The sources of finance through which business can raise funds could be classified under 3 categories which are as follows:
Long term period: As the name itself suggests that the funds are used for long period of time i.e. for more than one year. Sources through which we can arrange long term funds are Equity shares, preference shares and debentures etc. These types of funds are raised from capital market.
Short term period: These are funds which are used for short period of time i.e. generally more than one year. These types of funds are raised from money market and the sources through which we can arrange the funds are factoring, trade credit, commercial paper, treasury bill etc which is for particular time period and business need to keep a collateral as a security against it.
Factors Affecting Basis of Period
- Limited Fund: If a company needs limited amount of fund then it should go for short time period and in case the company needs large amount of finance then it should go for long term period.
- Finance for new company: If a person wants finance for setting up a new company then long term finance is suitable, otherwise for a running business or company short term finance is a better option.
- Change in assets: If a company wants to change its existing assets then there is a need of long term finance whereas if a company doesn’t want to change its existing assets and require capital for the day to day working only then it may go for short term finance.
- Procedure of raising funds: The procedure raising long term finance is lengthy and little difficult too, so the company’s those who wants to save the time generally go for short term finance.
On The Basis of Ownership
Owners Fund: Owners fund refers to those types of funds which are invested by the owners of the company. This is also known as owner’s capital. It is raised by issuing equity shares, preference shares, retained earning etc. Generally, these are for long time period.
Borrowed Funds: It refers to those types of funds which are generated from outsiders through loans and borrowings. It is for specific period of time. For example, loan from commercial banks such as ICICI bank, SBI or any other financial institutions.
Factor Affecting Basis of Ownership
- Cost: The cost of raising finance from various sources is different and finance manager always prefer the source which cost minimum to company, in this case owners fund should be preferred.
- Risk: More risk is associated with borrowed fund as compared to owner’s fund. Finance manager used to compare the risk with the cost of raising finance involved and prefers security with moderate or less risk factor.
- Cash flow position: The cash flow position of the company also helps in selecting the source of ownership. Companies with smooth and steady cash flow position can easily afford borrowed fund securities whereas the companies whose who face shortage of cash flow they used to go for owner’s fund only.
- Control Consideration: If existing shareholders want to retain the complete control over the business, then they should prefer borrowed fund securities to raise further funds whereas on the other hand if they do not mind to lose the control then they may go for owner fund securities.
- Floatation Cost: It refers to the cost involved in issue of securities such as broker’s commission, underwriter’s fees, expenses on prospectus etc. Company prefers the securities which involve least floatation cost.
- Fixed operating cost: If a company is having high fixed operating cost, then they must prefer owners fund because due to high operational cost, the company may not be able to pay interest on debt securities which can cause serious troubles for the company.
- State of capital market: The conditions in the capital market also helps in deciding the type of securities to be raised by the company. Generally during boom period, it is easy to sell equity shares as people are ready to take risk but in case during depression or recession period there is more demand for debt securities in capital market.
On the Basis of Source of Generation
Internal Source: The name itself suggests the nature of finance or capital. This type of finance is generated internally by the businessman by its own. For example, money raised through retained earnings, by selling assets of the company etc. This type of finance is free from any type of risk or dilution of control.
External Source: This is the source of finance through which money is arranged from outside the organization or we can say that from outside world. For example, issuing the equity shares to general public (in case of public company), loan from commercial banks, debentures etc. This type of finance is risky and there is also dilution in the control.
Factors Affecting Basis of Generation
- Cost: The cost of raising finance from internal source is less as compared to external source. When company have less finance to raise funds then it should arrange it from internal source.
- Risk: More risk is associated in external source as compared to internal source, so bear less risk and remain risk free a finance manager should arrange funds from internal source.
- Cash Flow Position: Cash flow position of the company also helps in selecting the source of generation of funds. With smooth and steady cash flow, companies can easily afford external source whereas if cash is flow is not up to the mark of the industry then it leads to compulsion for company to go for internal source
- Control Consideration: If the company’s existing shareholders do not want to lose their control over the company then they should choose internal source.
- Growth Opportunities: If a company a number of investment plans then external source is preferred because internal source like retained earnings, sale of asset does not provide sufficient amount of fund which can help as in growth and expansion.
- Floatation Cost: It refers to the cost involved in issue of securities such as broker’s commission etc. If a company wants to prefer a source with less floatation cost, then it should go for internal source otherwise vice versa.
About the Author
Arpit Goyal is pursuing CA and B.com & also working as an article assistant in Gurgaon. He has an immense interest in Taxation. He loves to use technology to spread knowledge about taxation & accounts.