Sources of Finance
Sources of Finance
• Sources of funds can be classified into two main categories: internal and
external.
•Internal Sources of Funds
• Retained earnings: Profits that are not distributed to shareholders as
dividends but are reinvested in the business.
• Accumulated depreciation: The cumulative amount of depreciation
expense that has been recorded over the life of a fixed asset. Depreciation
expense is a non-cash expense, so accumulated depreciation represents a
source of cash that can be used to finance new investments or pay down
debt.
• Sale of assets: The sale of fixed assets, such as land, buildings, or
equipment, can generate cash that can be used to finance new investments or
pay down debt.
External Sources of Funds
• Debt financing: The borrowing of money from lenders, such as banks
or bondholders. Debt financing can be used to finance new
investments, working capital needs, or acquisitions.
• Equity financing: The issuance of new shares of stock to investors.
Equity financing is used for raising capital for new investments,
working capital needs, or acquisitions.
• Government grants and subsidies: Grants and subsidies from
government agencies can be used to finance specific projects or
initiatives.
Hybrid Sources of Funds
• Venture capital: This is a type of equity financing that is for
early-stage companies with high growth potential. Venture capitalists
invest in companies that have not become profitable but have the
potential to become major players in their industry.
• Private equity: Private equity is a form of equity financing that is
provided to established companies. Private equity firms typically
acquire controlling stakes in companies and then work with
management to improve the company's performance and profitability.
Different Sources of Finance
• 1. Lease Financing
• It represents a contractual agreement between the asset owner (lessor)
and asset user (lessee). This is a long-term financing option where the
asset owner grants the right to another person to use the asset in lieu of
a periodic payment.
• A contract containing all terms and conditions of the lease is prepared.
The periodic payment made by lessee to lessor is known as lease
rental. Once the contract gets over, the asset is handed back to its
owner. If the owner wants, an agreement for further lending or
purchase of asset is offered.
2. Trade Credit
• Trade credit is one of the sources of finance offered by one trader to
another for purchase of products and services. This facilitates the
purchase of goods without making immediate payment. The credit
shows in the buyer of goods’ records as ‘accounts payable’ or ‘sundry
creditors’. Businesses use trade credit when they need a short-term
source of finance.
• Anyone with strong financial status and reputation is granted trade
credit. The term and amount of trade credit is determined by the
financial status, number of purchases, firm’s reputation, payment
history and market’s competition level.
3. Venture Capital
• It is a type of private equity and a financing option that is offered by
investors to startups and small businesses having long-term potential.
Well-known investors, investment banks and other financial
institutions provide venture capital as a source of finance. Other than
monetary aid, venture capitalists help with technical and managerial
expertise.
• Most venture capitalists invest in early-stage companies in lieu
of equity or ownership. Investing in such companies is done with the
aim of gaining ROI when the company becomes successful. Most
venture capital investments occur after the initial ‘seed funding’ round.
The first round of institutional venture capital for funding growth is
known as the Series A round.
4. Debenture
• A debenture is a bond or debt instrument which is not secured by
collateral. Such debt instruments must rely on the credit worthiness
and reputation of the issuer. Government, as well as organizations,
issue debentures for raising funds.
• Corporation use debentures as long-term loans, even if these are
unsecured. These are the debt instruments that pay an interest rate and
are redeemable or repayable on a fixed date. Debentures come with the
backing of the financial viability and credit worthiness of an
underlying company.
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5. Preferred Stocks
• It is a percentage of stock that refers to an ownership or equity in the
firm. Preferred stock is a special stock that pays a set schedule of
dividends. It has limited rights which do not include voting. Preferred
stock is the source of finance that combines the features of both
common stocks and bonds into one security.
• It combines stable and consistent income payments of bonds with the
equity ownership advantage of common stocks. This includes the
potential for shares to rise in value over time. Such a share provides
the holder with a priority over common stock holders for claiming the
company assets on liquidation. It also offers dividend payments to
shareholders.
6. Crowdfunding
• It refers to the use of the small amount of capital from multiple
individuals as a source of finance for business ventures. Here, many
people are invited from social media and crowdfunding websites to
bring together investors and entrepreneurs. Through crowdfunding,
entrepreneurs can raise money for investment purposes. Crowdfunding
is a great source for ensuring that both businesses and individuals
receive the required funding.
Term Loan
• A term loan offers borrowers with a lump sum of cash upfront on
following borrowing funds. The borrowers agree to pay certain
repayment schedules with fixed or floating rates of interest. It requires
a substantial down payment to reduce payment amounts and total loan
costs.
• Here, the borrower agrees to pay the lender with fixed amount over a
certain repayment schedule with fixed or floating rate of interest.
These are usually granted to small businesses that require cash for
purchasing equipment, fixed assets and buildings for production
processes. Many businesses borrow cash when they need to operate on
a month-to-month basis.
8. Angel Investors
• These are the high-net-worth individuals that provide financial
backing to entrepreneurs and startups. For angel investment, these
investors ask for ownership equity in the company. The financial
support provided by angel investors may be one-time investment or be
ongoing support for carrying out company operations. These investors
aim for startups with the capability of a higher return on investments
than focusing on traditional investment opportunities.
9. Retained Earnings
• It refers to the amount of profit available with the company once it has
paid direct and indirect costs, income taxes and dividends to
shareholders. When retained earnings are accumulated over years, it is
known as ‘accumulated profits’.
• It represents the portion of the company’s equity for investing in
research, marketing and purchasing new equipment. These are
reflected in the equity section of balance sheet. For smaller businesses,
retained earnings are reflected on the income statement.
