Business Finance: Internal, External, and Long-Term Sources
Sources of Finance
A business might have access to various sources for financing its needs. These sources of finance can be classified as:
Internal and External Sources
Internal: This is money raised from inside the business. It includes:
- Sales of Assets: Businesses might sell off old, obsolete assets that are no longer used to raise additional cash.
Advantage: Better use of capital.
Disadvantage: A new business might not have any old or obsolete assets.
- Retained Profits: Businesses (especially limited companies) usually keep a portion of their profit each year for future use. This is also known as ploughed-back profit. Over time, it can total a significant amount, which can be used for financing the business.
Advantage: Does not increase liabilities; no need to pay interest.
Disadvantage: Not available to new businesses.
- Reduction in Working Capital: Cutting stock levels can also help the business raise additional cash.
Advantage: Costs related to stock storage are reduced.
Disadvantage: May lead to a shortage of stock and loss of sales.
External: This is money raised from outside the business. It includes:
Short Term Finance
Bank Overdraft: A bank overdraft is a facility given by banks to their business customers who have current accounts. Through this facility, customers can overdraw their accounts to a greater value than the balance in the account. The overdrawn amount is agreed upon in advance with the bank manager. The bank assigns a limit to overdraw from the account, and the business can meet its short-term liabilities by writing cheques up to the allowed limit.
Advantage: No need for collaterals or security. More flexible, and the overdraft amount can be adjusted every month according to needs.
Disadvantage: Interest rates are usually variable and higher than bank loans. Cash flow problems can arise if the bank asks for the overdraft to be repaid on short notice.
Trade Credit: Usually, in business dealings, suppliers give a grace period to their customers to pay for purchases. This can range from 1 week to 90 days, depending on the type of business and industry.
Advantage: No interest has to be paid.
Disadvantage: The business may not get cash discounts.
Factoring of debts
Advantages and Disadvantages of debt factoring
Medium Term Finance
Hire Purchase: This involves purchasing an asset by paying for it over a period of time. Usually, a percentage of the price is paid as a down payment, and the rest is paid in installments for the agreed-upon period. The business has to pay interest on these installments.
Leasing: Leasing involves using an asset, but the ownership does not transfer to the user. Businesses can lease a building or machinery, and a periodic payment is made as rent until the business uses the assets. The business does not need to purchase the asset.
Advantage: The business can benefit from the asset without purchasing it.
Disadvantage: The total cost of leasing may end up higher than purchasing the asset.
Medium-Term Bank Loan: A bank loan for 1 year to 5 years.
Long Term Finance
Long-Term Bank Loan: Borrowing from a bank for a limited period. The business has to pay interest on the borrowing. This interest may be fixed or variable. Businesses taking out a loan will often have to provide security or collateral for the loan.
Issue of Shares: This is a permanent source of finance but only available to limited companies. Public limited companies can sell further shares up to the limit of their authorized share capital. Private limited companies can sell further shares to existing shareholders.
Advantage: Permanent source of capital. In the case of ordinary shares, the business will only pay dividends if there is a profit.
Disadvantage: Dividends have to be paid to the shareholders.