SOURCES OF FINANCE

INTRODUCTION
For many businesses, the issue about where to get funds from for starting up, development and expansion can be crucial for the success of the business. It is important, therefore, that you understand the various sources of finance open to a business and are able to assess how appropriate these sources are in relation to the needs of the business.

INTERNAL SOURCES
Traditionally, the major sources of finance for a limited company were internal sources: Personal savings Retained profit Working capital Sale of assets

EXTERNAL SOURCES
Ownership Capital In this context, 'owners' refers to those people/institutions who are shareholders. Sole traders and partnerships do not have shareholders - the individual or the partners are the owners of the business but do not hold shares. Shares are units of investment in a limited company, whether it be a public or private limited company. Shares are generally broken down into two categories:

Ordinary shares Preference shares

Non-Ownership Capital

Whilst the following sources of finance are important, they are not classed as Ownership Capital - Debenture holders are not shareholders, nor are banks who lend money or creditors. Only shareholders are owners of the company.

Debentures Other loans Overdraft facilities Hire purchase Lines of credit from creditors Financial structures of four well known British companies Grants Venture capital Factoring and invoice discounting:
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Factoring Invoice discounting

Leasing

INTERNAL SOURCE OF FINANCE

Finance is a constant requirement for every growing business. There are several sources from where a business can acquire finance or capital which it requires. But, the finance manager cannot just choose any of them indifferently. Every type of finance has different pros and cons in terms of its cost, availability, eligibility, legal boundaries etc. Choosing a right source of finance is a challenge. We need to have in-depth understanding of the characteristics of source of finance. Let us focus first on the internal source of finance / capital. Internal Source of Finance are the sources of finance or capital for business firms which are generated by the business itself in its normal course of operations. The key characteristic is that there is no outside dependency for catering the need of capital. Internal sources of finance are: The term Internal Source of Finance / Capital itself suggests the very nature of finance / capital. This is the finance or capital which is generated internally by the business unlike finances such as loan which is externally arranged from banks or financial institutions. Internal source of finance are retained profits, sale of assets and reduction / controlling of working capital.

1. Retained Profits / Retained Earnings:

Retained profits / earnings are called the internal source of finance for a business for the simple reason that they are the end product of running a business. The phenomenon is also known as Ploughing Back of Profits. Retained profits can be defined as the profit left after paying dividend to the shareholders or drawings by the capital owners. Formula for retained profits can be stated as below:

Retained Profits / Retained Earnings = Net Profits Dividend / Drawings

Characteristics of Retained Profits:

i. Retained earnings are a long term source of finance for a company because there is

no compulsory maturity like term loans and debentures. ii. Retained profits are also not characterized by fixed burden of interest or installment

payments like borrowed capital. Pros and Cons of Retained Profits as Internal source of finance / Capital: The advantage of having retained profits / earnings is clearly seen in its characteristics. First, they are long term finance and nobody can ask for their payments. Secondly, since there is no additional equity to be issued, there is no dilution of control and ownership in the business. Thirdly, there is no fixed obligation of interest or installment payments. Fourthly, retained earnings as an internal source of finance are cost effective considering the fact that there is no issue cost attached to it which ranges between 2 3 %. Lastly, investing retained earnings in the projects, with IRR better than ROI of the business, will directly have positive impact the shareholders wealth and thereby the core objective of management will be served.

This is often a very difficult idea to understand but, in reality, it is very simple. When a business makes a profit and it does not spend it, it keeps it - and accountants call profits that are kept and not spent retained profits. That's all. The retained profit is then available to use within the business to help with buying new machinery, vehicles, computers and so on or developing the business in any other way. Retained profits are also kept if the owners think that they may have difficulties in the future so they save them for a rainy day

1. Sale of Assets:
Another internal source of finance is the sale of assets. Whenever a business sells of its assets and the cash generated is used internally for financing the capital needs, we call it an internal source of finance by sale of assets. It can work as a short term or long term finance depending on what kind of assets are sold. Say, selling a car can cater short term and smaller finance needs and selling land, buildings, or machinery can cater to long term and bigger finance needs. A major drawback in this type of internal source of capital is that the benefits of useful assets which are sold can no more accrue to the business. A possible and perfect solution to that situation is Sale and Lease Back. It is a type of lease under which we can get the required cash and at the same time use the asset under concern in exchange for a lease rental. With this option, the business may end up paying more money in the long term but current finance problem can be solved. Reduction or Controlling of Working Capital: It is interesting to know how a reduction in working capital can work as an internal source of finance. Working capital has broadly, the following components: Current Assets, which include Stock / Inventory, Account Receivables - Debtors and Cash / Bank Balances Current Liabilities: which include Account Payables Creditors and Bank Overdraft. Normally, a business requires two types of finance viz. long term finance for capital expenditure and working capital finance for day to day needs. Reduction in working capital can be achieved either by speeding up the cycle of account receivables and stock or by lengthening the cycle of account payables. In essence, both will reduce the working capital requirement and therefore the funds invested for working capital can be utilized for the other finance or capital requirements.

This source has a little different analytics. This source is generated out of efficient management of working capital and appropriate usage of working capital management techniques. Internal source of finance are broadly covered under the above heads. Some other types of finance which are termed as internal source of capital are the employee contribution to the finance requirements of the company and the personal savings of the owners. Most of the times, a finance manager would try sourcing funds from internal sources because of the benefits as stated above. Businesses using internal source of financing also shows a sign of good performance as the business is independently satisfying its requirements with the help of its own efficiencies and operational profits. Business balance sheets usually have several fixed assets on them. A fixed asset is anything that is not used up in the production of the good or service concerned - land, buildings, fixtures and fittings, machinery, vehicles and so on. At times, one or more of these fixed assets may be surplus to requirements and can be sold. Alternatively, a business may desperately need to find some cash so it decides to stop offering certain products or services and because of that can sell some of its fixed assets. Hence, by selling fixed assets, business can use them as a source of finance. Selling its fixed assets, therefore, has an effect on the potential capacity of the business - the amount it can produce. Office buildings may be part of a firm's assets that could be sold off in times of slowdown in activity to raise finance.

2. PERSONAL SAVINGS Quite simply, personal savings are amounts of money that a business person, partner or shareholder has at their disposal to do with as they wish. If that person uses their savings to invest in their own or another business, then the source of finance comes under the heading of personal savings. Although we would generally discuss personal savings as a source of finance for small businesses, there are many examples where business people have used substantial sums of their own money to help to finance their businesses. A good and very public example here is Jamie Oliver, the television chef. Jamie financed his new restaurant, 'Fifteen', using fifteen raw recruits to the catering trade and a large amount (500,000) of his own cash

3. Working Capital This is the short-term capital or finance that a business keeps. Working capital is the money used to pay for the everyday trading activities carried out by the business stationery needs, staff salaries and wages, rent, energy bills, payments for supplies and so on. Working capital is defined as: Working capital = current assets - current liabilities 1. current assets are short term sources of finance such as stocks, debtors and cash - the amount of cash and cash equivalents - the business has at any one time. Cash is cash in hand and deposits payable on demand (e.g. current accounts). Cash equivalents are short term and highly liquid investments which are easily and immediately convertible into cash.

2. current liabilities are are short term requirements for cash including trade creditors, expense creditors, tax owing, dividends owing - the amount of money the business owes to other people/groups/businesses at any one time that needs to be repaid within the next month or so.

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