Study on Internal and External Sources of Finance Finance Essay

Study On Internal And External Sources Of Finance Finance Essay Finance is essential for business operations development and expansion finance is core limiting factor for most businesses and it is crucial for business to manage their financial resources properly. Finance is available to a business from variety of sources from both internal and external. It is also essential for business to choose most appropriate source of finance to its several needs as different sources have its own benefits and costs. Sources of finance can be classified based on a number of factors they can be classified as Internal and External factors Short Term and Long Term or Equity and Debt which would be easy to classify the sources as internal and external. Internal Sources of Finance: Internal sources of finance are the funds which are available promptly within the organisation. It consists of Personal Savings Retained Profits Working Capital Sale of fixed assets Personal savings: The amount of personal money of an owner or partner or share holder of business may execute anything at his administration when the business seeks to borrow the personal money of investor for a financial business needs this source of finance is known as personal savings. Retained Profits: Retained profits are undistributed profits of a company. Not all the profits made by a company are distributed as dividends to its shareholders. The remainder of finance is saved by the business as a backup in times of financial needs and maybe used later for a company’s development or expansion retained profits are valuable at no cost source of finance. Working Capital: Working capital refers the sum of money that a business uses its daily activities. Working capital is the difference of current assets and current liabilities (working capital = current assets – current liabilities). Proper working capital management is also vital as it also a source of finance for a business. Current Assets: “Current assets are also known as cash equivalents because they are easily convertible to cash. Current assets consist of Stock, Debtors prepayments, Bank and Cash these assets are used up, sold or keep changing in short run.

Stock: This refers to the stock of goods available to the business for sale at given time. It is very important to maintain the right amount of stock of goods for a business. If stock levels are too high it means that too much of money is being held up in the form of stock and if stock levels are too high it means that too much of money is being held up in the form of stock and if stock levels are too low the business will lose possible opportunities of higher sales. Debtors: Debtors is a type of business in which customers building up on the trade having been bought the business’s goods or service on credit. If a business has cash flow problems it can maintain a low level of debtors by encouraging the debtors to pay as early as possible. Prepayments: These are the expenses paid in advance the payment is being made even before the payment occurs is a prepayment.

Bank and cash: Bank is the cash held in banks and cash is money held by business in the form of cash. Having too much of money in the form of cash is also not good for a business since it can use that money to invest and earn a return but however a business should have healthy current ratio(Current Assets : Current Liabilities) of 2:1 Current Liabilities: Current Liabilities are short-term debts that are in immediate need of settlement. Some examples of current liabilities creditor’s accruals proposed dividends within a year. Creditors: also known as trade creditors. Trade creditors are Suppliers from whom the business purchased goods on credit. Paying the creditors’ as soon as possible will ease cash flow requirements for a business. Accruals – are the expenses owed by the business. Dividends proposed – are the dividends payable for the year that is not yet paid. Tax owing – is the sum of money owing as tax” [i] External sources of finance: Sources of finance that are not internal sources of finance are external sources of finance. External sources of finance are from sources that are outside the business. External sources of finance can either be: Ownership capital or Non-ownership capital Ownership capital:

Ownership capital is the money invested in the business by the owners themselves. It can be the capital funding by owners and partners or it can also be share bought by the shareholders of a company. There are mainly two main types of shares. They are: Ordinary shares Preference shares Ordinary shares: Ordinary shares also known as equity shares are a unit of investment in a company. Ordinary shareholders have the privilege of receiving a part of company profits via dividends which is based on the value of shares held by the shareholder and the profit made for the year by the company. They also have the right to vote at general meetings of the company. Companies can issue ordinary shares in order to raise finance for long-term financial needs. Preference shares: Preference shares are another type of shares. Preference shareholders receive a fixed rate of dividends before the ordinary shareholders are paid. Preference shareholders do not have the right to vote at general meetings of the company. Preference shares are also an ownership capital source of finance. There are several types of preference shares. Some of them are Cumulative preference share, Redeemable preference share, Participating preference share and Convertible preference share. Cumulative preference shares – if a company is in a loss making situation and is unable to pay dividends for one year then the dividend for that year will be paid the next year along with next year’s dividends. Redeemable preference shares – these preference shares can be bought back by the company at a later date. Normally the date of redemption is usually agreed. Participating preference shares – give the benefit of additional dividends to its shareholders above the fixed rate of dividends they receive. The additional dividend is usually paid in proportion to ordinary dividends declared.

Convertible preference shares – convertible preference shareholders have the option of converting their preference shares to ordinary shares. Non-ownership capital: Unlike ownership capital, non-ownership capital does not allow the lender to participate in profit-sharing or to influence how the business is run. The main

obligations of non-ownership capital are to pay back the borrowed sum of money and interest. Different types of non-ownership capital: Debentures Bank overdraft Loan Hire-purchase Lease Grant Venture capital Factoring Invoice discounting Debentures: Debentures are issued in order to raise debt capital. Debenture holders are not owners but long-term creditors of the company. Debenture holders receive a fixed rate of interest annually whether the company makes a profit or loss. Debentures are issued only for a time period and thus the company must pay the amount back to the debenture holders at the end of the agreed period. Debentures can be secured, unsecured, fixed or floating. Secured debentures – are debentures that are secured against an asset. They are also called mortgage debentures. Unsecured debentures – these debentures do not have an asset as collateral. Fixed debentures – have a fixed rate of interest. Floating debentures – do not have fixed rate of interest and are not tied to any specific asset. Bearer debentures – these debentures are easily transferable. Registered debentures – are not easily transferable and legal procedures have to be followed in case of a transfer. Convertible debentures – can be converted to stock at the end of the debenture repayment date.

DIFFERENCES BETWEEN LONG/MEDIUM TERM AND SHORT TERM SOURCES: Introduction: “Finance sources may be internal or external but they may also be short medium or long term Short Term: Short term Finances the business up to 1 year Medium Term: Medium term finances the business up to 5 years Long Term: Long term finances the business more than 5 years” Short Medium and long term Sources: Long Term Medium Term Short Term

Personal Resources Personal Resources Personal Resources Ordinary Share Capital Bank Loan Bank Loan Bank Overdraft

. ii Long term Sources: Long Term Sources generally refer to those requirements of funds which are for a period exceeding 5-10 years. All investments in plant, machinery, land, buildings, etc., are considered as long term financial needs. Funds required to finance permanent or hard core working capital should also be procured from long term sources. Medium term Sources: Medium Term refers to those funds which are required for a period exceeding one year but not exceeding 5 years. For example, if a company resorts to extensive publicity and advertisement campaign then such type of expenses may be written off over a period of 3 to 5 years. These are called deferred revenue expenses and funds required for them are classified in the category of medium term financial needs. Sometimes long term requirements, for which long term cannot be arranged immediately, may be met from medium term sources and thus the demand of medium term financial needs are generated. As and when the desired long term funds are made available, medium term loans taken earlier may be paid off. Short term financial Sources: Short Term Sources takes place to finance in current assets such as stock, debtors, cash, etc. Investment in these assets is known as meeting of working capital requirements of the concern. Firms require working capital to employ fixed assets gainfully. The requirement of working capital depends upon a number of factors which may differ from industry to industry and from company to company in the same industry. The main characteristic of short term financial needs is that they arise for a short period of time not exceeding the accounting period, i.e., one year. The basic principle for meeting the short term financial needs of a concern is that such needs should be met from short term sources, and for 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. Basically, there are two sources of raising funds for any business enterprise. Viz., owners’ capital

and borrowed capital. The owners’ capital is used for meeting long term financial needs and it primarily comes from share capital and retained earnings. Borrowed capital for all the other types of requirement can be raised from different sources such as debentures, public deposits; loans form financial institutions and commercial banks, etc.

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