Finance is the most important component of any firm, and it becomes difficult for businesses to survive when their resources are depleted. Have you ever pondered how Apple, Google, Wipro, TCS, L&T, and other significant corporations are able to operate for so long despite experiencing highs and lows?
Managing cash for a firm or startup is the most important aspect of entrepreneurial expertise, whether you are just starting out or have been in business for several years. Businesses require capital to operate, expand, and advance to the next level.
This page will provide in-depth information on the many types of business financing.
Sources of funds—Classification
Before proceeding, we must comprehend the classification of funds. The firms require financing largely for their fixed capital and working capital requirements.
The source of funds can be categorized according to the following criteria:
- Time Period: According to the duration of financing, the sources of financing are classified.
- Ownership: According to ownership or control.
- Source of Generation: As per usual, the source of generation of funds for businesses.
1) Time Period:
Since time duration plays a major part in determining numerous significant factors such as interest rate, repayment period, and the purpose of money, among others, it is essential to consider the passage of time. Even if the requisite finances are available for short-term periods, a company cannot undertake an overseas investment. When time considerations are not correctly accounted for, the objective of finances is invalidated.
- Long-term sources of finance
- Equity Shares/Share Capital
- Preference Shares
- Venture Capital
- Business Loans
- External Sources
- Medium-term sources of finance
- Term Loans
- Public deposits
- Lease financing
- Short-term sources of finance
- Trade Credit
- Bill Discounting
- Customer’s Advance
- Commercial Paper
Long-term Sources of Finance
Long-term varies from business to business, but in general, sources with a duration of five years or longer are considered long-term. These sources are utilized by businesses for expansion, the purchase of fixed assets, investing in R&D, and other purposes.
If the business’s short-term prospects are favorable, this is the optimal method for attracting a sizeable sum. Here, a firm launches its first public offering (IPO) or initial public offering (FPO) and asks investors to purchase shares or equity in the company.
You may have heard of Sensex, NIFTY, the Bombay Stock Exchange, and other words associated with the stock market. There are around 20 share markets in India, with the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) being the most prominent. A company issues an IPO to raise long-term money for its operations, expansion, interest payments, capital expenditures, and other expenses.
This is another type of stock market listing in which the shares are allocated to certain preferred investors in exchange for a fixed dividend. These investors get preferential rights and receive dividends from the company’s profits. Financial experts place this group between the equity and debt categories. Significant categories include fixed dividends, preference over equity, and preferential shares without voting rights.
Here, tiny businesses receive funding from large organizations or wealthy, reputable investors. These opportunities are unavailable to the general public. Experts refer to this as a company financing another business model.
A business sets aside a percentage of its income or earnings for operational and other expenses. When the company requires an additional source of funding, it uses its internal accruals. It can also be referred to as “saving for the future” since it proves handy when needed.
It is a sort of written instrument in which the business promises to deliver certain benefits, such as a higher interest rate, a percentage of their profits, and preferential treatment for the acquisition of shares. The business issues these bonds to the general public at a predetermined price and with predetermined terms and conditions. The bond matures after a specified term, and the investor receives the rewards. The company issues a variety of bonds, including zero-coupon, plain vanilla, deferred coupons, step-downs, inverse floaters, and participation.
There are a few distinctions between bonds and debentures. It is primarily issued during the normal course of business, and unlike bonds, it is not backed by collateral or security. In the financial market, debentures are viewed as riskier than bonds because businesses require greater interest payments.
Types of Debentures
Term loans refer to the borrowing of funds for a period of 5 to 10 years. Long-term loans are provided to enterprises by financial institutions such as banks, the government, and international organizations, etc., based on their business prospects. The amount borrowed is repaid to the lender in accordance with the terms and conditions agreed upon at the time of contract execution.
An external financing source
Large corporations are also able to draw financing from internal sources, such as foreign currency loans, Global Depository Receipts (GDR), American Depository Receipts (ADR), Euro issues, etc. This strategy is highly advantageous for businesses when the Indian rupee depreciates, since they receive more funding when the loan is converted into Indian rupees. However, the business must pay extra when it is time to repay the loan.
medium-term source of finance
Medium-term financing refers to the method of financing in which the business must repay the loan within three to five years. If the long-term source is unavailable or if certain financial obligations must be met, businesses prefer to pursue medium-term financing.
In common terminology, all long-term sources are also available for medium-term use. They obtain funding through the stock market, preferential share placement, bond and debt issuance, financial institutions, internal accruals, and others.
Short-term Sources of Funds
As the name implies, firms require such funds when they need cash for a short period of time, typically less than a year. It is used to maintain inventories, pay salaries and interest, and meet other working capital needs, among others.
All major commercial banks give businesses either short-term or working capital loans. A business must provide the necessary documentation for financing. Due to the high risk and short repayment duration, these types of loans carry hefty interest rates.
In this manner, enterprises obtain credit from other businesses or organizations, including suppliers, contractors, creditors, and others. It is also known as a delay in payment based on credit; the business is excused from paying any outstanding debts or obligations for a period of time. The trade credit potential is determined by factors such as competition, buyer credibility, business prospects, liquidity situations, payment records, profit-making capacity, etc.
In this scenario, a business sells its bill receivables at a discount to another entity in order to raise capital. It is similar to internal management between corporations to raise short-term funds. Factoring decreases credit risk and helps the organization maintain a healthy working capital cycle.
This applies to businesses who sell or supply goods or services on the market. In this case, the business recovers a portion of the invoice from financial intermediaries, buyers, etc. before to the due date. In the case of high-value transactions, discounting invoices is a sensible practice. Financial intermediaries such as banks assist firms with short-term financing and mitigate the default risk associated with economic cycles.
This is the easiest and most crucial option for the firm to obtain short-term financing. It indicates that the company receives the goods or services without making immediate financial payments to suppliers or dealers. In basic terms, a business receives the raw materials immediately and agrees to pay the agreed-upon price at a later date.
Creditors can be any individual, company, or financial organization. Businesses accept short-term loans from anyone with excess funds or with the intention of earning additional funds through interest. Additionally, a business receives credit from other businessmen and repays the principal amount plus interest via EMI or a single payment.
Large consumers pay in advance to receive the goods/services at the agreed upon time. When a substantial investment is necessary for a business to develop products or provide services, this method of financing is highly widespread. Additionally, the business receives advances if the product’s supply is limited and demand is high. For instance, when a reputable automaker debuts a new automobile variety, clients pay a deposit to reserve the vehicle, with delivery promised in the future.
Sources of finance: Control and Ownership
In common language, businesses raise capital either by diluting their ownership or by paying interest to their debtors. When a business is required to pay interest, the second alternative often proves to be the most expensive. In such a scenario, a number of business owners dilute their ownership with creditors and convert long-term to short-term cash. Here, the financing sources can be divided into two categories:
As the term implies, firms own the capital until they are unable to pay the agreed-upon sum or decide to sell their assets. Capital owned includes equity, convertible debentures, earnings, venture funds, etc. A company offers shares to raise capital for its needs.
Eventually, the equity will be traded on the stock market and will rise and fall based on numerous situations. At a later stage, when the equity value is high, the business retains the option to either repurchase the equity or split ownership with the investors.
A business is not required to pay interest on its own capital, and this reduces the risks connected with conducting a business.
To meet their cash needs, businesses borrow money from financial institutions, commercial banks, the general public, and others. Here, the firm pays the agreed-upon interest rate for keeping the funds for itself.
Hopefully, you have some understanding of the business’s financial resources. A corporation is comparable to a powerful, adaptable, and prospectively expanding collection of people. They utilize all internal and external financial sources and obtain them as needed.
It is a straightforward give-and-take arrangement in which the other person(s) or institution(s) gives money to a firm in exchange for interest or control.