3.1 External and internal sources of finance

Need for funds:

1.     Start-up

During commencing a business finance is required to purchase resources like premises, plants and machineries, to pay bills for legal formalities, etc.

2.     Cash flow for day-to-day cost / Working capital

Working capital is the money required to fund the day-to-day expenses of the business.

3.      Expansion

Every firms wish to grow and expand. To expand funds are required to purchase new land and machines, employ more labour, etc.

4.     Emergency funding

If there is insufficient funds to settle unexpected payments like tax, etc then businesses need to introduce new capital, take loans, etc.

Types of sources of finance:

1.     Internal sources of finance

Funds come from inside the business. Types of internal sources of finance are:

v  Retained profit

v  Working capital

v  Sale of assets

2.     External sources of  finance

Funds come from outside the business. Types of external sources of finance are:

·        Short term sources of finance

Funding obtained for less than one accounting/fiscal year, i.e. the payback period is expected to be within one year. The sources are:

v  Bank overdraft

v  Unsecured bank loan

v  Hire purchase

v  Leasing

v  Factoring

v  Trade credit

v  Credit cards

·        Long term sources of finance

Funding obtained for more than one accounting/fiscal year, i.e. the payback period is expected to be over more than one year. The sources are:

v  Owner’s equity

v  Share capital

v  Loan capital

v  Debentures

v  Mortgages

v  Venture capitalist

3.     Government finance

Governments give financial support to the businesses. Government finance schemes are:

v  Enterprise Finance Guarantee (EFG)

v  Working Capital Scheme

v  Capital for Enterprise Fund (CFE)

v  Enterprise Capital Funds (ECFs)

Choosing sources of finance:

1.     Cost of finance

Businesses prefer the cheapest source of finance which means the interest payment, administration cost, other expenses will be cheapest.

2.     Use of funds

If funds are used for heavy capital expenditure then long-term sources are used.

3.     Status and size of the business

Different types of businesses have access to their respective sources of finance. E.g. limited companies are bigger firms so they often raise finance from sale of shares.

4.     Financial situation

If the liquidity position of the company is not sound then it’s difficult to raise funds. Also the lenders are reluctant to lend funds without collateral assets.

5.     Risk

In limited companies one way of measuring the risk of choosing source of finance is looking at the gearing of the company. Gearing shows the relationship between the loan capital and the share capital of a company.

Formula:

Working Capital = Current Assets – Current Liabilities

Format of Working Capital

Businesses improve working capital by:

·         Reducing debtors

·         Delaying creditors

·         Selling assets

·         Getting O/D or short-term loan

·         Introducing new or fresh capital

N.B.“don’t waste time and money,

Spend smartly!”