Main Sources of Funds
- Internal Sources of Funds
- External Sources of Funds
1. Internal Sources of Funds: Internal sources of funds are derived from within the business itself. These are often the first option for businesses since they do not involve third-party debt or dilution of ownership.
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- Retained Earnings:
- Definition: Profits that a company has earned in previous years and has decided to reinvest in the business rather than distributing them as dividends to shareholders.
- Advantage: This is the cheapest source of finance since there’s no need to repay or pay interest.
- Disadvantage: Limited to the profitability of the company; if profits are low, this source will be insufficient.
- Example: A company makes $100,000 in profit and retains $40,000 to fund new equipment rather than distributing it as dividends.
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- Sale of Assets:
- Definition: Companies may sell non-essential or obsolete assets (like old machinery, real estate, or inventory) to raise capital.
- Advantage: It’s a quick way to generate cash without taking on debt.
- Disadvantage: Can affect the company's operations if productive assets are sold.
- Example: A manufacturing firm sells off unused land to fund the expansion of its production line.
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- Depreciation:
- Definition: Although depreciation itself is a non-cash expense, some companies use the cash saved from depreciation (as it reduces taxable income) to reinvest in the business.
- Advantage: It provides additional funds without affecting cash flow.
- Disadvantage: Depreciation itself does not directly generate cash; it only reduces taxable income.
- Example: A company allocates funds freed up by depreciation expense to acquire new machinery.
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- Reduction in Working Capital:
- Definition: By reducing the amount of working capital tied up in stock, debtors, and other short-term assets, a company can generate funds for immediate use.
- Advantage: Can free up a significant amount of cash if managed efficiently.
- Disadvantage: Reducing working capital too much can disrupt day-to-day operations.
- Example: A company tightens its inventory levels and speeds up collections from customers to free up cash.
3. External Sources of Funds: External sources involve raising capital from outside the business, such as through borrowing or issuing equity. These sources are typically used when internal funds are insufficient for the company’s needs.
- Equity Capital (Ownership-Based Financing):
- Definition: Capital raised by issuing shares of the company to investors. Shareholders become part-owners of the company and are entitled to a portion of its profits (dividends).
- Advantage: No obligation to repay; it’s a permanent source of capital.
- Disadvantage: It dilutes ownership and control; also, dividends may be expected by shareholders.
- Example: A tech startup issues new shares to venture capitalists to raise $1 million for product development.
- Types of Equity Capital:
- Private Equity: Investments from private individuals or institutions.
- Public Equity: Funds raised by selling shares on the stock exchange (Initial Public Offering - IPO).
- Debt Financing (Borrowing):
- Definition: Raising funds by borrowing, which needs to be repaid over time, usually with interest.
- Advantage: It does not dilute ownership or control of the company.
- Disadvantage: The company must pay interest and principal, which can strain cash flow.
- Types of Debt Financing:
- Bank Loans: Borrowing from a bank for specific terms and at an agreed interest rate.
- Corporate Bonds: Companies can issue bonds to the public, which investors purchase in exchange for regular interest payments and repayment of principal.
- Debentures: Long-term unsecured loans that rely on the creditworthiness of the company.
- Overdrafts: Short-term borrowing facility from a bank, allowing the company to withdraw more than what is available in its account.
- Trade Credit: Suppliers allow the company to purchase goods or services on credit, paying at a later date.
- Example: A company takes a $500,000 loan from a bank to purchase new manufacturing equipment.
- Venture Capital and Angel Investors:
- Venture Capital: Funds provided by institutional investors to small, high-risk startups with high growth potential. They usually take equity in the company.
- Angel Investors: Wealthy individuals who invest their own funds into early-stage startups in exchange for equity or convertible debt.
- Advantage: Provides not just funding but often guidance and industry connections.
- Disadvantage: Venture capitalists and angel investors often expect high returns and may demand significant control or influence in the company’s decisions.
- Example: A healthcare startup receives $2 million in venture capital to develop a new medical device.
- Grants and Subsidies:
- Definition: Funds provided by governments, non-governmental organizations (NGOs), or international institutions, often with no obligation to repay, for specific purposes (e.g., research, innovation, sustainability).
- Advantage: No repayment or interest.
- Disadvantage: Often comes with restrictions on how the funds can be used; not easily accessible for all businesses.
- Example: A company developing renewable energy solutions receives a $100,000 government grant to support its R&D.
- Crowd funding:
- Definition: Raising small amounts of capital from a large number of individuals, typically through online platforms like Kickstarter, GoFundMe, or Indiegogo.
- Advantage: Can raise funds quickly without borrowing or giving up significant equity.
- Disadvantage: Often limited to specific projects and can be risky if the target funding is not achieved.
- Example: An entrepreneur raises $50,000 on Kickstarter to fund the production of a new gadget.
- Leasing:
- Definition: Instead of purchasing an asset (like machinery, equipment, or vehicles), a business can lease it, paying regular rental payments over time.
- Advantage: Low initial capital outlay and flexibility to upgrade assets without large upfront costs.
- Disadvantage: Does not provide ownership of the asset, and over time, lease payments may exceed the cost of purchasing the asset outright.
- Example: A logistics company leases trucks instead of buying them to reduce upfront capital costs.
- Factoring:
- Definition: Selling accounts receivable (unpaid customer invoices) to a third party (called a factor) at a discount to get immediate cash.
- Advantage: Quick access to cash for day-to-day operations without waiting for customer payments.
- Disadvantage: The company receives less than the full value of the receivables due to the discount taken by the factoring company.
- Example: A small business factors $200,000 worth of unpaid invoices, receiving $180,000 in cash upfront from the factoring company.
Short-Term vs. Long-Term Sources of Funds
- Short-Term Sources: These funds are typically used for working capital needs and have a repayment period of less than one year. Examples: Trade credit, bank overdrafts, short-term loans, factoring.
- Long-Term Sources: These are used for major investments or expansion and have a longer repayment period (more than one year). Examples: Equity capital, long-term loans, bonds, retained earnings.
Summary of Sources of Funds
Conclusion:
Understanding the different sources of funds is crucial for businesses as it helps them choose the right financing option based on their needs, whether it’s short-term working capital, long-term investments, or funding for growth. Each source has its advantages and disadvantages, and businesses often use a combination of these sources to meet their financial objectives.