A company would choose from among various sources of finance depending on the amount of capital required and the term for which it is needed. Finance sources can be divided into three categories, namely traditional sources, ownership capital and non-ownership capital.
Traditional Sources of Finance
Internal resources have traditionally been the chief source of finance for a company. Internal resources could be a company’s assets, factoring or invoice discounting, personal savings and profits that have not been reinvested or distributed among shareholders. Working capital is a short term source of finance and is the money used for a company’s day-to-day activities, including salaries, rent, payments for raw materials and electricity bills.
Sources of Finance: Ownership Capital
Ownership capital is the capital owned by the shareholders of a company. A company can raise substantial funds through an IPO (initial public offering). These funds are usually used for large expenses, such as new product development, expansion into a new market and setting up a new plant. The various types of shares are:
- Ordinary shares: These are also known as equity shares and give the owner the right to share the company’s profits and vote at the firm’s general meetings.
- Preference shares: The owners of these shares may be entitled to a fixed dividend, but usually do not have the right to vote.
Companies that are already listed on a stock exchange can opt for a rights issue, which seeks additional investment from existing shareholders. They could also opt for deferred ordinary shares, wherein the issuing company is not required to pay dividends until a specified date or before the profits reach a certain level.
Unquoted companies (those not listed on stock exchanges) can also issue and trade their shares in over-the-counter (OTC) markets.
Sources of Finance: Non-Ownership Capital
Non-ownership capital includes funds raised from lenders, such as banks and creditors. Companies typically borrow a fixed amount from a bank, at a predetermined interest rate and with a fixed repayment schedule. Certain bank accounts offer overdraft facilities. This is used by companies to meet their short-term fund requirements, as they usually come at a very high interest rate.
Factoring enables a company to raise funds using its outstanding invoices. The company typically receives about 85% of the value of the invoice from the factor. This method is more appropriate for overcoming short-term cash-flow issues.
Hire purchase allows a company to use an asset without immediately paying the complete purchasing price. Trade credit enables a company to obtain products and services from another firm and pay the bill later.
Sources of Finance: Venture Capital
Firms in the early stages of development can opt for venture capital. This option gives the financing company some ownership as well as influence over the direction of the enterprise.
Sources of Finance: Duration
Depending on the date of maturity, sources of finance can be clubbed into the following:
Long-term sources of finance: Long-term financing can be raised from the following sources:
- Share capital or equity share
- Preference shares
- Retained earnings
- Debentures/Bonds of different types
- Loans from financial institutions
- Loan from state financial corporation
- Loans from commercial banks
- Venture capital funding
- Asset securitisation
Medium-term sources of finance: Medium-term financing can be raised from the following sources:
- Preference shares
- Public deposits/fixed deposits for duration of three years
- Commercial banks
- Financial institutions
- State financial corporations
- Lease financing / hire purchase financing
- External commercial borrowings
- Foreign currency bonds
Short term sources of finance: Short-term financing can be raised from the following sources:
- Trade credit
- Commercial banks
- Fixed deposits for a period of 1 year or less
- Advances received from customers
- Various short-term provisions