Major sources of Finance

Published on 14 April 2025 at 19:31

What is Finance?

Finance is the strategic management of money, investments, and other financial instruments. It involves activities like budgeting, saving, borrowing, lending, and planning to ensure efficient use of financial resources for individuals, businesses, or governments. Essentially, finance revolves around making informed decisions to maximize value and minimize risks.

For business finance it is effective utilization of financial resources to maximize the returns

Why There is financial Needs?

Business organizations need financial resources to meet their different types of requirements. All the financial needs of a business organization may be classified into the following three categories:

Long-term financial needs: The Long term needs generally refer to those `requirements of funds which are for a period exceeding 5-10 years. They are also called as capital investment like Investments in plant, machinery, land, buildings, etc., are considered as long- term financial needs.

Apart from Capital investment funds required to finance permanent or hard-core working capital should also be treated as long term sources.

Medium-term financial needs: Such requirements refer to those funds which are required for a period exceeding one year but not exceeding 5 years. This might be needed for stores and spares, critical spares, tools, dies, Moulds.

Short-term financial needs: - Short term financial needs are those need which arises for short period of time i.e that is not exceeding 1 year (accounting period) This is generally known as requirement of working capital of the business organization. Such type of financial needs arises to finance current assets such as stock, debtors, cash etc.

Sources of Finance 

Basically, Short term financial needs of a business concern should be met from short term sources, and medium-term financial needs from medium term sources and long-term financial needs from long term sources. Accordingly, the method of raising funds is to be decided with reference to the period for which funds are required

There are mainly three ways of classifying various financial sources

  1. Based on basic Sources
  2. Based on Maturity of repayment period
  3. Based on Ownership and Control.

Based on Basic Sources: -

  1. External Sources
  2. Share capital
  3. Equity Share capital
  4. Preference share capital
  5. Debt (Borrowed Capital)
  6. Debentures
  7. Loan from Financial institution
  8. Others
  9. Internal Sources
  10. Mainly retained earning

Based on Maturity of repayment period

  1. Long Term sources of finance
    1. Share capital or Equity shares
    2. Preference shares
    3. Retained earnings
    4. Debentures/Bonds of different types
    5. Loans from financial institutions
    6. Loans from State Financial Corporations
    7. Loans from commercial banks
    8. Venture capital funding
    9. Asset securitization
    10. International
    11. financing like Euro- issues, foreign currency loans

 

  1. Medium Term Sources of Finance
  2. Preference shares
  3. Debentures/Bonds
  4. Public deposits/fixed deposits for duration of three years
  5. Medium term loans from Commercial banks, Financial Institutions, State Financial Corporations
  6. Lease financing/Hire- Purchase financing
  7. External commercial borrowings
  8. Euro-issues
  9. Foreign Currency bonds

3. Short-term Sources of Finance

  1. Trade credit
  2. Accrued expenses and deferred income
  3. Short term loans like Working Capital Loans from Commercial banks
  4. Advances received from customer
  5. Various short-term provisions

Based on Ownership and Control.

  1. Owners Fund
    1. Equity Share capital
    2. Retained Earnings

Equity Share Capital

  1. Borrowed Fund
    1. Debentures
    2. Loan from bank
    3. Loan from Financial institutions
    4. Others

Long Term sources of finance

There are different sources of funds available to meet long term financial needs of the business. These sources may be broadly classified into:

  1. Share capital: - Equity shares or Preference shares
  2. Debt (including debentures, long term borrowing or other debt instruments).

 

  1. Owners Capital or Equity Capital

Organisation may raise funds from promoters or from the investing public by way of owner’s capital or equity capital by issuing ordinary equity shares.

Some of the characteristics of Owners/Equity Share Capital are:

  1. It is a source of permanent capital. They are called equity shareholders or ordinary shareholders.
  2. They are owners of the company as they undertake the highest risk.
  3. They are entitled to dividends after the income claims of other stakeholders are satisfied. The dividend payable to them is an appropriation of profits and not a charge against profits.
  4. In the event of winding up, ordinary shareholders can exercise their claim on assets after the claims of the other suppliers of capital have been met.
  5. The cost of ordinary shares is usually the highest. They expect higher rate of return (High Risk -High return)
  6. Ordinary share capital also provides a security to other suppliers of funds. There can be various types of equity shares like New issue, Rights issue, Bonus Shares, Sweat Equity.

Advantages of raising funds by issue of equity shares:

  1. It is a permanent source of finance. These are not redeemable; the company has no liability for cash outflows associated with its redemption. (They are tradeable)
  2. Equity capital increases the company’s financial base and thus helps to further the borrowing powers of the company (It Helps in borrowing other debt)
  3. A company is not obliged legally to pay dividends. (If company not performing well- no dividend)
  4. A company can make further increase its share capital by initiating a right issue.

Disadvantages of raising funds by issue of equity shares:

Raising of funds through equity share capital has some disadvantages in comparison to other sources of finance. These are as follows:

  1. Investors find ordinary shares riskier because of uncertain dividend payments and capital gains.
  2. The issue of new equity shares reduces the earning per share of the existing shareholders until and unless the profits are proportionately increased.
  3. The issue of new equity shares can also reduce the ownership and control of the existing shareholders.

 

  1. Preference Share Capital

These are special kind of shares; these shares enjoy priority, on payment of a fixed amount of dividend and also towards repayment of capital on winding up of the company.

Characteristics of Preference Share Capital:

  1. Long-term funds from preference shares can be raised through a public issue of shares.
  2. Such shares are normally cumulative,

Cumulative: -The dividend payable in a year of loss gets carried over to the next year till there are adequate profits to pay the cumulative dividends.

  1. The rate of dividend on preference shares is normally higher than the rate of interest on debentures, loans etc.
  2. Most of preference shares these days carry a stipulation of period and the funds have to be repaid at the end of a stipulated period.
  3. Preference share capital is a hybrid form of financing which has some characteristics of equity capital and some attributes of debt capital.
  4. Cumulative Convertible Preference Shares (CCPs) may also be offered, under which the shares would carry a cumulative dividend of specified limit for a specified period which the shares are converted into equity shares.
  5. Preference share capital may be redeemed at a pre decided future date or at an earlier stage inter alia out of the profits of the company.

Types of Preference shares

Sl. No. Type of Preference Shares Salient Features
1 Cumulative Arrear Dividend will accumulate.
2 Non-cumulative No right to arrear dividend.
3 Redeemable Redemption should be done.
4 Participating Can participate in the surplus which remains after payment to equity shareholders.
5 Non-Participating Cannot participate in the surplus after payment of fixed rate of Dividend.
6 Convertible Option of converting into equity Shares.

Advantages of raising funds by issue of preference shares:

  1. No dilution in EPS on enlarged capital base
  2. There is advantage of leverage as it bears a fixed charge (companies are required to pay a fixed rate of dividend). Non-payment of preference dividends does not force a company into liquidity.
  3. There is no risk of takeover as the preference shareholders do not have voting rights except where dividend payments are in arrears.
  4. The preference dividends are fixed and pre-decided. Cannot participate in surplus profit.
  5. Preference capital can be redeemed after a specified period.

Disadvantages of raising funds by issue of preference shares are:

  1. Preference dividend is not tax deductible and so does not provide a tax shield to the company
  2. Preference dividends are cumulative in nature. And without payment to preference shareholder ordinary shareholder cannot take dividend.

Difference between Equity Shares and Preference Shares

Sl. No. Basis of Difference Equity Share Preference Share
1 Dividend payment Equity Dividend is paid after preference dividend. Payment of preference dividend is preferred over equity dividend.
2 Rate of dividend Fluctuating Fixed
3 Convertibility Not convertible Convertible
4 Voting rights Equity shareholders enjoy full voting rights. They have very limited voting rights.

Retained Earnings

Long-term funds may also be provided by accumulating the profits of the company and by ploughing them back into business. Such funds belong to the ordinary shareholders and increase the net worth of the company. Such funds also entail almost no risk. Further, control of present owners is also not diluted by retaining profits.

The decision to plough back depends on the rate of return generated by company vs expected cost of equity.

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