1.1 Key sources of finance for business organisations
Although there are a variety of financial resources that are available to business organisations, there is not one source of finance that is better than another. The decision about the best financing option ultimately rests on a variety of considerations, such as the business ownership structure, its stage of development and its future goals.
It is quite intuitive to see how the financing needs of newly established businesses could differ significantly from those of a well-established company. For example, for a business in its early stages, common financing options could be funds from the owner’s family, friends or their own savings. These types of funding will not be appropriate to sustain the complex business plans of established companies. Understanding the basic sources of finance and their features is essential for successful financial decision making and business success, since identifying the best and most appropriate available sources is a vital step in reaching the goals set.
Before going into the details of the various sources of finance, it is useful to look at the overall picture. Broadly speaking, sources of finance can be categorised according to two main features:
- whether the finance is generated internally or externally
- whether the duration of the financing is long- or short-term.
The space dimension: internal and external sources of finance
Sources of finance can be either generated internally or raised externally. Internal sources of finance refer to resources that are generated from within, through the business’ activities. External sources are retrieved from third parties. Amongst external sources of finance, it is possible to distinguish between equity financing (i.e. obtaining funds for the company by issuing shares) and debt financing (i.e. obtaining borrowed funds, for example, in the form of bank loans or, in the case of Plc's, by issuing bonds).
Debt finance, which you will look at more closely in Section 1.2, only implies the payment of interests on the total amount raised. It does not mean sharing any part of the business’ decision-making process or legal ownership with the lender. By way of contrast, equity finance presumes that part of the business’ ownership and control over decisions is shared with investors.
The time dimension: short- and long-term finance
Financial sources can also be classified according to the time period over which they are made available to the organisation. Accordingly, it is possible to distinguish between short-term and long-term finance.
Short-term finance typically refers to any financing that will be paid back within a year, while long-term finance refers to any financing that will be repaid over several years. Short-term financing is typically used to finance temporary deficiencies in funds, such as those arising from a delay in the payments from customers. In contrast, long-term financing is better suited to finance the acquisition of long-term assets such as plant and equipment. In general, bank overdrafts are considered an example of short-term finance, while bank loans are generally categorised as long-term finance.
When choosing between short-term versus long-term borrowing, the following elements should be considered:
What type of asset will the funds be raised for?
Long-term borrowings might be more appropriate for financing non-current assets such as property, plant, equipment, or intellectual property (e.g. patents). Current assets (e.g. raw materials), which are held for a short period, would be more efficiently financed by more flexible short-term borrowings.
What is the cost of short-term v. long-term finance?
Interest payments on long-term borrowing tend to be higher relative to those for short-term borrowing. This is because the lender requires higher returns to cover the longer period over which funds are loaned, as well as the higher risk associated with long-term borrowing. Despite this, since short-term borrowing must be renewed frequently, it could carry higher indirect costs, such as arrangement fees.
Table 1, below, summarises the different sources of finance that will be discussed in Section 1.2 and 1.3, according to the categorisation described above.