Sources of Funds and its Classification
Operating a business in this dynamic world is not an easy task. Every business requires funds to operate and carry out various activities, and without funds, there is no future for any organization. Therefore, finance is called the lifeblood of any business. There is always an initial amount of capital invested by the entrepreneur, which is not always sufficient to grow the business. So various sources of funds are required for running a business. There are various sources through which funds could be generated, but the correct knowledge of various sources is a vital part to make the correct decision because every source of the fund comes with a cost that needs to be compared and calculated before deciding which source is better for the organization. Therefore, every source of funds needs to be analyzed carefully.
There are two types of financial needs of a business:
- Fixed Capital Requirement: Fixed capital refers to the money which is required to purchase fixed assets of a business such as Plants and Machinery, Land and Buildings, etc. These assets are kept in the business for more than one year. There are different types of business enterprises whose requirements for capital may vary. The nature of the business plays a very important role in deciding the type of capital requirements. If the business concern is based on retailing, then it requires very less fixed assets as compared to the manufacturing industry.
- Working Capital Requirement: The requirement of working capital is a vital aspect of any business organization, whether it is trading, manufacturing, or retailing. No matter how large or small the enterprise is, working capital is required. The amount required for working capital may vary according to the size of the enterprise. The day-to-day operations, such as payments to creditors and suppliers and payment of salaries, rent, and wages fall under the category of working capital.
Classification of Sources of Funds
Based on period
- Long-term Sources: Long-term sources of funds fulfill the needs of any business for a long period that is for a period exceeding 5 years. Long-term funds are generally used for purchasing fixed assets. Examples of long-term sources of funds are shares, debentures, bonds, long-term loans from banks, etc.
- Medium-term Sources: The funds which are required for more than one year but less than five years. These include public deposits, borrowing from banks, lease financing, etc.
- Short-term Sources: The funds which are required for less than one year is termed short-term sources of fund. These kinds of funds are easily available and are easy to repay also. For Example, short-term loans from commercial banks, trade credit, factoring and commercial paper.
Based on ownership
- Owner’s Funds: As the name suggests, owner’s funds are those which are provided to the firm by its owners. The owner can be a sole trader, a shareholder of the company, or a partner. The owners not only invest capital but also reinvest profits in the organization. The owner does not have to refund the invested amount during the lifetime of the organization. The investment made by the owners decides their control over the management. Issue of equity shares and retained earnings are the two most important sources of the owner’s fund.
- Borrowed Funds: As the name suggests, it is a fund which is borrowed from different financial institutions or raised through the issue of bonds debentures. These sources provide a firm with different sources of funds for a fixed period and come with a fixed amount of interest, which a company has to pay whether it is making a profit or not. Usually, the borrowed funds are provided to the firms by keeping some fixed assets as security. So this source of funds is a bit riskier as compared to the owner’s fund. For Example, public deposits, loans from a bank, debentures bonds, etc.
Based on the Source of Generation
- Internal Sources – Every business organization has some funds which are kept aside for future uncertainties and needs. When the funds are generated internally, then they are said to be internal sources of funds. Internal sources of funds have their own merits and demerits. The biggest advantage of internal sources is that these are a permanent source of funds that could be easily availed, and does not involve any explicit cost as it belongs to the business enterprises only. However, internal funds lead to various risks to the firm and can accomplish only the limited needs of the firm. For example, equity share capital, retained earnings, etc.
- External Sources – When a large amount of funds is required by a business enterprise, then it opts for external financing. Therefore, external sources of finance are the sources that are obtained from outside the business. The cost of raising funds from external sources is more than the cost from internal sources. Sometimes, an organization has to mortgage its assets as security. For example, lease financing, factoring, preference shares, Commercial papers, etc.