finance arranged from outside sources.

ACCORDING TO SOURCE OF GENERATION

INTERNAL SOURCES EXTERNAL SOURCES

The internal source of capital is the one which is generated internally by the
business.

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.

Financial Gearing

Financial gearing refers to the relative proportions of debt and equity that a
company uses to support its operations. This information can be used to
evaluate the risk of failure of a business. When there is a high proportion of
debt to equity, a business is said to be highly geared.

The formula used for financial gearing is:

(Short-term debt + Long-term debt + Capital leases) ÷ Equity

For example, ABC International is unable to sell any additional shares to

investors at a reasonable price to fund its expansion, and so obtains a
$10,000,000 short-term loan instead. The company currently has $2,000,000
of equity, so there is now a 5x ratio of debt to equity. The company would
most definitely be considered highly geared.

A company that engages in financial gearing probably does so for one of the
following reasons:

 The current owners do not want to dilute their ownership by issuing

shares to any new investors, so debt is the only remaining alternative for
raising funds.
 A company needs a large amount of cash right now, perhaps for
an acquisition, and cannot raise sufficient cash from investors to meet its
requirement.
 A company wants to increase its return on equity measurement, and
can most easily do so by using new debt to buy back shares from investors.
 A company is suffering a cash shortfall from its operations, and needs
additional cash to bolster its operations.
A major downside of financial gearing is that the cost of the debt could
increase, due to changes in market rates. Or, a company is achieving an
insufficient return on its use of the funds, and so cannot pay for the interest or
the return of principal. In either case, excessive gearing presents a significant
risk of bankruptcy. This is a particular problem during an industry downturn,
when cash flows inevitably decline. Consequently, the use of financial gearing
must be prudent, to allow for some use of additional funds while not putting a
business in jeopardy.