What are the sources to finance your business? How to finance your business
1. Meaning of Business Finance
Business is concerned with the production and distribution of goods and services for the satisfaction of the needs of society. For carrying out various activities, business requires money. Finance, therefore, is called the lifeblood of any business. The requirement of funds by a business to carry out its various activities is called business finance.
Business Finance means the funds and credit employed in the business. A business cannot function unless adequate funds are made available to it. The initial capital contributed by the entrepreneur may not always be sufficient to take care of all financial requirements of the business. A business person, therefore, has to look for different other sources from where the need for funds can be met.
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2. Why Business Finance
Growing a business from the first seed of an idea is not a smooth linear journey and it’s not as simple as going from A to B. The destination is seldom decided as the business idea takes form, becomes a reality and then grows into a successful enterprise. The finance journey is continuous; there may never be an arrival point.
For any business to travel on a journey it needs at all points of that journey to be appropriately financed. Businesses need to make sure there is the finance to back their growth plans. Businesses are often started on overdrafts or credit cards, or with help from friends or family or by using the family property as collateral. But soon after that, the business will need to be financed so it can stand on its own two feet if it is to be a sustainably growing proposition.
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3. Need for Business Finance
Once a business is up and running on the growth journey, management will need to ensure that future plans for growth can be financed. If not, there is a chance the business will fail. On the growth journey, there will undoubtedly be ups and downs. Throughout the life of a business, as soon as plans are made, be they looking for growth or for survival or to batten down the hatches, the finance must be in place to support those plans
The need for funds arises from the stage when an entrepreneur makes a decision to start a business. Some funds are needed immediately say for the purchase of plant and machinery, furniture, and other fixed assets. Similarly, some funds are required for day-to-day operations, say to purchase raw materials, pay salaries to employees, etc. Also, when the business expands, it needs funds.
4. Classification of Financial Needs
The financial needs of a business can be categorised as follows:
(a) Fixed capital requirements
Funds or capital is required to start a business, run the business, purchase fixed assets like land and building, plant and machinery, and furniture and fixtures, to spend for long-term expenditures like research and developments etc. This is known as the fixed capital requirements of the enterprise. The funds required in fixed assets or long-term intangible assets remain invested in the business for a long period of time.
Different business units need varying amounts of fixed capital depending on various factors such as the nature of business, etc. A trading concern, for example, may require a small amount of fixed capital as compared to a manufacturing concern. Likewise, the need for fixed capital investment would be greater for a large enterprise, as compared to that of a small enterprise.
(b) Working capital requirements
The term working capital requirement is a financial metric showing the number of financial resources needed to cover the costs of the production cycle, upcoming operational expenses and the repayments of debts.
The financial requirements of an enterprise do not end with the procurement of fixed assets. No matter how small or large a business is, it needs funds for its day-to-day operations. This is known as the working capital of an enterprise, which is used for holding current assets such as stock of material, bills receivables and for meeting current expenses like salaries, wages, taxes, and rent.
The amount of working capital required varies from one business concern to another depending on various factors. A business unit selling goods on credit, or having a slow sales turnover, for example, would require more working capital as compared to a concern selling its goods and services on a cash basis or having a speedier turnover.
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5. Classification of Sources of Business Finance
In case of proprietary and partnership concerns, the funds may be raised either from personal sources or borrowings from banks, friends etc. In the case of company/ corporate form of organisation, the different sources of business finance which are available may be categorised on the basis of:-
- Source of generation
A) Based on Period
On the basis of the period, the different sources of funds can be categorised into three parts. These are long-term sources, medium-term sources and short-term sources as given in Chart 1.
Chart 1: Classification of business finance based on the period
a) Long-term sources of finance
The long-term sources fulfil the financial requirements of an enterprise for a period exceeding 5 years and include sources such as shares and debentures, long-term borrowings and loans from financial institutions. Such financing is generally required for the acquisition of fixed assets such as equipment, plant, etc
b) Medium-term sources of finance
Where the funds are required for a period of more than one year but less than five years, medium-term sources of finance are used. These sources include borrowings from commercial banks, public deposits, lease financing and loans from financial institutions.
c) Short-term source of finance
Short-term funds are those which are required for a period not exceeding one year. Such funds include Trade credit, loans from commercial banks, working capital facilities and commercial papers are some of the examples of the sources that provide funds for a short duration.
Short-term financing is most common for financing current assets such as accounts receivable and inventories. Seasonal businesses that must build inventories in anticipation of selling requirements often need short-term financing for the interim period between seasons. Wholesalers and manufacturers with a major portion of their assets tied up in inventories or receivables also require a large amount of funds for a short period.
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B) Based on Ownership
On the basis of ownership, the sources can be classified as given in Chart 2:
Chart 2: Classification of business finance based on ownership
a) Owner’s fund
The funds financed or contributed by owners of an enterprise are called owner’s funds. Owners may be sole traders or partners or shareholders of a company. Apart from capital, it also includes profits reinvested in the business. The owner’s capital remains invested in the business for a longer duration and is not required to be refunded during the life period of the business.
Such capital forms the basis on which owners acquire their right of control of management. Issue of equity shares and retained earnings are the two important sources from which the owner’s funds can be obtained. We can also include those fund sources that need to be converted to equity such as convertible notes, convertible preferred shares/ debenture etc.
b) Borrowed funds
Borrowed funds’ on the other hand, refer to the funds raised through loans or borrowings. The sources for raising borrowed funds include loans from commercial banks, loans from financial institutions, issues of debentures, public deposits and trade credit. Such sources provide funds for a specified period, on certain terms and conditions and have to be repaid after the expiry of that period.
C) Based on the Source Generation
Another basis for categorising the sources of funds can be whether the funds are generated from within the organisation or from external sources (Chart 3).
Chart 3: Classification of business finance based on the source of generation
a) Internal sources of finance
Internal sources of funds are those that are generated from within the business. A business, for example, can generate funds internally by accelerating the collection of receivables, disposing of surplus inventories and ploughing back its profit. The internal sources of funds can fulfil only limited needs of the business.
b) External sources of finance
External sources of funds include those sources that lie outside an organisation, such as suppliers, lenders, and investors. When a large amount of money is required to be raised, it is generally done through the use of external sources. External funds may be costly as compared to those raised through internal sources
Issue of debentures, borrowing from commercial banks and financial institutions and accepting public deposits are some of the examples of external sources of funds commonly used by business organisations.
6. Sources of business finance
The sources of funds available to a business include retained earnings, trade credit, factoring, lease financing, public deposits, commercial paper, issue of shares and debentures, loans from commercial banks, financial institutions and international sources of finance.
a) Retained earnings
The portion of the net earnings of the company that is not distributed as dividends is known as retained earnings. The amount of retained earnings available depends on the dividend policy of the company. It is generally used for the growth and expansion of the company.
b) Trade credit
The credit extended by one trader to another for purchasing goods or services is known as trade credit. Trade credit facilitates the purchase of supplies on credit. The terms of trade credit vary from one industry to another and are specified on the invoice. Small and new firms are usually more dependent on trade credit, as they find it relatively difficult to obtain funds from other sources.
Factoring has emerged as a popular source of short-term funds in recent years. It is a financial service whereby the factor is responsible for all credit control and debt collection from the buyer and provides protection against any bad-debt losses to the firm. There are two methods of factoring—recourse and non-recourse factoring.
d) Lease financing
A lease is a contractual agreement whereby the owner of an asset (lessor) grants the right to use the asset to the other party (lessee). The lessor charges a periodic payment for renting of an asset for some specified period called lease rent.
e) Public deposits
A company can raise funds by inviting the public to deposit their savings with their company. Pubic deposits may take care of both the long and short-term financial requirements of the business. The rate of interest on deposits is usually higher than that offered by banks and other financial institutions.
f) Commercial paper (CP)
It is an unsecured promissory note issued by a firm to raise funds for a short period The maturity period of commercial paper usually ranges from 90 days to 364 days. Being unsecured, only firms having good credit ratings can issue the CP and its regulation comes under the purview of the Reserve Bank of India or the concerned central banks.
g) Issue of equity shares/ common stocks
Equity shares represent the ownership capital of a company. Due to their fluctuating earnings, equity shareholders are called risk bearers of the company. These shareholders enjoy higher returns during prosperity and have a say in the management of a company, through exercising their voting rights.
h) Issue of preference shares/ preferred equity
These shares provide a preferential right to the shareholders with respect to the payment of earnings and the repayment of capital. Investors who prefer steady income without undertaking higher risks prefer these shares. A company can issue different types of preference shares.
i) Issue of debentures
Debenture represents the loan capital of a company and the holders of debentures are the creditors. These are the fixed-charged funds that carry a fixed rate of interest. The issue of debentures is suitable in the situation when the sales and earnings of the company are relatively stable.
j) Issue of convertible notes/ convertible preferred equity/ convertible debentures
These are debt instruments often used by angel or seed investors and growth-stage companies looking to fund an early-stage startup or a growth plan that has not been valued explicitly. After more information becomes available to establish a reasonable value for the company, convertible note investors can convert the note into equity. It is a hybrid security with debt- and equity-like features.
k) Commercial banks
Banks provide short and medium-term loans to firms of all sizes. The loan is repaid either in a lump sum or in instalments. The rate of interest charged by a bank depends upon factors including the characteristics of the borrowing firm and the level of interest rates in the economy.
l) Financial institutions
Both central and state governments have established a number of financial institutions all over the country to provide industrial finance to companies engaged in business. They are also called development banks. This source of financing is considered suitable when large funds are required for expansion, reorganisation and modernisation of the enterprise.
m) Business Development Companies (BDCs)
A Business Development Company is a form of an unregistered closed-end investment company in the United States that invests in small and mid-sized businesses. A business development company invests money in privately owned, small- and medium-sized companies. Generally, the businesses are facing challenges and need help to grow or get back on track, and they may not be able to obtain financing through traditional means, like bank loans or bond issues.
n) Business angels
Business angels are individuals who make equity investments in businesses with growth potential, businesses in the early stages of development, or established businesses looking for expansion capital. Angels back high-risk opportunities, with the potential for high returns.
o) Venture capitalists
Venture capitalists invest in businesses with the potential for high returns – those with products or services with a unique selling point, or competitive advantage. They invest in a portfolio where a significant number of businesses may fail, so those that succeed have to compensate for those losses. They also want proven track records, and so rarely invest at the start-up stage.
p) Private equity investors
PE makes medium- to long-term investments in, or offers growth capital to, companies with high-growth potential. PE investors would usually improve the profitability of the business through operational improvements and aim to grow revenue through investment in product lines or new services, or expansion into new territories. They will also typically introduce corporate disciplines and a management structure to the business, to give it a platform on which it can grow further.
q) International financing
With the liberalisation and globalisation of the economies worldwide, companies have started generating funds from international markets. The international sources from where the funds can be procured include foreign currency loans from commercial banks, financial assistance provided by international agencies and development banks, and the issue of financial instruments (GDRs/ ADRs/ FCCBs) in international capital markets.
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About the author
Mr Dileep is currently the managing partner of Unifinn Capital Global and an advisor to the investment banking and corporate finance world. He is a mentor, entrepreneur and business advisor with an overall 19 years experience, 12 plus years of banking and finance experience and 7 plus years experience in investment banking and corporate finance, with relevant experience in handling private equity transactions, private debt, venture capital, angel investing, M&A, other growth capital transactions and real estate financing transactions.