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The Major sources Designed for the Purposes of Financing
The question of financing is considered to be one of the most important for various businesses in view of the fact that money flow is a crucial condition for a business’s long-lasting success and prosperity. In this case financing, or funding is an essential factor that plays an important role in the operation and development of ongoing business structures. In order to provide a business with the necessary amount of money for its development, an entrepreneur has to find relevant sources of finance that meet all the actual requirements his or her business has. Based on various factors, the sources of finance can be divided into several groups. Generally, they are classified as external sources and internal sources.
The present paper gives a complete description of the major sources designed for the purposes of financing that are available to different types of businesses. External and internal sources of financing that are taken as a general classification are discussed and analysed. Moreover, a strong emphasis is placed on the advantages and disadvantages of each of the source mentioned in the paper has. Therefore, the given paper particularly covers all the aspects of the financing sources available to businesses.
When a business is established, it needs a certain amount of money to be operated with in order to develop and prosper. The initial investments that are put into a business are named as owner’s capital investments. These are the money taken from different sources as personal savings, redundancy, inheritance, any other investments, etc. Over time, when a business properly functions, there occurs a need to increase initial investments. Normally, such a need is satisfied by an actual profit this business generates. All the described above sources are known as internal sources of business finance.
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In case the sources of finance, available within an ongoing business (internal sources of business finance) do not solve the issue of money flow for a normal business functioning, an owner starts to focus on the sources out of his or her business. These are called external sources of finance. Basically, they are divided into three major types due to their length and duration. These are the following: long term sources, medium term sources and short term sources.
Short term sources of business finance are mostly used, when there is a need to receive additional working capital that helps to fund daily management and operation activities. A period of a short term finance is no more than one year. There are three main subtypes of these sources, which are factoring, trade credit and overdrafts.
According to factoring, finance is raised against trade debtors, who are customers that bought some goods, or services from a business on credit, but did not paid for them yet, and already broke their credit terms. In this case, a factoring institution, or organization that is usually a financial establishment, such as bank, assesses a way a particular credit worthy these customers are, and proceeds to collect the debts for the account of the business (Klein, 2010). There is a fee determined between a bank and a business involved for this operation. As soon as the debts are received by a financial institution, the business receives the value of the invoice, but already without the fee meant for financial institution.
The advantages of the given source of finance lie in the following:
- a large amount of money is received within a short period of time;
- it helps a business to support smooth money flow operations;
- a factoring company undertakes all the money from trade debtors.
The disadvantages of the source are fees necessary to be paid for a factoring company services, lack of privacy, and trade debtors would not like to deal with factoring companies that try to collect their debts.
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According to the source of trade credit, a supplier, whom a business purchased goods or services from, is a provider of trade credit. This means that a business does not pay to a supplier at once. There is a credit period that is usually between thirty and ninety days. Also, a supplier may offer a discount on purchase for a prompt payment. This type of the source finance is not direct, and does not give any additional amounts of money to a business, though it still makes it possible to redirect money within a business until there is a need to pay creditors.
Overdraft is a type of a bank loan. It is set up on a business’s account, and can be used whenever there is a need for additional working capital. A bank loan attracts a high interest rate that makes it expensive. That is why, when a business needs money for a period less than a year, it is better to consider to set up a short term bank loan, or even borrow money from family members. A bank sets up a fixed fee for a bank loan, and will be paid back in instalments. Also, a bank will require a sort of security for the loan. In this case, if a business cannot pay for a bank loan, it takes a claim to any actual assets. For example, this may be an owner’s car or house.
The advantages of a bank overdraft include:
- being a short term debt, it is not shown in calculating a business’s gearing ration;
- it is quick to arrange;
- it is best for a short period cash flow deficit.
The disadvantages of the present source of finance are:
- bank loans are designed only for a short period of time;
- there is a limit to the amount of money that can be overdrawn;
- any bank loan can be recalled by a bank at any time.
Medium-term sources are designed for a period of five to seven years. They are usually used, when there is a need to buy assets, or expensive equipment, vehicles, fixtures for a business. Basically they are secured against business assets and an owner’s personal assets. These sources are leasing, hire purchase and medium term loans.
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Leasing is used to acquire assets at a lower cost. Leases are paid monthly, or early. This option can be used if a residual value of an asset is uncertain when it comes to a question of selling this asset, or in case when an asset is required for a particular period of time (Melicher, 2008). There are a lot of advantages when choosing this type of the financing source. Payments are made only for the usage duration of an asset. There is no need to pay the amount in full in order to start using the asset. The lease period and the total cost are always predetermined. However, the ownership of the asset remains with the lessor even when all payments are made.
Hire Purchase is a Sort of Traditional Borrowing
It allows a buyer to use an asset as soon as he paid a deposit. A deposit represents the 1st payment in numerous instalments that should be paid over a fixed period of time at regular intervals. When the last instalment is paid, a buyer becomes a legal owner of an asset. The advantages of using this source of finance include affordable instalments payments over a fixed period of time, ownership transferred to a buyer after the last payment made, possibility to use an asset before all the payments for it are made. Nevertheless, a buyer will pay more than the original value of an asset, and in case an asset needs to be replaced due to some reasons, such as breakdown, a buyer still has to make payments for it.
Medium term loans are the same as a bank loan described above. The only difference is that it can be obtained not only from a financial establishment, but also from a government, friends, or family members. Moreover, it has a longer time duration, though the conditions and terms of the loans are similar to those that short term bank loans have.
When there is a need to obtain assets that are considered to provide economic gain to a business during a long period of time, long term sources of finance are generally used. This type of finance has a time duration longer than seven years, and includes two major categories, which are equity finance and debt finance.
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Equity finance refers to a kind of finance that is raised by the selling of ordinary shares. Only limited liability companies can take advantage of this type of the source of finance. There are three major types: sell shares, when limited companies sell shares on the stock exchange to raise capital; formal venture capital, which are generally from pension funds; informal venture capital that is provided by a wealthy person, who wants to invest in private companies (Dlabay, 2007). Therefore, a business can receive large amounts of money, and valuable experience and expertise brought by investors, though an owner of business should deal with strict rules of the stock exchange, present a business plan and define a business strategy to a potential investor, and when his business plan is approved, he has to share profits that a business earns with an investor. All these aspects make the present types of sources inappropriate.
Debt Finance has also Three Major Types
They include debenture, mortgage and long term loans. Debentures as well as equity finance sources can be used only by limited liability companies. All the payments are basically made in full at a fixed date in future. A holder of a debenture is usually a private, or corporate investor, who normally receives a fixed rate of interest. Debentures can be sold on the stock exchange. Moreover, an interesting fact is that comparing to an equity agreement, debentures are much lower risk for an investor. The advantages of such source of finance for a business lies in tax benefits. All debenture interests are treated as expenses. Nevertheless, all the money borrowed should be paid back at a fixed date as well as debenture interests regardless of business’s earning profits, or losing money.
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Mortgage is a type of a long term loan that is designed to buy premises or land. It is usually provided by a financial establishment as a building society, or a bank. There is a specific time framework for payments to be made over years. Generally, it is around thirty years. The mortgage interest rate can be fixed, or variable. Payments can be made at the end of the loan term, or in instalments during a whole time duration.
Therefore, there are a lot of different sources of finance, available to a business. Some of them are appropriate for one type of business, and unappropriate for another one. A choice of the source of finance for a certain business typically depends on a wide range of reasons that an entrepreneur should consider in order to achieve the best results, and make his or her business successful among others. In the present paper internal and external sources of finance have been described. The advantages and disadvantages of each type of source have been represented.