External Sources
of Finance means external sources from which fund can be collected, such
as, fund collected by taking a loan from bank. External sources
of finance are very popular. Two reasons of these are identifiable:
a) If business is financed externally through loan,
then tax is imposed on the profit left after deducting the interest of loan.
Thus less amount of tax can be paid.
b) In the case of small business, many times
internal financing becomes comparatively less in amount; as a result, external
sources act as the main sources of finance.
But one problem of external sources is the compulsory
payment of interest. It was previously said that, whether profit is earned or
not, business is bound to pay the imposed interest as per schedule. This
problem doesn’t create if internal sources are used. On the basis of terms,
external sources can be divided into three types: a) Short term, b) Mid-term
and c) Long term. Now we will grow ideas of these three types of sources.
After reading this chapter we shall be able to do:
·
Sources of short term finance
·
Sources of mid-term finance
·
Sources of long term finance
Short Term Financing
Short term means less than one year. Most of the finances of
an organization are usually collected from short term sources which are repaid
within a year. In the case of short term financing, an organization enjoys some
benefits, for example:
First: Cost of capital from the short term sources
may be comparatively both the highest and the lowest. For example, loan
collected from the commercial bank required to pay high rate of interest in
short term. Again, different interest free sources like purchase on credit or
wages kept due, a business organization can create fund for short term, which
has no cost of capital. (We will learn in details about the cost of capital in
the following chapters.)
Second: The process of short term capital exchanges
is the fastest and simple process. On the other hand, the exchange of
mid-term and long term financing requires to expend huge time and to follow
long process.
Third: The business institutions whose products
demand changes very swiftly within one year cannot make long term plan
of production and financing. For example, due to the rapid change of demand for
the fashion house’s products, these types of business make plan for short term
production, and thus require small amount of money at a time. Short term
sources of financing are suitable for these types of businesses.
Now we will discuss about the short term sources of finance.
The sources of finance of this term can be divided into two types. We will
discuss below first about the institutional sources of short term finance and
then non-institutional sources of short term finance will be discussed.
1. Institutional Sources of Short Term Financing
a) Discounting Bills Receivable
When products are purchased on credit, the buying firm
promises to the selling firm through signing a document to pay specified amount
of money after expiry of the certain period (usually 3 months). This type of
document is called the bill of exchange. This bill is receivable for the
selling firm. So, selling firm can collect cash by exchanging or discounting
this bill in a commercial bank. Let us assume, on January, buyer purchases
goods of $5 on credit and agreed through signing the Bill of Exchange that he
would be bound to pay $5 to the selling firm on March 30. In this condition, if
the seller needs money before March 30, he can sell this bill to a bank before
the expiry of the period but he has to receive less than $5, for example, with
a discount rate of 3%, after discounting he will receive $4.
b) Bills Payable
In above example, bill of exchange is a bill receivable from
the perspective of the seller, which is a bill payable to the buyers and is one
of the sources of short term finance. When a business institution purchases raw
materials, production materials, etc. on credit, then finance inflows for a
short time in the business. Because, if business couldn’t get the opportunity
of credit purchasing then finance would be required to buy on cash payment,
hence if loan was collected from the bank then interest would have to be paid.
c) Short Term Bank Loan
In the case of short term finance, unsecured bank loan is
one of the popular sources of finance. This kind of loan may be of different
types. For example, in the case of short term bank loan, usually interest with
principle amount has to be repaid at a time after a specified time period. Many
times, bank tries to collect full portion or part of the sanctioned loan before
the specified time period and for this purpose bank gives discount on the total
amount receivable as an incentive of earlier payment. For example, if a
creditor repays $6000 before the expiry of the credit term of 6 months, then he
can give 2% less than the total amount, which means, the creditor can repay $4800.
Besides, if the creditor agrees to repay on demand instead
of agreeing on a fixed term, then this type of loan is called “Demand Loan”.
The institutions which have alternative sources of finance can use this source
at a low cost of capital.
Bank Overdraft is another type of short term bank loan.
Every institution usually realizes its receivables and repays its payables
through current account. This type of bank account mainly gives to its account
holders the opportunity of withdrawing more than the amount of savings in this
account; however, the bank restricts the maximum amount of overdraft.
Generally, finance collection from this type of source is a well-known system
for those institutions where sales decrease for some time of a year. As an
example it could be mentioned, an ice cream factory spends money throughout the
year for production, warehousing, management etc. but maximum amount of ice
cream is sold in summer season, so for the purpose of financing in other time
of the year this type of source can be used. Generally, in the case of other
types of loan, interest has to be paid till the full repayment of loan, but
interest for such types of loan has to be paid only when this loan is being
used. However, the rate of interest of this type of loan is higher than the
other types of loan and it is repayable on demand.
d) Small Credit
This type of loan is generally provided to meet the demand
of current asset for agriculture based and small & cottage industry, such
as, management of a small industry, purchasing of agriculture based materials,
management of a firm etc. Grameen
Bank, Youth Development Bank, Co-operative Banks are used to provide such
kind of bank. This kind of loan is given step by step on the achievement of
goal.
2. Non-Institutional Source of Short Term Loan
a) Commercial Papers
A business organization sells Commercial Paper through
promising to pay back the principal amount with interest after expiry of the
certain period. At that time the company’s goodwill acts as a security to the
purchaser. Usually, those persons who have some excess money left as unutilized
for the time being purchase commercial papers as an alternative of investment
in shares. Generally, well known person, commercial bank, insurance company,
pension fund etc. can arrange finance for a short time by selling commercial
papers.
b) Advance from Purchaser
Many times, trustful and permanent customers pay as advance
to the producing or selling firm the full amount or part of their total
purchase, and as a result, this act as a source of finance to the seller for
the time being.
c) Inventory Financing
For the purpose of short term financing, warehouse asset can
be used. If any business firm uses its inventory as security of loan received
from a well-known person or organization, it is called the inventory financing.
d) Village Moneylenders
From long days ago, rich people of the villages have been
providing short term loans to the poor people. In this case, if the period of
loan repayment is expired, the debtor has to pay high rate of interest. If the
person fails to pay back the loan with interest within specified period, the
moneylenders took the possession of his (debtor’s) tangible and intangible
property. Village moneylenders count to impose interest on this loan on day
basis, weekly basis and monthly basis.
Mid Term Financing
This type of loan extends for 1 to 5 years. A business firm
uses this fund to meet the demand of long term needs of the current capital.
Cost of capital or interest rate of this fund is higher than that of the short
term sources of finance and less than that of the long term sources of finance.
Sources of this type of loan according to their different features are
discussed below:
a) Commercial Bank Loan
Loans which the commercial banks provide for mid-terms are
usually given against security. Current capital or even fixed asset can be used
as security for obtaining this type of loan. Huge amount of loan payment (at a
time) may be a risky job for a commercial bank. So, when a commercial bank pays
huge amount of loan, it creates syndication of a number of commercial banks
together to bear in group the high risk of loan payment. Before sanctioning the
loan, a commercial bank finalizes its interest rate by analyzing the interest
rate fixed by Government Bank and the demand of the loan.
b) Specialized Financial Institution
Generally, some financial institutions are established under
the government ownership which is engaged in the development of the country’s
specialized sectors. These institutions provides term loan on favorable conditions
to the relevant sectors. Industrial Bank, Agriculture Bank, and Cottage
Industry, etc. are examples of such institutions.
c) Non-Government Institutions
There are different kinds of NGOs working in the world which
provide mid-term loan to the business institutions. For example, Midas, BRAC, Grameen Bank, etc. are
doing business as an NGO by
getting legal entity. Besides providing fund, these institutions also provide
consultancy, training, support in efficiency building activities etc. to the
business organizations.
d) Capital Market Institutions
Different types of capital institutions such as insurance
company, investment bank, finance mediatory institutions (underwriters) also
provide mid-term loans.
Long Term Financing
Long term financing extends from 5 years to maximum till any
duration. Long term financing has some distinctive features. We will now
discuss about these features. First feature of long term finance is the amount
is bigger than the mid or short term funds, so this fund is usually used to
acquire fixed asset like- land, building, equipment etc. Another feature is
related with the repayment schedule. If long term fund is collected through
loan, it has to repay as per contracted payment schedule. Again if long term
fund is collected through selling shares, then this fund is considered as
owner’s capital, so this liability need not be repaid till the business
dissolution. In sole proprietorship and partnership businesses, the owner’s
capital too can usually be used for indefinite long period. The tax-related
feature is that share dividend is taxable but interest of debenture is
non-taxable. That’s why the cost incurred from share selling is higher than the
finance through long term loan. Now we will discuss about the sources of long
term fund.
a) Loan
Generally, any organization takes long term loans against security
to bear the expenses of expensive equipment’s, machineries, buildings, land
purchase, etc. Before sanctioning long term loans, banks analyze different
information like income of the company, goodwill, amount of fixed asset,
previous events of taking loan and loan repayment trends etc. Long term loan is
collected for fixed investments, such as, expansion of scope of the business,
factory construction, building construction, purchasing heavy equipment’s, etc. Before taking these investment
decisions, the concerned business organization makes an estimate which is known
as capital budgeting. Through this process future profit or loss is measured by
adopting different procedures. If the financing organization is satisfied by
this estimate of profit and loss, only then loan is sanctioned.
b) Debenture
In the case of debenture, fund is collected through
selling the large amount of loan after dividing into small fractions. It is an
alternative to share. But, debenture holders are bound to pay fixed rate of
interest which is kept mentioned in debenture. Loan is taken for any long term
starting from 5 years. Whether profit is earned or not, the business is bound
to repay the interest of the lenders. Main advantage of financing through
selling debenture is the long term existence of fixed rate of interest; and as
interest rate is predetermined, financial managers can make an effective plan
of financing.
c) Leasing
Leasing is an amazing method of long term financing.
If an organization needs expensive machine, equipment’s, transport etc., then
it has to purchase those things directly or instead of purchasing directly the
organization can use those things through a lease contract from a leasing company.
But at that case, company does not get the ownership of the machine. Leasing
company is the owner of the machine. To enter into a leasing contract, the
organization has to pay rent (like interest) to the leasing company at a fixed
rate and thus it can get the opportunity of using the leased properties. Let us
assume, a business firm takes a photocopy machine as lease from a leasing
company for 3 years by pledging to pay a fixed amount of rent and returns it to
the leasing company after the expiry of the period. That means, on a leasing
contract, ownership of the property is retained to the leasing company. As an
advantage of leasing, the organization needs not to take long term loan or to
use savings fund. For this reason, leasing is a source of long term financing.
Newly established companies or the small companies whose capital for investment
is not sufficient also can use expensive machines, etc. through leasing. The
leasing company provides repair and maintenance services for the lease
properties.
End
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