Tag: Budgeting Forecasting

Every business organization requires finance for its establishment, operation and expansion. Money is needed to purchase land and machinery, pay wages and salaries, buy raw materials, and meet day-to-day expenses. The various methods through which a firm obtains money are known as sources of funds. Selection of proper sources is one of the most important functions of the finance manager because wrong choice may increase cost, risk and financial burden on the company.

Sources of funds refer to the various ways through which a business raises finance to meet its short-term and long-term financial requirements. Every organization needs funds for purchasing assets, meeting operating expenses, expansion, and modernization. The finance manager must select suitable sources depending upon cost, risk, control and repayment conditions.

Types of Sources of Funds

(A) Long-Term Sources of Funds

Long-term funds are required for acquiring fixed assets, expansion, modernization and permanent working capital. These funds are usually raised for more than five years and form the capital structure of the company.

• Equity Shares

Equity shares represent the ownership capital of a company. Equity shareholders are the real owners and they have voting rights in company management. Dividend on equity shares is not fixed; it depends upon the profits earned by the company. When the company performs well, shareholders receive higher dividends, but when profits are low, dividends may not be paid.

Equity capital is a permanent source of finance because it does not require repayment during the lifetime of the company. It provides financial stability and increases creditworthiness. However, issuing additional equity shares dilutes ownership control and may reduce earnings per share.

• Preference Shares

Preference shares are shares that carry preferential rights over equity shares regarding dividend payment and return of capital at the time of liquidation. Preference shareholders receive a fixed rate of dividend before any dividend is paid to equity shareholders.

They have lower risk compared to equity shareholders but generally do not have voting rights. This source is useful for companies that want to raise funds without giving management control to outsiders. However, payment of preference dividend becomes a financial obligation and reduces distributable profits.

• Debentures

Debentures are long-term debt instruments issued by a company to borrow money from the public. Debenture holders are creditors and not owners of the company. They are entitled to receive a fixed rate of interest at regular intervals irrespective of profit or loss.

Debentures are secured by the assets of the company and must be repaid after a specified period. They are cheaper than equity capital because interest is tax-deductible. However, they increase financial risk as interest and principal must be paid even during periods of low earnings.

• Retained Earnings (Ploughing Back of Profits)

Retained earnings refer to the portion of profits that is not distributed as dividend but kept in the business for reinvestment. It is an internal source of finance and also called self-financing.

This method involves no interest payment, no flotation cost and no dilution of ownership. It strengthens the financial position and increases independence from external borrowing. However, excessive retention may cause dissatisfaction among shareholders who expect regular dividends.

• Term Loans from Financial Institutions

Companies can obtain long-term loans from commercial banks, development banks and government financial institutions. These loans are usually taken for purchasing machinery, construction of buildings, or expansion projects.

Loans are repayable in installments along with interest. This source does not affect ownership control but creates a fixed financial commitment. Failure to repay loans on time may damage the credit reputation of the company.

(B) Short-Term Sources of Funds

Short-term funds are required to meet working capital needs such as purchase of raw materials, payment of wages, and operating expenses. These funds are generally repayable within one year.

• Trade Credit

Trade credit is the credit allowed by suppliers when goods are purchased on credit. The buyer can pay after a certain period, usually 30 to 90 days.

It is one of the most common and convenient sources of short-term finance. It requires no security and minimal formalities. However, delay in payment may lead to loss of cash discount and damage business goodwill.

• Bank Credit (Cash Credit and Overdraft)

Businesses obtain short-term finance from banks in the form of cash credit or overdraft facility. Under cash credit, the bank sanctions a borrowing limit and the firm can withdraw funds as required. In overdraft, the firm is allowed to withdraw more than the balance available in its account.

Interest is charged only on the amount actually used. Bank credit is flexible and useful for managing working capital, but it requires security and regular documentation.

• Bills Discounting

When goods are sold on credit, the seller receives a bill of exchange from the buyer. Instead of waiting for the due date, the seller can discount the bill with a bank and obtain immediate cash.

The bank deducts a small amount as discount charges and pays the remaining amount. This improves liquidity and accelerates cash inflow, although it involves a cost of discounting.

• Public Deposits

Public deposits are funds raised directly from the public for a short period, generally one to three years. Companies offer a fixed rate of interest to attract investors.

It is a simple and economical source because it involves fewer formalities and no collateral security. However, failure to repay deposits on maturity may harm the company’s reputation and credibility.

• Commercial Paper

Commercial paper is an unsecured promissory note issued by large and financially sound companies to raise short-term funds from the money market. It is issued for a period ranging from a few months up to one year.

This source is cheaper than bank loans and does not require security, but only companies with high credit rating can use it. It is widely used for meeting working capital requirements.