There are many different sources of finance available to modern businesses. There are also many factors that influence the choice of sources of finance.
Businesses raise business finance from a wide range of sources in order to pay for a wide range of business activities.
Main sources of finance
In general, businesses can fund their activities using both internal sources of finance and external sources of finance.
A. Internal sources of finance
It is internal money that already belongs to the business. It includes money raised from the owner’s savings, selling business’s own assets or from retained profits earned by the business at the end of the fiscal year, and ploughed-back for future growth.
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This type of money has no direct cost to the business. It does not increase the liabilities or debts of the business. And, there is no risk of loss of control by the original owners as no shares are sold. Having a written business plan is not necessary to secure internal sources of finance. However, it may guide the actions and decisions of the owners in the early months and years of the running their businesses.
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It is not available for all companies as newly formed businesses do not have much assets, and unprofitable firms do not have any profit to reinvest. Using internal sources of finance for expansion can slow down business growth, as the pace of development will be limited by the annual profits or the value of assets to be sold. Thus, rapidly expanding companies should depend on external sources for much of their finance.
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It is not available for all companies as newly formed businesses do not have selling shares is not a form of internal finance for companies. Although the shareholders own the business, the company is a separate legal unit and, therefore, the shareholders are ‘outside’ of it.
B. External sources of finance
It is all the external money raised from sources outside the business. This money does not belong to the business. External sources of finance are classified into short-term finance, medium-term finance and long-term finance.
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This type of money has direct cost to the business. It does increase the liabilities or debts of the business. And, there is risk of loss of control by the original owners as shares are sold. Having a written business plan is often necessary to secure external sources of finance. The business plan provides evidence to investors and lenders to make the finance application more likely to be successful.
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Without solid evidence that the business managers have thought the business through, and planned its future, it is most unlikely that Venture Capitalists (VCs) or potential shareholders will invest money in the business. A well-written business plan will be used to convince external lenders to extend finance to the business. If the business plan is poor, then the prospective investors and creditors can delay taking a finance decision, or even refuse the money.
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The business plan itself does not guarantee the success of a new business proposal. If the business borrows too much, there will be high interest payments on the debt which will reduce Net Profits After Interest and TAX. Also, if the owners issue too many shares to external investors, they may lose control of the business, especially when competitors buy those shares.
Who decides about sources of finance?
In smaller businesses, it is the owners who will choose the most appropriate sources of finance for a given situation.
In larger businesses, it is the Finance Manager together with the CEO and The Board of Directors who will decide on the sources of finance the most suitable for the business needs.
