Sources of Finance

This section explains sources of finance. Businesses require different sources of finance depending on their needs, whether for short-term or long-term purposes. Short-term finance is typically used to cover day-to-day operational costs, while long-term finance is used for larger investments or to fund growth and expansion. Here’s an overview of various sources of finance:

Short-term Finance

Short-term finance is generally used to fund day-to-day operational expenses or cover short-term cash flow problems. These sources are typically repaid within a year.

Overdrafts

Definition: An overdraft is an arrangement with a bank that allows a business to withdraw more money than is currently in its account, up to a certain limit.

Advantages:

• Provides quick access to funds.
• Flexible – businesses can use the funds as needed and only pay interest on the amount borrowed.

Disadvantages:

• High interest rates and fees.
• If the business exceeds the overdraft limit or doesn't repay on time, the bank can demand repayment immediately or charge higher fees.

Trade Credit

Definition: Trade credit is an agreement where suppliers allow businesses to buy goods or services and pay for them later, usually within 30, 60, or 90 days.

Advantages:

• Helps businesses manage cash flow by delaying payments.
• No interest is charged if payments are made within the agreed period.

Disadvantages:

• Late payments can harm relationships with suppliers or result in penalties.
• Trade credit can be limited based on the business’s creditworthiness, potentially restricting the ability to purchase needed stock.

Long-term Finance

Long-term finance is used for investments or projects that will provide a return over a long period, typically longer than one year. This type of financing is used for expansion, buying equipment, or other significant capital investments.

Personal Savings

Definition: Owners or entrepreneurs may invest their personal savings into the business.

Advantages:

• No interest or fees are involved.
• Full control over the funds without needing to rely on external lenders or investors.

Disadvantages:

• Risk to personal financial security if the business fails.
• Limited to the amount the business owner is able to invest.

Venture Capital

Definition: Venture capital (VC) is money provided by investors to start-up businesses with high growth potential in exchange for equity (ownership) in the business.

Advantages:

• Provides substantial funding, often when other sources of finance are not available.
• Investors may provide expertise and guidance to help the business grow.

Disadvantages:

• Owners must give up a portion of the business (equity).
• Involves a loss of control as venture capitalists often want a say in how the business is run.
• Investors expect a high return, which can pressure the business to grow quickly.

Share Capital

Definition: Share capital is money raised by issuing shares in the business to external investors. This is common in public and private limited companies.

Advantages:

• The business does not need to repay the money raised through shares.
• Shareholders share the risk and reward, which can provide the business with more financial stability.

Disadvantages:

• Issuing shares means giving away part of the business's ownership and control.
• Dividends may need to be paid to shareholders, which can be expensive.

Bank Loan

Definition: A bank loan is a sum of money borrowed from a bank that must be paid back with interest over a fixed period.

Advantages:

• Provides a large sum of money upfront.
• Fixed repayment schedule makes budgeting easier.

Disadvantages:

• Interest must be paid, which increases the overall cost of borrowing.
• The business may need to offer collateral (assets) to secure the loan.
• If repayments are not made on time, the business may face penalties or legal action.

Retained Profit

Definition: Retained profit refers to the portion of a business’s profits that is not distributed to shareholders as dividends but is reinvested back into the business.

Advantages:

• No interest or repayments, as the money is already owned by the business.
• Provides a flexible source of finance for future growth.

Disadvantages:

• The business must be profitable to generate retained profits.
• Retaining profits may lead to shareholder dissatisfaction if dividends are reduced.

Crowdfunding

Definition: Crowdfunding involves raising small amounts of money from a large number of people, typically via an online platform (e.g., Kickstarter or GoFundMe). In return, the backers may receive a product, equity, or other rewards.

Advantages:

• Allows businesses to raise money without taking on debt or giving up equity (depending on the model used).
• Can generate publicity and customer loyalty.
• Ideal for projects with a clear consumer interest or social benefit.

Disadvantages:

• Can be time-consuming and requires effective marketing to attract backers.
• If the campaign fails to reach its target, no funds are raised.
• The business may need to deliver rewards or products, which can be costly.

Comparison of Short-term and Long-term Sources of Finance

Conclusion

The choice of finance source depends on the amount of money needed, the purpose of the funds, and the timeframe for repayment. Short-term finance like overdrafts and trade credit can help manage cash flow and immediate operational costs, while long-term finance like venture capital, share capital, and bank loans are typically used for business growth, expansion, or large-scale investments. Understanding these sources and their advantages and disadvantages allows businesses to select the most appropriate finance option for their needs.