what are the Sources of Financing?

Having known that there are many alternatives of finance or capital, a company can choose from. Choosing right source and the right mix of finance is a key challenge for every finance manager. The process of selecting right source of finance involves in-depth analysis of each and every source of finance. For analyzing and comparing the sources of finance, it needs understanding of all the characteristics of the financing sources. There are many characteristics on the basis of which sources of finance are classified.

Sources of financing for a company can be mainly classified as:

  • Internal Sources
  • External Sources

Internal Sources:

Internal source of capital is the capital which is generated internally from the business. These are as follows:

  • Retained profits
  • Reduction or controlling of working capital
  • Sale of assets etc
  • own capital

The internal source has the same characteristics of owned capital. The best part of the internal sourcing of capital is that the business grows by itself and does not depend on outside parties. Disadvantages of both equity capital and debt capital are not present in this form of financing. Neither ownership dilutes nor fixed obligation / bankruptcy risk arises.

External Sources:

An external source of finance is the capital generated from outside the business. Apart from the internal sources finance, all the sources are external sources of capital. Ex: shares,debentures,Bank loans,bank overdrafts.

According to Ownership:

OWNED CAPITAL

Owned capital also refers to equity capital. It is sourced from promoters of the company or from the general public by issuing new equity shares. Promoters start the business by bringing in the required capital for a startup. Following are the sources of Owned Capital:

  • Equity Capital
  • Preference Capital
  • Retained Earnings
  • Convertible Debentures
  • Venture Fund or Private Equity

BORROWED CAPITAL

Borrowed capital is the capital arranged from outside sources. These include the following:

  • Financial institutions,
  • Commercial banks or
  • The general public in case of debentures.

According to Time-Period:

Long term sources of finance

Long-term financing means capital requirements for a period of more than 5 years to 10, 15, 20 years or maybe more depending on other factors. Capital expenditures in fixed assets like plant and machinery, land and building etc of a business are funded using long-term sources of finance. Part of working capital which permanently stays with the business is also financed with long-term sources of finance. Long term financing sources can be in form of any of them:

  • Share Capital or Equity Shares
  • Preference Capital or Preference Shares
  • Retained Earnings or Internal Accruals
  • Debenture / Bonds
  • Term Loans from Financial Institutes, Government, and Commercial Banks
  • Venture Funding
  • International Financing by way of Euro Issue, Foreign Currency Loans, ADR, GDR etc.

Medium term sources of finance

Medium term financing means financing for a period of 3 to 5 years and is used generally for two reasons. One, when long-term capital is not available for the time being and second, when deferred revenue expenditures like advertisements are made which are to be written off over a period of 3 to 5 years. Medium term financing sources can in the form of one of them:

  • Preference Capital or Preference Shares
  • Debenture / Bonds
  • Medium Term Loans from
  • Financial Institutes

Short term sources of finance

Short term financing means financing for a period of less than 1 year. The need for short-term finance arises to finance the current assets of a business like an inventory of raw material and finished goods, debtors, minimum cash and bank balance etc. Short term financing is also named as working capital financing. Short term finances are available in the form of:

  • Trade Credit
  • Short Term Loans like Working Capital Loans from Commercial Banks
  • Fixed Deposits for a period of 1 year or less
  • Advances received from customers
  • Creditors.