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. They are classified based on time period, ownership and control, and
their source of generation. It is ideal to evaluate each source of capital before opting for it.

Having known that there are many alternatives to finance or capital, a company can choose from.
Choosing the right source and the right mix of finance is a key challenge for every finance
manager. The process of selecting the right source of finance involves in-depth analysis of each
and every source of fund. For analyzing and comparing the sources, it needs the understanding of
all the characteristics of the financing sources. There are many characteristics on the basis of
which sources of finance are classified.
On the basis of a time period, sources are classified as long-term, medium term, and short term.
Ownership and control classify sources of finance into owned and borrowed capital. Internal
sources and external sources are the two sources of generation of capital. All the sources have
different characteristics to suit different types of requirements.

1) 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 MEDIUM TERM SHORT TERM

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

Share Capital or Equity Preference Capital or

Shares Preference Shares Trade Credit

Preference Capital or
Preference Shares Debenture / Bonds Factoring Services

Retained Earnings or
Internal Accruals Lease Finance Bill Discounting etc.
 Advances received
Debenture / Bonds Hire Purchase Finance from customers

Term Loans from Medium Term Loans Short Term Loans like
Financial Institutes, from Financial Institutes, Working Capital
Government, and Government, and Loans from
Commercial Banks Commercial Banks Commercial Banks

Fixed Deposits (<1

Venture Funding Year)

Receivables and
Asset Securitization Payables

International Financing by
way of Euro Issue,
Foreign Currency Loans,
ADR, GDR etc.

1) Long-Term Sources of Finance

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.
Part of working capital which permanently stays with the business is also financed with long-
term sources of funds. Long-term financing sources can be in the form of any of them. These
include;

 Share Capital or Equity Shares

 Preference Capital or Preference Shares

 Retained Earnings or Internal Accruals

  Debenture / Bonds

 Term Loans from Financial Institutes, Government, and Commercial Banks

 Venture Funding

 Asset Securitization

 International Financing by way of Euro Issue, Foreign Currency Loans

2) Medium 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. Medium term financing sources can in the form of one of them:

 Preference Capital or Preference Shares

 Debenture / Bonds

 Medium Term Loans from

 Financial Institutes

 Government, and

 Commercial Banks

 Lease Finance

 Hire Purchase Finance

3) Short Term Sources of Finance

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. Short-term financing is also named
as working capital financing. Short term finances are available in the form of:

 Trade Credit

 Short Term Loans like Working Capital Loans from Commercial Banks

 Fixed Deposits for a period of 1 year or less

 Advances received from customers

 Creditors

 Payables

 Factoring Services

 Bill Discounting 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. Some entrepreneurs may not like to dilute their ownership rights
in the business and others may believe in sharing the risk

OWNED CAPITAL BORROWED CAPITAL

Equity Financial institutions,

Preference Commercial banks or

Retained Earnings The general public in case of debentures.

Convertible Debentures

Venture Fund or Private Equity

a) Owned 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. Following are the sources of Owned Capital:

 Equity

 Preference

 Retained Earnings

 Convertible Debentures

 Venture Fund or Private Equity

Further, when the business grows and internal accruals like profits of the company are not
enough to satisfy financing requirements, the promoters have a choice of selecting ownership
capital or non-ownership capital. This decision is up to the promoters. Still, to discuss, certain
advantages of equity capital are as follows:

It is a long-term capital which means it stays permanently with the business. There is no burden
of paying interest or installments like borrowed capital. So, the risk of bankruptcy also reduces.
Businesses in infancy stages prefer equity for this reason.
b) Borrowed Capital

Borrowed or debt capital is the finance arranged from outside sources. These sources of debt
financing include the following:

 Financial institutions,

 Commercial banks or

 The general public in case of debentures

In this type of capital, the borrower has a charge on the assets of the business which means the
company will pay the borrower by selling the assets in case of liquidation. Another feature of the
borrowed fund is a regular payment of fixed interest and repayment of capital. Certain
advantages of borrowing are as follows:

There is no dilution in ownership and control of the business.

The cost of borrowed funds is low since it is a deductible expense for taxation purpose which
ends up saving on taxes for the company. It gives the business the benefit of leverage.

According To Source of Generation:

Based on the source of generation, the following are the internal and external sources of
finance:

INTERNAL SOURCES EXTERNAL SOURCES

Retained profits Equity

Reduction or controlling of working capital Debt or Debt from Banks

All others except mentioned in

Sale of assets etc. Internal Sources

a) Internal Sources
The internal source of capital is the one which is generated internally by the business. These are
as follows:

 Retained profits

 Reduction or controlling of working capital

 Sale of assets etc.

The internal source of funds has the same characteristics of owned capital. The best part of the
internal sourcing of capital is that the business grows by itself and does not depend on outside
parties. Disadvantages of both equity and debt are not present in this form of financing. Neither
ownership dilutes nor fixed obligation/bankruptcy risk arises.

b) External Sources

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. Deciding the right source of funds
is a crucial business decision taken by top-level finance managers. The usage of the wrong
source increases the cost of funds which in turn would have a direct impact on the feasibility of
the project under concern. Improper match of the type of capital with business requirements may
go against the smooth functioning of the business. For instance, if fixed assets, which derive
benefits after 2 years, are financed through short-term finances will create cash flow mismatch
after one year and the manager will again have to look for finances and pay the fee for raising
capital again.

Explanations

a) Debentures

Debentures are a debt instrument used by companies and government to issue the loan. The loan
is issued to corporates based on their reputation at a fixed rate of interest. Debentures are also
known as a bond which serves as an IOU between issuers and purchaser. Companies use
 debentures when they need to borrow the money at a fixed rate of interest for its expansion.
Secured and Unsecured, Registered and Bearer, Convertible and Non-Convertible, First and
Second are four types of Debentures.

Advantages and Disadvantages of Debentures

Advantages of Debentures

 Investors who want fixed income at lesser risk prefer them.

 As a debenture does not carry voting rights, financing through them does not dilute control
of equity shareholders on management.

 Financing through them is less costly as compared to the cost of preference or equity capital
as the interest payment on debentures is tax deductible.

 The company does not involve its profits in a debenture.

 The issue of debentures is appropriate in the situation when the sales and earnings are
relatively stable.

Disadvantages of Debentures

 Each company has certain borrowing capacity. With the issue of debentures, the capacity of
a company to further borrow funds reduces.

 With redeemable debenture, the company has to make provisions for repayment on the
specified date, even during periods of financial strain on the company.

 Debenture put a permanent burden on the earnings of a company. Therefore, there is a

greater risk when the earnings of the company fluctuate.

Types of Debentures
i. Secured and Unsecured:

Secured debenture creates a charge on the assets of the company, thereby mortgaging the assets
of the company. Unsecured debenture does not carry any charge or security on the assets of the
company.

ii. Registered and Bearer:

A registered debenture is recorded in the register of debenture holders of the company. A

regular instrument of transfer is required for their transfer. In contrast, the debenture which is
transferable by mere delivery is called bearer debenture.

iii. Convertible and Non-Convertible:

Convertible debenture can be converted into equity shares after the expiry of a specified period.
On the other hand, a non-convertible debenture is those which cannot be converted into equity
shares.

iv. First and Second:

A debenture which is repaid before the other debenture is known as the first debenture. The
second debenture is that which is paid after the first debenture has been paid back.

b. Preference Shares

Preference shares are hybrid financing instruments having several benefits and disadvantages of
using them as a source of capital. Benefits are in the form of an absence of a legal obligation to
pay the dividend, improves borrowing capacity, saves dilution in control of existing shareholders
and no charge on assets. The major disadvantage is that it is a costly source of finance and has
preferential rights everywhere.

Preference shares are used by big corporate as a long-term source of funding their projects. They
are known as hybrid financing instruments because they share attributes of both equity and debt. It
is important to analyze the benefits and disadvantages affixed with using preference shares as a
medium of financing.

Advantages of Preference Shares

i) Dividends paid first

As mentioned, the chief benefit for shareholders is that preference shares have a fixed dividend
that must be paid before any dividends can be paid to common shareholders. While dividends are
only paid if the company turns a profit, some types of preference shares (called cumulative shares)
allow for the accumulation of unpaid dividends. Once the business is back in the black, all unpaid
dividends must be remitted to preferred shareholders before any dividends can be paid to common
shareholders.

ii) Higher claim on company assets

In addition, in the event of bankruptcy and liquidation, preferred shareholders have a higher claim
on company assets than common shareholders do. This makes preference shares particularly
enticing to investors with low risk tolerance. The company guarantees a dividend each year, but if
it fails to turn a profit and must shut down, preference shareholders are compensated for their
investments sooner.

iii) Additional investor benefits

Other types of preference shares carry additional benefits. Convertible shares allow the
shareholder to trade in preference shares for a fixed number of common shares. This can be a
lucrative option if the value of common shares begins to climb. Participating shares offer the
shareholder the opportunity to enjoy additional dividends above the fixed rate if the company
meets certain predetermined profit targets. The variety of preference shares available and their
attendant benefits means that this type of investment can be a relatively low-risk way to generate
long-term income.

Preference shares also have a number of advantages for the issuing company, including:
i) Lack of shareholder voting rights

The lack of shareholder voting rights that may seem like a drawback to investors is beneficial to
the business because it means ownership is not diluted by selling preference shares the way it is
when ordinary shares are issued. The lower risk to investors also means the cost of raising capital
for issuing preference shares is lower than that of issuing common shares.

ii) Right to repurchase shares

Companies can also issue callable preference shares, which afford them the right to repurchase
shares at their discretion. This means that if callable shares are issued with a 6% dividend but
interest rates fall to 4%, the company can purchase any outstanding shares at the market price and
then reissue shares with a lower dividend rate, thereby reducing the cost of capital. Of course, this
same flexibility is a disadvantage to shareholders. Financing through shareholder equity, either
common or preferred, lowers a company's debt-to-equity ratio, which is considered by both
investors and lenders to be a sign of a well-managed business.

Disadvantages of Preference Shares

i) Investors can't vote

From the investor's perspective, the main disadvantage of preference shares is that preferred
shareholders do not have the same ownership rights in the company as common shareholders. The
lack of voting rights means the company is not beholden to preferred shareholders the way it is to
equity shareholders, though the guaranteed return on investment largely makes up for this
shortcoming. However, if interest rates rise, the fixed dividend that seemed so lucrative can
quickly look like less of a bargain as other fixed-income securities emerge with higher rates.

ii) Higher cost than debt for issuing company

The chief disadvantage to companies is the higher cost of this type of equity capital relative to
debt.
CAPITAL STRUCTURE

Operating leverage

Operating leverage is a cost-accounting formula that measures the degree to which a firm or
project can increase operating income by increasing revenue. A business that generates sales
with a high and low variable costs has high operating leverage. The higher the operating
leverage, the greater the potential danger from forecasting risk, where a relatively small error in
forecasting sales can be magnified into large errors. The operating leverage formula is used to
calculate a company’s break-even point and help set appropriate selling prices to cover all costs
and generate a profit. The formula can reveal how well a company is using its fixed-cost items,
such as its warehouse and machinery and equipment, to generate profits. The more profit a
company can squeeze out of the same amount of fixed assets, the higher its operating leverage.

One conclusion companies can learn from examining operating leverage is that firms that
minimize fixed costs can increase their profits without making any changes to the selling price,
contribution margin or the number of units they sell.

Financial leverage

Financial leverage which is also known as leverage or trading on equity, refers to the use of debt
to acquire additional assets. The use of financial leverage to control a greater amount of assets
(by borrowing money) will cause the returns on the owner's cash investment to be amplified.
That is, with financial leverage:
 an increase in the value of the assets will result in a larger gain on the owner's cash, when the
loan interest rate is less than the rate of increase in the asset's value
 a decrease in the value of the assets will result in a larger loss on the owner's cash
Examples of Financial Leverage
Mary uses $500,000 of her cash to purchase 40 acres of land with a total cost of $500,000. Mary
is not using financial leverage.
Sue uses $500,000 of her cash and borrows $1,000,000 to purchase 120 acres of land having a
total cost of $1,500,000. Sue is using financial leverage to own/control $1,500,000 of property
with only $500,000 of her own money. Let's also assume that the interest on Sue's loan is
$50,000 per year and it is paid at the beginning of each year.

Break-even leverage

Break-even analysis tells a company how much it needs to sell in order to pay for an investment
— or at what point expenses and revenue are equal. Break-even analysis helps to provide a
dynamic view of the relationships between sales, costs and profits. By providing a better
understanding of the amount of success an investment or project must attain, break-even analysis
gives companies a benchmark to compare to and an idea about what level of operating leverage
will be ideal to generate greater profits.

Combined leverage

Combined leverage is a leverage which refers to high profits due to fixed costs. It includes fixed
operating expenses with fixed financial expenses. It indicates leverage benefits and risks which
are in fixed quantity. Competitive firms choose high level of degree of combined leverage
whereas conservative firms choose lower level of degree of combined leverage. Degree of
combined leverage indicates benefits and risks involved in this particular leverage.