Source of finance

The source of finance is a provision of finance for a business to fulfil its operational requirements.
This includes short-term working capital, fixed assets, and other investments in the long term. There
are two sources of finance: internal and external. Internal sources of finance come from inside the
business, meanwhile, external sources of finance come from outside the business.

Internal sources of finance examples:- The internal sources of finance signify the money that comes from
inside the organisation. There are various internal ways an organisation can utilise, for instance, owner’s
capital, retained profit, and sale of assets. Internal finance can be considered as the cheapest type of finance,
this is because an organisation will not have to pay any interest on the money.

1. Capital brought by the owner:- This is the investment that the entrepreneur brings into the business. This
typically originates from their personal savings. This source of finance is the least expensive as there is no
interest. It is generally the most significant source of finance for a startup business because the business will
not have the assets or trading record which will help to get a bank loan.

2. Retained profit:- It is when a business makes a profit, so it can reinvest it into the business if it decides to
expand. Retained profit is also a good source of finance for the business as there is no interest charge,
therefore, it is a desired type of finance.

3. Discount selling:- Retail businesses have the choice to sell the unsold inventory in order to generate the
much-required finance.A retail store could sell the extra clothes from the last season at a lower price so that
quick cash can be raised, this will also save the expense of storage.

4. Selling of fixed assets:- This money is raised from the sale of fixed assets in the business which may not be
required anymore. Several businesses have additional vehicles, equipment, or machinery that they can simply
sell.

Advantages and disadvantages of internal sources of finance

Some of the advantages of internal sources of finance include:

 Internal sources of finance let the business sustain complete control. When the business is utilizing
its internal sources of finance, then it does not have any repayment obligations as it’s the case in
external debt. There is no pressure to match the payment roster to the earnings roster.
 It enhances the planning process.
 It lowers the overall cost of projects. When the business is using external sources of finance, then it
will have to pay interest on it which makes it expensive to borrow. However, if it’s using internal
sources of finance to purchase something, then it will pay just the expense of purchase without
having to pay any interest charges on it.
 It will improve the reputation and value of the business. A great deal of external debt borrowed by
the business is not liked by the investors. Higher debt ratios show higher risk levels, hence reducing
the value of the business as a whole.
 Some of the disadvantages of internal sources of finance include:
 There will be an adverse effect on the operating budget. Since the business is utilizing internal
sources to finance its needs, that money should come from somewhere. For the majority of
businesses, it means using cash from the capital or operating budget. Hence, there is not sufficient
money available for managing daily expenses. That is why businesses use internal sources only to
finance the short-run project.
  It needs accurate estimations to be effective. If the business is using internal sources of finance for a
project, then the project’s cost estimations should be considered accurate for it to be effective.
Precise estimates are needed in order to calculate the forecasted return, which is essential for future
needs to plan a budget.

External sources of finance:- External sources of finance can come from individuals or other sources that do not
have direct trade with the organisation.

External sources of finance signify the money that comes from outside the organisation.

Long-term external sources of finance

Equity shares
They are a common source of financing for established businesses. All businesses can not utilize this form of
financing as it is administered by several regulations. The main element is the division of ownership rights in
equity shares; hence, the present shareholder rights are reduced to a certain extent.

Debentures:-Debentures are a usual source of finance utilized by businesses who choose debt on equity. Debt
is regarded as the cheapest form of finance in comparison to equity. There is no sharing of control with
investors. This is due to the reason that the interest given to debenture holders is tax-deductible.

Term loan:- The components of a term loan are identical to debentures apart from that it does not have a lot
of cost of issuing as it is provided by a bank or other financial institutions. A thorough evaluation of the
organisation’s financials and forthcoming plans is done by the bank to assess the debt servicing capability of
the business. Such loans are assured by some assets.

Short-term external sources of finance

Bank overdraft:_ It is a simple form of short-term finance. At times a business may require money for daily
expenses which may be because of a time gap amid the collection and payments. So, in order to fill this gap, a
bank draft is a perfect short-term source of financing.

Trade credit:- It is the credit that is provided to a company by its creditor or suppliers. This permits a company
to postpone its payments for a certain period of time. This time of credit is subject to the credit terms among
the company and the suppliers.

External sources of finance examples

1. Family and friends :-A business can borrow money from family and friends and it is fast and cheap to
arrange in comparison to a bank loan. There can be negotiations about flexible interest charges and
repayment.

Advantages and disadvantages of an external source of finance

Some of the advantages of external sources of finance include:

 Conserving the internal resources - External financing permits the business to utilize the internal
financial resources for some other usage. If a business has an investment that has a high-interest rate
in comparison to the bank loan, then it's logical that the business preserves its internal resources and
places its money in that investment, and uses external sources of finance for business operations.
  Growth - One of the reasons that businesses go for external financing is that it permits them to
finance growth projects that the business can not finance on its own.

 Guidance and expertise - Institutions that finance a business are usually valuable sources of expert
assistance. Also, an investor may be willing to offer his expertise or direct towards suitable sources of
advice.

A bank that might have funded several other small businesses can give advice on how to prevent traps that
created difficulty for some.
Some of the disadvantages of external sources of finance:

 Loss of ownership - Certain external sources of finance may require the business to share ownership
in the company for their funding. The business may get a large amount of money it requires to launch
or promote a new product but will also have to give the investor this right to vote on the company's
decisions.

 Interest charges - External sources of finance need a return on their investments. For example, a bank
will have an interest charge on the loan and an investor will require a return on his investment.
Typically, interest will add up to the cost of investment making it a greater burden than in the initial
plan.

What are the factors of business financing?

Financial factors are the factors used to assess the different options concerning financial measures. Although
each organisation is diverse, the general factors included in business financing are consistent and lasting.

1. Capability to repay:-The most persistent factor is the ability to pay back is of utmost importance. Any
business should be able to show this ability prior to considering other factors. The business should have proof
that they have enough cash flow above operating expenses in order for the repayment of the loan.

2. History of repayment:-The history of a business’s repayment records on time is a crucial factor. If the
business has a clear record of paying the loans, then it should be able to obtain the finance it requires. But if
the business previously had problems, then it will have to prepare a letter explaining the issues and indicate
that the repayment issues have been resolved.

3. History of cash flows:-Although very profitable businesses are always striking, consistent cash flow is a
highly significant factor in commercial loans. Lenders are aware that cash flow shows the ability of the business
to repay. Hence, even though the company shows historically decent profits- still close to the break-even point
and the company shows consistently increasing cash flows, then lenders are not too sceptical to lend.

What are the factors that affect business financing?

The factors are as follows:

1. Nature of the business:-If the nature of the company needs hefty equipment and machinery, then fixed
capital will considerably be needed, or else a small amount of fixed capital will be needed. But if the nature of
the business is to manufacture consumer goods, then higher levels of finance will be needed.

2. Size of the business:-If a company is of huge size, then it will need more land and building, equipment and
machinery, etc. In order to fulfil these needs, there is a higher volume of fixed and working capital needed.

3. Production method:-If the production method is more labour-intensive, then low finance is required. But if
there is more usage of machinery instead of labour with a complex production process, then high financing is
needed.

4. Business cycle:-If the business cycle is in the boom, then there is low capital needed, however, the need for
working capital will increase.

What are the factors that influence the choice of business financing?

There are different factors that have an impact on the choice of sources of financing. Some of the are as
follows:
Cost - Businesses have to assess the cost to mobilize and utilize the funds. For example, where the interest
charges could be comparatively low in debentures, term loans, etc.

Sources of Finance - The choice of funding sources is based on the type of the company. The issuing of shares
and debentures cannot be done by sole proprietors and partnership businesses. They have to rely on short-
term sources, for example, hire purchase, leasing, bank finance, etc. Unlikely, businesses, government
organisations, and cooperative organisations can get funds from long-term as well as short-term sources.

Time period - The time period for which the company needs finance ascertains the relevant source. For
example, if funds are needed for the short-term then bank overdraft, cash credit, leasing, bill discounting, etc.
are more appropriate. If funds are needed for the long term- then issuing shares, term loans, debentures, etc.
are more appropriate.

The risk aspect - Funds owned by the business do not have any risk but borrowing funds involve a great deal of
risk. This is because of the interest charges which may result in the liquidation of the business in addition to
the damage to the reputation.

The phase of development - A newly launched business may find it difficult to mobilize business finance in
comparison to a developed business. Hence, it might have to depend on the owned sources in the early stages.
Once the business is developed it can then consider borrowing funds and will be in a position to keep its assets
as a security.

Credit worth of the business - Certain sources of finance like debentures and creditors need the company to
mortgage the assets. This will damage the creditworthiness of the business