Chapter 02: Sources of Finance

Prepared By:
Nusrat Nargis
Assistant Professor of Finance
Department of Business Administration

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 Chapter 02: Sources of Finance

To start a business and run daily activities, it is very much essential to

make correct decision about financing. Required fund can be collected

from various sources, but at first all available sources to listed, then

appropriate sources to be chosen for raising required fund. Not only to

raise fund is important, but also to use fund properly, effectively and

profitably is important for a business.

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 Sources of Financing

Internal Sources External Sources

1. Promoters’ Initial capital 1. Commercial Bank

2. Retained Earnings 2. Non-Bank Financial Institutions

3. General Reserves 3. Specialized Financial Institutions

4. Dividend Equalization Fund 4. Leasing

5. Sinking Fund 5. Issuance of Financial Assets- Share, Bond

6. Workmen‘s Compensation and Welfare Fund 6. Trade Credit

7. Outstanding Expenses 7. Accrued Expenses

8. Provident Fund of Officers and Employees 8. Mortgage Loan

9. Sale of fixed asset and overuse of fixed asset 9. NGOs and money lenders

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 Sources of Internal Financing
• Promoters’ initial capital- This is the capital brought by owners when they start
a business. According to the formation and nature of organization the amount
of owners capital vary.

• Retained earning- it is the amount of net profit after distribution of dividend to

the shareholders. It is an important source of internal capital. It can be in the
form of Internal Financing

• General reserve- It is the amount of reserve accumulated for general purpose

rather than distributing it as dividend from the net profit. The largest amount of
accumulated profit is transferred to this reserve.

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 Sources of Internal Financing
• Dividend Equalization Fund- Every company’s shareholder expect divided at a
particular rate but due to the instability of earning that is not always possible,
so in the years when more profit is earned a part is kept aside to compensate
for the years when the earning is too low to declare divided. This fund is a
source of internal financing.

• Sinking fund- Whenever organizations take long term loan or issue bond there
is a sinking fund provision where a fund is kept aside from the net profit so they
are not under financial pressure at the time of loan repayment. Every year a
certain amount of profit is put aside in this fund and until the loan is repaid this
fund acts as an internal source.

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 Sources of Internal Financing
• Workmen’s compensation and welfare fund- A fund is created to pay
compensation to workers who get injured on duty and until they are paid this is
can be used as an internal source.

• Outstanding expenses- now a days most transactions are conducted on the

basis of credit even bill payments are deferred. Until these payment are made
this fund can be used as an internal source of fund.

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 Sources of Internal Financing
• Provident fund of officers and employees- in order to make sure that the
employees do not suffer from insecurity in their old age a portion of fund in
kept aside from their salary. The amount accumulated in their fund will be paid
at the end of their service so in the time being this can be used for internal
financing.

• Sale of fixed asset and overuse of fixed asset- many a times companies have
asset that has been left unused, overused or does not have any more utility,
fund can be accumulated by selling these assets. Sometimes overused asset are
further used to avoid huge amount of cash outflow needed to replace it with a
new one.

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 Advantages & Disadvantages of Internal Financing

Advantages

1. Capital is immediately available

2. No interest payments
3. No control procedures regarding creditworthiness
4. Spares credit line
5. No influence of third parties Disadvantages

1. Expensive because internal financing is not tax-

deductible
2. No increase of capital
3. Not as flexible as external financing
4. Losses (shrinking of capital) are not tax-deductible
5. Limited in volume (volume of external financing as well
is limited but there is more capital available outside - in
the markets - than inside of a company)
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 Sources of External Financing
1. Commercial Bank

2. Non-Bank Financial Institutions

3. Specialized Financial Institutions

4. Leasing

5. Issuance of Financial Assets

6. Trade Credit

7. Accrued Expenseses

8. Mortgage Loan

9. NGOs and money lenders

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 Sources of External Financing
Commercial Banks is the main source among the institutional sources. It acts as a middle man
by borrowing excess funds from the public at a fixed rate of interest. Usually fund is provided
for establishment of new plant, expansion or modernization of product line etc. Loans can be in
the form of long term secured loan or short term non secured loan.

Non-Bank Financial Institutions:

Investment Bank- Investment bank purchase the newly issued share of public limited
companies and sell it in the capital market to expand the base of investment.

Insurance company- Insurance companies collect more premium from the policy holders in
comparison to payment made for fulfilling the claim of the policy holders. As a result a large
amount of capital lay idle for a log period of time from which it provides credit for a longer
period of time. But unlike commercial bank the insurance companies provides loan for secured
big established companies and at a higher rate of interest.

Development financing institution- to accelerate industrialization these types of institutions

are established. There is Bangladesh Development Bank (BDB) with its objective to provide
finance for the establishment and expansion of new plants. Long term loan is given in local as
well as foreign currency and when needed it provides short term bridge financing facility as
well.
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 Sources of External Financing

Specialized Financial Institutions: HBFC, PKSF, Bangladesh Krishi Bank, RKUB,

Samabay Bank etc.

Leasing companies- Industrial Development Leasing Company(IDLC) and United

Leasing company these two companies provide medium term financing by allowing
companies to use their required asset for few years.

Issuance of Financial Assets:

Share capital refers to the portion of a company's equity that has been obtained
by trading stock to a shareholder for cash.

Bond and Debenture- Big Blue Chip companies usually raise fund by issuing bonds
and the difference with common share is a fixed rate of interest needs to be paid.
Depending on the terms of repayment, interest rate there may be different types
of bonds.

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 Sources of External Financing
Trade Credit- many a times goods are purchased on credit for the purpose of
selling and repaying the money later once it is sold. These short term credit is
called trade credit. However these sort of credits are given only when the
wholesaler purchase goods from the manufacturer or when the retailer from
the wholesaler.

Outstanding Expenses- sometimes bills such as telephone, gas, electricity are

deferred. Until these payments are made these act as short term external
source of financing.

Mortgage- Large organization sometimes obtain loan by mortgaging their

permanent and temporary assets. Here the amount of loan along with term
and rate of interest is to be mentioned. If the person taking loan by
mortgaging property fails to repay loan as par mortgage contract then the
lender has the right to recover the amount form the property that has been
mortgaged.
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 Sources of External Financing

Friends and Relatives- usually in case of sole proprietorship and

partnership this is used as a source and the amount is usually small
bearing no interest.

Money lenders- the biggest non institutional source and since there is no
regulatory body the interest rate is usually higher. Usually sole traders
who do not have access to other sources of financing and can not raise
capital from issuing shares have these money lenders as their last resort.

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 Equity Capital vs. Debt Capital

Equity capital- Equity capital is capital that comes from the sale of stock to
investors. To start any business the initial capital provided by owners or later
by selling share in the capital market and the retained earning together is
identified under this heading. The owners have legal claim only on the
amount left behind after all sorts of claim has been met from the main
capital.

Debt capital- Debt capital is the capital that a business raises by taking out a
loan. when the owner’s capital is deduced from the main capital the amount
left is identified as debt capital.

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 Equity Capital vs. Debt Capital

Sources of Equity capital Sources of Debt capital

A. Common stock capital A. Outstanding expenses
B. Share premium B. Provident fund
C. Retained earning C. Trade credit/ accounts payable
D. Reserve D. Commercial bank
i) General reserve E. Leasing company
ii) Sinking fund F. Specialized financial institution
iii) Dividend equalization fund G. Mortgage
iv) Other reserve H. Bond and debenture
I. Friends and relatives
J. Money lenders

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 Equity Capital vs. Debt Capital

1. Definition

2. Risk Level

3. Bindings in payment

4. Certainty/Uncertainty in extra Payment

5. Duration

6. Nature of Extra Payment

7. Examples (Instruments)

8. Control

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 Equity Capital vs. Debt Capital

Position with regard to claim on income and assets: After meeting all sort of expenses
including both interest and scheduled principal payments of creditors the board of
directors will decide on the amount of net profit is available for distribution among
the owners as dividends. But there is no guarantee that there will be net profit there
might be losses when no dividend will be distributed so the claim of the equity holders
is secondary claim. If the firm fails then assets will be sold and proceeds will are
distributed to the employees, customer, government, creditors and finally equity
holders.

So the creditors are more or less sure about getting their interest and principal amount
according to the terms of contract. Because equity holders are the last to receive any
distribution of assets they expect greater returns from dividend and increase in stock
price.
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 Equity Capital vs. Debt Capital

Position with regard to risk- the following are the risks incurred by business

A. Business risk- the risk that the earning of the firm becomes uncertain due to
financial depression, reduction in demand etc.

B. Financial risk- the risk that arises due to use of leverage in the capital structure.

C. Risk of reducing income- due to the obligation of payment of interest to

shareholders at a fixed rate the earning of the shareholders may reduce.

D. Bankruptcy risk- it happens when the firms’ income reduce or it suffers from
liquidity crisis and fails to meet the claim of the creditors.

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 Equity Capital vs. Debt Capital

Maturity- Equity financing does not have any maturity and it is liquidated only
in case of bankruptcy proceeding. But the debt must be repaid after a certain
time.

Tax treatment- Interest payments to debt holders are tax deductible

expenses by the issuing firm, whereas dividends payments to a firm’s
common and preferred stockholders are not tax deductible. The tax
deductibility of interest lowers the corporation’s cost of debt financing .

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 Equity Capital vs. Debt Capital

Debt Equity

Voice in Management No Yes

Claims on income & asset Senior Subordinate

Maturity Stated None

Tax treatment Interest deduction No deduction

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 Types of Finance Based on Duration

1. Short Term Financing

2. Intermediate Term Financing

3. Long Term Financing

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 Short Term Financing

Definition: Capital required to buy raw material for production, giving wages and meeting up the

expenses for other administrative and marketing purpose is called short term financing.

Characteristics:

 Time : Short term capital is usually used for one year or lesser period.

 Purpose: Short term financing is usually used to meet up the requirement of current capital.

 Costly and risky: As the short term capital is given for a short period, the risk factor is more.

That is why the provider of short term capital charges higher interest.

 Security: The Short term financing does not need security as the short term money can be

adjusted by the sale proceeds of the product derived from the businesses’ day to day

operation and current property purchase within a short period of time.

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 Short Term Financing

 Recycling: One advantageous characteristics of short term financing is that, there

is always a scope to collect money at a regular basis from this kind of source.

 Renewal: If the short term loan which Institutional organization, such as

Commercial Banks and other financial institutions disburse is adjusted as per the
terms and conditions of the sanction advice, it gets easier to get loan again. Even
if the loan is not adjusted within the stipulated time of the sanction advice , it can
be renewed.

 Size and nature of the firm: Usually small, medium, big business firms collect
money from short term financing. But short term loan is required more by the
business firms than manufacturers.

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 Intermediate Term Financing
Definition: The interim term financing arrangement between short term and long term
financing, the validity of which is more than one year but less than ten years is called
the intermediate term financing.
Characteristics:
 Maturity: Intermediate financing is usually done for one year and less than five years.
But to some the validity for this kind of financing could be more than one year but less
than ten years.
 Objective of credit: In most of the cases the Intermediate term financing is required to
meet up the current capital requirement, to purchase machinery, in special cases to
develop and extend the building and to replace the machinery.
 Size of loan: The amount for Intermediate financing is usually less. Because the loan
providers are the commercial banks and insurance companies , and they usually dot not
sanction big loans for expansion of business. There might be deviation depending on
individual situations.
 User of Intermediate term financing: Small, medium and big firms can utilize this sort of
loan. But usually small and medium scale firms take the opportunity of financing
through intermediate term financing.

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 Intermediate Term Financing

 Repayment method: In most of the cases the repayment of the intermediate term
loan is done through installment. Again in some cases it is done through a single
payment . That means it depends on the agreement between the borrower and
the loan provider ( Bank, NBFI).
 Security provision: Maximum of the Intermediate term finance is given against
security as this financing is used to buy fixed asset, such as machinery, building,
plan.
 Renewable: This sort of term finance is renewable. Banks and other NFBI can
renew the loan in favor of the borrowers depending upon their genuine cause.

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 Long Term Financing

Definition- When loan is taken to fulfill the requirement of permanent property or for
the purpose of long term investment the process is called long term financing.

Characteristics of Long term Financing

Duration- The duration of the loan is 7 to 20 years. In certain circumstances it is
even longer than 20 years. The capital of the owners and shareholders are invested
for an indefinite period of time.
Use of fund- it is used for land, machinery, building, furniture.
Size of fund- Since it is used for land purchase, building construction, machinery
purchase the amount is substantial.

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 Long Term Financing

 Nature of fund- it can be in the local currency as well as foreign currency according
to the need.
 Repayment method- it is being repaid according to the agreement between the
borrower and lender. Usually repaid in quarterly, half yearly or yearly installments.
 Security- if long term financing is provided by owners there is no security but if is
acquired through credit adequate security is required.
 Cost of fund- since it is provided for a long term the risk of the fund provider is less
providing less income to them. So the cost of long term financing is less than short
or medium term financing.

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