sources of business finance

sources of business finance

Exploring Sources of Business Finance

1. Introduction to Business Finance

In this chapter, you will learn: what business finance is, what are its different sources and the benefits of using them, and how business finance affects business activities, and the key factors influencing the choice of sources of business finance. You will also be introduced to the group of institutions providing various financial services. During the course of doing business, a company invariably faces cash flow difficulties and the need for additional funds, which it might not have. It then looks around for sources from where such funds could be arranged. It could be friends, relatives, banks, and some small institutions. But before doing this, the company has to understand the advantages provided by each source, as well as the disadvantages. After eliminating or minimizing the different disadvantages of the sources of finance, a company can make proper use of the sources of funds to expand their business and avail of new opportunities.

2. Internal Sources of Finance

These sources of finance get classified as external sources of finance. In some cases, finance is also acquired from internal sources. The point where the two types of source of finance differ most is undoubtedly in the amount of cost that becomes payable by the business. Many forms of external finance have to be repaid both the principal sum itself and an additional sum representing a cost to the business that arises from the fact that the lender has effectively lent the money to the business for the period that they are not in possession of it. This cost is known as interest, and in some cases, it is claimed over the whole amount that is lent. Although no extra interest is levied, shareholders also require a return that is significantly higher than the amount that they might be able to get from safer investments such as building society deposits or government bonds. Although one source of finance that virtually all businesses are able to call upon is the relative ease that is found by all of us in finding additional funds that come from the selling of the rights to any amount of excess resources.

Of the wide range of different forms of finance that are utilized by businesses, some, such as overdraft facilities and trade credit, are essentially a means for the business to extend the length of time that it is able to take to pay its suppliers. Other sources, such as long-term loans or equity issues, provide funds that are mainly used to meet the business’s own need for capital. Certainly, the Barclay brothers will have used the funds that Bowater Industries Plc, as it then was, borrowed to acquire their holding. But the brothers themselves were not required to find any amount of funds that was equal to the value of their shareholding. All that the shareholders had to do was agree to the board’s plan to add to the total amount of assets that were owned and managed by the group’s businesses.

3. External Sources of Finance

Large projects with long time horizons are financed by loans from banks, governments, insurance companies, investment institutions, hire purchase companies, or suppliers, who usually want part-payment in advance. Hire-purchase provides an important source of capital finance; no other secure assets are surrendered, so that there is no hindrance to the further use of capital goods. Entity ownership – to the seller of the goods until the sums due are paid off. Small businesses which need finance to help get established will be able to attract loans only if it can be shown that their prospects are good. Odious conditions may be attached, particularly when the venture is a risky one. For larger enterprises a second source of risk financing is open. Through the issue of new shares.

So far, we have discussed internal sources of finance. Businesses, however, do have obligations to outsiders as well as to those who supplied their original funds. Funds from the owner that have to be paid back as loans do not add to the normal working capital of the firm and only the legally available working capital, which has no fixed date for payment, is important on this account. All the legal reserves may become invested, and it is this long-term investment for which the firm must seek outside finance.

4. Alternative Sources of Finance

Does the firm’s profit need to be reinvested in the business in order that it may grow? Would the owners be better off by extracting some of the profits out of their business and investing them instead in property, fixed interest securities or other forms of investment?

Most of the businesses we are considering in this book finance the growth of their business out of their annual profits. They hope to make some profits and to spend most of these profits, that is their reward for their hard work and running the business successfully, on more working capital, getting ever bigger and ever richer. This is a simple circular argument. You expand and finance the expansion of your business out of the business’s own profits. This mindset is sometimes considered the all-American way of running a small business. However, you have discovered it and perhaps now that you are able to write the business plan for your fast growing, medium sized business, has convinced you that perhaps there might exist alternative sources of business finance.

5. Conclusion and Future Trends

Entrepreneurial firms in their first stages of startup or early development face a severe handicap in having poor or difficult access to capital. Their investment and growth are more risky, and therefore return is uncertain, and there is less security to back up bank borrowing. Despite the increasing sophistication of the banking system and its few alternatives, there is still a need for government policy intervention to stimulate commercial and industrial development, the spread of ownership and capital wealth benefits, and a more broadly based mass participation in financing the market economy to generate the extra dynamic growth. The future for smaller entrepreneurial firms would seem, therefore, to depend very largely on the success of the venture capital and business angel markets.

This chapter has described the range of sources that businesses can use to finance the working capital and funding needs for long-term growth, expansion, and diversification. It has seen how an enterprise may finance its needs from the traditional sources of owner’s capital in the form of share capital and debt finance, both from the traditional banking sector or indirectly through the capital markets. The more recent developing sources of business finance are the venture capitalists and business angels, and these new sources serve another important social need, linking ideas to funds, commercializing new technologies, and providing the required risk capital for the continuing development of a growing, dynamic economy.