Finance
means fund collection, its management and distribution. In this chapter, we
will learn about the concept of the sources of finance for doing the fund
collection activity efficiently. Different sources of finance have different
features. For these different features, fund should be collected from different
sources suitable for different situations of the business. For example, to
purchase a fixed asset fund should be collected through share selling. Again,
to meet the daily needs such as, raw materials purchase, credit purchasing can
be used or short term bank loan can be utilized.
After reading this chapter we shall be able to do:
·
Classification of sources of finance
·
Comparative discussion of the advantages and
disadvantages of different term finances.
Introduction
The fund required for the purpose of starting any business
or to conduct the daily activities of business, selection of the sources of
finance is one of the important decisions in financial management. Because,
different sources has different costs of capital and the sources of different
terms have different advantages and disadvantages. An institution collects fund
by analyzing different sources to select that mixture of sources which will
provide maximum benefit and minimum cost. Main objective of investment is
profit earning. We can get net profit by subtracting the cost of capital and
tax from total profit. So, the cost of capital should be reduced to maximize
the profit of the business.
Concept of the different sources of finance
Business finance means supplying of fund required for
running a business. Mr. William is the owner of a tailoring shop. He purchased
some machines at the beginning of the business. Generally, a business person
tries to collect fund from his own savings for the purpose of machines purchase
related fixed investment. But if he sees after calculations that his own
savings is not sufficient to purchase the machines, then he can collect fund
through loan at a certain rate of interest from different commercial banks or
other loan providing financial institutions. He usually collects this type of
loan for a fixed term. Fund can also be collected from bank and other
non-institutional sources against collateral of fixed property of business,
like- building, factory and current property, like- raw materials, salable
products etc. Besides, Mr. William may meet the needs of finance by reinvesting
the profit earned by him without withdrawing this it from the business. If Mr.
William feels cash crisis to meet the current needs, like- maintenance of
machinery, payment of house rent, payment of labor wages, payment of
electricity bill etc. during the time when the business is in operation, then
he can receive advance from the buyers against future selling. Moreover,
purchase on credit is another source of finance. Sometimes heavy machinery,
big equipment, building, land, etc. can be rented from different organizations
for a fixed period instead of purchasing and thus the business person can
remain protected from the risk of huge investment at a time.
Thus, due to the differences of forms, nature and objectives
of business, an organization collects fund from different sources. In every
organization there are two separate sources of finance. One is the owners and
the other is the creditors. Fund provided by the owners are called internal
sources of finance and that provided by the creditors are called external
sources of finance. Most of the organizations usually utilize both these two
sources.
In the below table, classifications of these two sources of
finance have been shown:
Internal Sources of Finance
Fund which the owner of a business invests through his saved
profit or un-utilized profit is called the internal sources of finance. Internal
sources of finance can be divided into two types: a) Ownership-based sources,
b) Profit-based sources. Now we will know about the different kinds of these
two sources of finance. |
Classification of the sources of finance
|
Ownership Based Classifications of Internal Sources
Nature of internal fund is different for different kinds of
business organizations. We know, based
on ownership organizations may be of Sole
Proprietorship, Partnership
or Joint
Stock Company. In sole
proprietorship business, sources of internal fund are owner’s own savings
or it may be any kind of factors of production measurable in money, such as:
land, labor, capital and organization which are used in production. If the
organization is a partnership
business, fund invested by the partners is considered as the owner’s
capital. On the contrary, if the organization is a company, fund collected
through shares selling is considered as internal source of finance. Joint
stock companies are of two types: Public Ltd. Company and Private Ltd.
Company. Number of Initiators in private ltd. company is 2 to 50 and in public
ltd. company it is minimum 7 and the maximum number may be any number limited
to the shares. Both public and private ltd. companies collect capital through
share selling. But a private ltd. company sells shares among the specified
owners instead of selling them in the share market. An important source of
capital collection for a public ltd. company is share selling.
Profit-oriented Classification of Internal Sources of Finance
A business institution earns money through producing goods and
providing services. The money which remains left after deducting the production
cost, selling expenses, etc. from this earnings is the profit of the business.
The remaining portion of profit after deducting the interest of loan and the
tax payable to the government can be used in various
ways as a source of fund – these are discussed below. As in the case of loan,
interest payment is compulsory but in the case of internal financing almost
nothing is to be done as compulsory; so, the risk of repayment related
inability is decreased. Now, we will be introduced with some profit oriented
sources of finance.
a) Undistributed Profit and Savings Fund
The portion of profit which is invested in the
business instead of distributing among the shareholders is called undistributed
profit. If this undistributed profit is kept in separate fund for the purpose
of business expansion in future it is called savings fund. Besides, this type
of fund may also be created to overcome financial disasters in future.
b) Dividend Equitable Fund
Shareholders of a company usually get dividend from
the company on a regular basis. Goodwill of the company implicated with giving
this dividend. If in any year business earns less amount of profit then payment
of dividend is not possible. But inability of dividend payment may deteriorate
the business image in the market; so, in the year when the business earns huge
profit, the company keeps aside small portion from the net profit as dividend
equitable fund which can be used to pay the dividend also in the year when business
earns insufficient profit. Thus, this fund gives the business ability to pay
dividend on regular basis.
External Sources of Fund
External fund means external sources from which fund
can be collected, such as, fund collected by taking a loan from bank. It is a
popular source of finance. Bank loan has some features. First: Bank loan has a
fixed term, within this term loan is to be utilized and the principal amount
with interest has to be paid back to the bank. Second: Rate of interest remains
the same, for the long period of its term no change is made. Third: Repayment
of interest and installment of loan regularly and repaying the principal amount
within the term is compulsory for the business. These dues have to be repaid
even though the business is not profitable. Besides, fund can also be collected
through selling debentures or bonds to the bank. Selling of preference shares
is another source of external financing.
For learn more about External Sources of Finance. Click
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Considerable Factors for Selecting the Sources
Organizations collect funds from different sources
to meet the need for money. For selecting the sources, we need to analyze
advantages and disadvantages of different sources and take into considerations
the cost of fund collection, nature of the organization, type and purpose of
need of the fund, etc. Making a right mix of the sources of fund is an
important decision of the finance management. Things that should be taken into
consideration for selecting right source of fund are mainly:
a) Type of Business
In the case of sole
proprietorship and partnership
businesses, fund is collected usually through own savings, profit of
business, or loans taken from relatives. In the case of large scale purchase,
leasing is also a good source of finance. In the case of public limited
companies, instead of these most funds are collected through issuing shares and
debentures. In (Picture: Selecting Sources of Finance based on the Types of
Business Organizations) a structure of the sources of finance mix based on
different formations and purposes of the business has been furnished. In the
first line of the picture, we see, the source is fit for sole proprietorship
and partnership business. Hereafter, it is found that undistributed profit,
overdraft, short term loan and leasing are acceptable for all kinds of
organizations. But long term loan and share issuing are applicable only for
companies. |
Picture: Selecting
Sources of Finance based on the Types of Business Organizations
|
b) Insufficiency of Security Property
Usually in the case of a new business organization, getting loan
against fixed asset as security is not possible. Besides, the selling of share
and debenture is also a bit uncertain for the new
companies. In such situation, if long term fund is needed, it is more logical
to collect that through leasing.
c) Types of the Needs of Finance
If a company wants to buy expensive equipment’s, machinery, land, buildings, etc., then use of long term sources like- issuing
share and debenture, taking lease, taking loan against security, etc. are
effective. If there is shortage of fund to bear the expenditure of raw material
purchase, paying wages, paying house rent, etc., then use of short term sources
like- credit purchase, receivable bill security, bank overdraft can be
accepted.
d) Cost of Sources of Fund
Fund can be collected from many sources. But an
organization takes loan from that source where the expenses are the least. So,
it issues shares for fund collection. But for collecting fund through shares
the company has to pay dividend to the shareholders, which is a cost of this
source. Besides, the company can mortgage its property for buying the new
factory. If through such mortgage the company takes loan for long term, it has
to pay installments with interest to the lending organization until the loan is
fully realized. As a result, this source is also expensive. The company can
accept that source of the two where the cost is least for it. Or, it can
collect fund by making a profitable mix of the two sources. Dividend of share
is taxable, but interest of debenture is non-taxable. Therefore, to reduce the
load of tax, taking loan on interest from bank or other sources is better than
collecting fund from internal sources. In many cases, more advantages are got
and cost is also reduced by using a mix sources instead of using a single
source.
e) Risk of Sources of Fund
If a company takes loan against security, then it
has to keep properties as security to the lending organization. If it is not
possible for the company to repay the loan within the specified period, then it
is bound to repay the money by selling property kept as security. As a result,
in selecting the suitable source, related risks of the concerned source also
have to be considered.
End
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