do you want know finance your business but don’t know the sources of finance and how to finance the business or are you a student who want answers to the question above? or on the other hand you are wondering about the questions below;
- What are the 5 sources of finance?
- What are the main sources of finance?
- What are the six sources of finance?
- What are the two main sources of finance?
Then you have to worry no more because this guide or article is going to reveal all the answers to these questions with examples
1: Trade Credit, Instalment Credit and Bank Credit Session
2: Customers’ Advances, Factoring, Bill of Exchange Session
3: Merits and demerits of short-term finance Session
4: Shares, Debentures, Bonds and Retained Earnings Session
5: Venture Capital, Angel Investors and Leasing Session 6: Capitalization
Table of Contents
SOURCES OF FINANCE, THE MAIN SOURCES OF FINANCE
Growing a business from the first seed of an idea is not a smooth linear journey and it’s not as simple as going from A to B. The destination is seldom decided as the business idea takes form, becomes a reality and then grows into a successful enterprise.
Read also: Meaning of business finance
The finance journey is continuous; there may never be an arrival point. For any business to travel on a journey it needs at all points of that journey to be appropriately financed.
Businesses need to make sure there is the finance to back their growth plans. Businesses are often started on overdrafts or credit cards, or with help from friends or family or by using the family property as collateral.
But soon after that, the business will need to be financed so it can stand on its own two feet if it is to be a sustainably growing proposition.
Financing is needed to start a business and ramp it up to profitability. There are several sources to consider when looking for start-up financing. But first, you need to consider how much money you need and when you will need it.
The financial needs of a business will vary according to the type and size of the business. For example, processing businesses are usually capital intensive, requiring large amounts of capital.
Retail businesses usually require less capital. Debt and equity are the two major sources of financing. Government grants to finance certain aspects of a business may be an option.
Also, incentives may be available to locate in certain communities and/or encourage activities in particular industries. In this unit, we shall discuss both short-term and long-term sources of finance and also examine their relative merits and demerits.
Objectives by the end of this Unit, you should be able to:
(a) discuss the sources of short-term funds for a business
(b) explain the merits and demerits of short-term funds
(c) demonstrate understanding of customers’ advances, factoring, bill of exchange (d) discuss bonds, shares and retained earnings as long-term sources of funds
(e) distinguish between angel investors and venture capital firms
(f) describe capitalizations and their various types
TRADE CREDIT, INSTALMENT CREDIT AND BANK CREDIT
Introduction Sources of finance are the most explored area especially for the entrepreneurs about to start a new business. It is perhaps the toughest part of all the efforts.
There are various sources of finance classified based on time period, ownership and control, and source of generation of finance.
On the basis of a time period, sources are classified into long term, medium term, and short term. Ownership and control classify sources of finance into owned capital and borrowed capital. Internal sources and external sources are the two sources of generation of capital.
All the sources of capital have different characteristics to suit different types of requirements.
Objectives by the end of this session, you should be able to:
(a) state and explain the sources of short-term funds
(b) discuss the types of bank credit
(c) outline the merits and demerits of instalment credit
(d) distinguish between a bank loan and cash credit
Now read on …
SHORT-TERM SOURCES OF FUNDS
Short-term financing means financing for a period of less than one year. The need for short-term finance arises to finance the current assets of a business like an inventory of raw material and finished goods, debtors, minimum cash and bank balance etc. Short term financing is also named working capital financing.
The following are examples of short-term sources:
Trade credit, Bank credit such as Loans and advances, Cash Credit, Overdraft, discounting of bills; and the rest include Customers’ advances, Factoring services, Instalment credit and Loans from credit unions. We shall take you through these in the next discussion.
Trade credit refers to credit granted to manufactures and traders
by the suppliers of raw material, finished goods, components, etc. Usually, business enterprises buy supplies on a 30 to 90 days’ credit.
This means that the goods are delivered but payments are not made until the expiry of the period of credit. This type of credit does not make the funds available in cash but it facilitates purchases without making an immediate payment.
Trade credit a short-term credit facility extended by the creditors to the debtors. Normally, it is common for traders to buy the material and other supplies from the suppliers on a credit basis.
After selling the stocks, the traders pay the cash and buy fresh stocks (also known as inventories) again on credit. Sometimes, the suppliers may insist on the buyer signing a bill (bill of exchange). This bill is called bills payable.
Instalment credit is another source of short-term financing,
in which the borrowed amount is paid in equal instalments with interest. It is also called an instalment plan or hire-purchase plan.
Instalment credit is granted to the enterprise by the suppliers on the assurance that the repayment would be done in fixed instalment at regular intervals of time. It is mostly used to acquire long-term assets used in production processes.
Instalment credit is nowadays a popular source of finance for consumer goods like television, refrigerators as well as industrial goods. Only a small amount of money is paid at the time of delivery of such articles. The balance is paid in a number of instalments.
The supplier charges interest for extending credit. The amount of interest is included while deciding on the amount of instalment. Another comparable system is the hire purchase system under which the purchaser becomes the owner of the goods after the payment of the last instalment.
Sometimes commercial banks also grant instalment credit if they have suitable arrangements with the suppliers.
Advantages of instalment credit
The advantages of instalment credit are as follows:
(i) Convenient Mode of Payment – It implies that instalment credit is an easy mode of payment as it divides the burden of payment into easy instalments paid at regular intervals.
(ii) Protecting Blockage of Funds – It refers to the fact that instalment credit helps the enterprise in saving capital, which can be used for other productive activities. It helps the enterprise in purchasing goods and services by making a part of the payment.
(iii)Facilitating Modernization – It implies that instalment credit helps the enterprise in acquiring new machines and technology even in the absence of sufficient funds for the time being.
(iv) Quick Possession of Assets – It requires very little paperwork to transfer the ownership of assets from one party to another.
Disadvantages of instalment credit
The disadvantages of instalment credit are as follows:
(i) Influence on Liquidity Position – It refers to the impact of instalments on the liquidity position of the enterprise. The payment of an instalment is considered as an additional burden on the short-term capital of the enterprise.
(ii) Extra Cost – It refers to the extra amount to be paid by the enterprise in the procurement of goods through instalment credit. If an enterprise buys goods on instalment credit, then it needs to pay a higher amount as compared to a one-time payment. This happens because the instalments include the amount of borrowing and the interest.
(iii)Extra Liability – It refers to the extra burden imposed on the enterprise in case of default. If the enterprise fails to pay the instalment amount in the allotted time, it may seriously affect the image of the enterprise. Therefore, it becomes the liability of the enterprise to pay an instalment on time.
Commercial banks grant short-term finance to business firms which are known as bank credit. When bank credit is granted, the borrower gets a right to draw the amount of credit at one
time or in instalments as and when needed. Bank credit may be granted by way of loans, cash credit, overdraft and discounted bills. Banks sometimes require securities on credits granted.
When a certain amount is advanced by a bank repayable after a specified period, it is known as a bank loan. Such advance is credited to a separate loan account and the borrower has to pay interest on the whole amount of the loan irrespective of the amount of loan actually drawn.
Usually loans are granted against the security of assets. These loans are usually given for a period of one year or less. The loans can be given by other financial institutions such as savings and loans companies and microfinance institutions.
It is an arrangement whereby banks allow the borrower to withdraw money up to a specified limit. This limit is known as the cash credit limit. Initially, this limit is granted for one year.
This limit can be extended after review for another year. However, if the borrower still desires to continue the limit, it must be renewed after three years. The rate of interest varies depending upon the amount of limit. Banks ask for collateral security for the grant of cash credit.
In this arrangement, the borrower can draw, repay and again draw the amount within the sanctioned limit. Interest is charged only on the amount actually withdrawn and not on the amount of the entire limit. It operates in the form of a credit card. Example Barclays Bank Credit Card.
When a bank allows its depositors or account holders to withdraw money in excess of the balance in his account up to a specified limit, it is known as an overdraft facility.
This limit is granted purely on the basis of the creditworthiness of the borrower. In this system, the borrower has to show a positive balance in his account. Interest is charged only on the overdrawn money. The rate of interest in case of overdraft is less than the rate charged under cash credit.
The granting of the overdraft facility is based on the application submitted by the client of the bank. This makes available short-term funds for the business.
Banks also advance money by discounting bills of exchange, promissory notes etc. When these documents are presented before the bank for discounting, banks credit the amount to the customer’s account after deducting the discount.
The amount of discount is equal to the amount of interest for the period of the bill. Sometimes it could be in the form of invoice discounting. Taking credit on the face value of outstanding credit sales.
SECURITIES FOR BANK CREDIT
Loans and advances are granted by the bank on the personal security of the borrower as well as on the security of some tangible assets, besides the standing of the firm. Securities against credit may be of two types: personal security and security of tangible assets.
Personal security means the creditworthiness of the borrower. Banks judge the creditworthiness of the borrower on the basis of his or her financial soundness and past dealings with the bank.
Securities for intangible assets include Moveable goods, shares certificates, documents of title to goods e.g. bills of lading; fixed deposit receipts, Life insurance policies and Precious metals like gold, diamond etc.
In this session, we found out that there are different sources of short-term funds a business can fall on at any given time. We examined trade credit, instalment payments and bank
credit. We discussed the different types of bank credit and securities that are needed for a bank credit to be granted.
By: Eric Adjei
A professional with six (7) years’ experience in finance and accounting. Demonstrating expertise in accounting procedures, computerized accounting system management and financial operations. Financially astute with excellent analytical, problem solving, management, people supervision, organizational, business administration, operation and commercial management and teaching skills.