SOURCES OF FINANCE

Sources of finance In our present day economy, finance is defined as the provision of money
at the time when it is required.
Every enterprise, whether big, medium or small, needs finance to carry on its operations and
to achieve its targets.
In fact finance is so indispensable today that it is rightly said that it is the life blood of an
enterprise.
 Why do we need finance?
1. Setting up a business
2. Need to finance our day-to-day activities
3. Expansion
4. Research into new products
5. Special situations such as a fall in sales.
 The various sources of finance available to business may be classified as –
(A) External Sources.
(B) Internal Sources.

(A) External Sources : External sources are outside of the firm. They are used
extensively for collecting initial capital. The important external sources are –
1) Issue of shares
2) Issue of debentures
3) Public deposits
4) Loan from institutions
5) Bank Credit

(B) Internal Sources : Internal sources are available within the firm. They
develop after few years of profitable working of the firm.
The important internal source of finance is 'retained profit'. It is also called as
'ploughing back of profit'. Here the undistributed profit of the firm is
reinvested in the business.

 The external source and internal source, may be further classified as

(a) Long term source
(b) Short term source

(a) Long term source : A business firm requires long term finance for meeting fixed
capital needs. These funds are required generally for long duration. The main sources
of long term finance may lie divided into –
 (1) Owned Capital
(2) Debt Capital
(b) Short term source : The short term funds are required for meeting working capital
requirement. These funds are required for a short period. The short term funds can be
arranged from taking short term loans, accepting deposits, etc.

Financial analysis It is a process of :

i. Analyzing and interpreting financial statements.
ii. Analyzing means simplifying the data and interpreting means
explaining the meaning and significance of data so simplified.
iii. Critically examining the accounting information given in the financial
statements.
iv. Evaluating relationships between the component parts of financial
statements to obtain a better understanding of firm’s position and
performance.
Importance:
• To assess the earning capacity and profitability of firm
• To assess the operational efficiency and managerial effectiveness.
• To make inter-firm comparisons.
• To make forecasts about future prospects of firm
• To help in decision making and control
• To guide or determine the dividend action
• To identify the reason for change in profitability and financial position of the firm.
• To assess the progress of firm over a period of time.

COST OF CAPITAL
Cost of capital is the rate return the firm requires from investment in order to increase the
value of the firm in the market place.
 The sources of capital of a firm must be in the form of preference shares, equity
shares, debt and retained earnings.
 In simple cost of capital of a firm is the weighted average cost of their different
sources of financing.
Components Of Cost Of Capital
A firm’s cost of capital include 3 components :
 1) Return at zero risk level :- It relates to the expected rate of return when a project
involves no financial or business risk.
2) Business risk premium :- Generally business risk premium is determined by the
capital budgeting decisions for investment proposals.
If the firm selects a project which has more than the normal risk, the suppliers of the
funds for the project will naturally expect a higher rate of return than the normal rate.
Thus the cost of capital increases.
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 cost and Implicit cost Historical cost and Future cost :- Historical cost are
the costs which are incurred for the procurement of funds based upon the existing
capital structure of the firm. It is a book cost.

MEANING OF CAPITAL STRUCTURE

Capital structure refer to the proportion between the various long term source of finance in
the total capital of firm A financial manager choose that source of finance which include
minimum risk as well as minimum cost of capital.
Sources of long term finance Proprietor’s funds Equity capital Preference capital Reserve and
surplus Borrowed funds Long term debts
I. Capital structure determine the risk assumed by the firm
II. Capital structure determine the cost of capital of the firm
III. It affect the flexibility and liquidity of the firm
IV. It affect the control of the owner of the firm

 Capital can be collected by using two sources debt and equity, when a business
establishes its capital structure arises the problem of how much should be debt and
how much should be equity, each manager targets to get at an optimal capital
structure which is hard to be achieved.