Understand the sources of finance available to a business - Assignment Example

? Understand the sources of finance available to a business Table of Contents Introduction 3 Identifying different sources of finance available to a business 3 Assessment the implications of the different sources 4 Analyse the costs of different sources of finance 6 Evaluation appropriate sources of finance for different business projects 7 Reference 8 Introduction This paper represents training guideline report about understanding the different sources of finance available to a business. This report has been developed as a financial training tutorial for medium enterprises in the local area. Therefore, main objective of this report is to make the participants clear understand about one of the most important areas business finance i.e. source of finance. This paper will qualitatively address different sub-areas of this topic like assessing various source of finance; control, bankruptcy and legal implications of those sources; in-depth analysis of financial implications and tax effects; selection of appropriate source of finance for various projects. This paper mainly consists of qualitative discussion on these four areas. Identifying different sources of finance available to a business Finance is very much essential for a new as well as an existing business. Efficient financing is also essential in all stages of a business. Finance is required for business development, business operation and business expansion. Finance is core limiting factor to any business and hence, it is crucial a business to manage its financial resources strategically and efficiently. There are various sources of finance available to a business at different benefit and cost. Therefore, it is important for a company to choose most suitable source of finance based on its requirement and potential to optimally utilize the resources to generate adequate return. A business must need potential to generate more return than the cost of finance i.e. rate of return on investment must be more than interest rate. Available sources of finance can be categorized by some parameters like time or tenure and characteristics. Main two different sources of finance of a business are internal source of finance and external source of finance. There are various sources under both of these major categories. External sources of funds are of two categories based on nature of the find like debt finance and equity finance. Internal sources of finance are owner’s personal savings, retained profits, working capital, suppliers’ credit and sale of assets. External sources of finance are debt finance and equity finance. Under debt finance, important sources are debentures, bank loan, bank overdraft, fire-purchase, grant, lease, venture capital, invoice discounting, factoring, and angle investors. Sources of finance under equity finance category are ordinary shares and preference share. Again, various sources under internal and external categories can also be categorized by another important parameter i.e. tenure or duration. These are long term, medium term and short term sources of finance. Long term sources of finance are equity shares, preference shares, retained profit, debentures or bonds, loan from private and public institutions, venture capital, asset selling etc. Medium term sources of finance are preference shares, debentures or bonds, loan from term deposits, loan from financial institutions, lease financing or hire purchase financing, foreign currency bonds and commercial borrowings. Short term sources of finance are trade credit, differed income, suppliers’ credit, customers’ advances, certificate of deposits and public deposits etc. Assessment the implications of the different sources Internal sources of fund: These are the most preferable sources of finance of any business. Internal sources are used at start up or even for expansion of business. Businesses do not have obligation to pay any interest or refund of this sources as internal sources belongs the businesses only. Therefore risk is less in these categories of sources. The businesses have full control on internal financing and there is no possibility of bankruptcy and any legal obligations. Personal savings of the owner and the patterns are used as most effective sources in sole proprietorship or partnership businesses. This source is used at initial start up of a business, business expansion and crucial stages of business when operating income of a business is very low to manage the overall business operation. Retained profits are the undistributed percentage of profit of a company. It is equal to the net profit of private limited companies which are not publicly traded. It is valuable non cost fund of any business. Working capital is another cost free sources of fund which is the difference of current assets and current liabilities. It is the best sources of fund generally used for business operation and short term investments. Sales of non potential assets are another efficient internal source of fund. Business can reconstruct asset turnover through selling of non potential fixed assets and invest that amount in new potential projects. Debt finance: This is one sub category of external sources of finance. Debt finance is also termed as non ownership sources of finance. Lenders are not allowed to participate in profit sharing and strategic business decisions of the borrowers. Main obligation of this finance is that the business is bound to pay the borrowed amount with interest. If not possible, then there is possibility of bankruptcy of the business. There are many legal rules and regulations the borrower need to adhere to. Businesses also have limited control on these sources of finance. Popular debt finance sources are bank loan, overdraft, debentures or bonds etc. Equity finance: Equity finance is also termed as ownership capital. This source of finance can be capital funding by the owner and the partners for private limited companies or it can be share capital for incorporated companies. There two types of equity financing. Ordinary shares also termed as equity shares where the shareholders are the lenders and they get unit ownership of the company after lending. They have the privilege of getting profit sharing as dividend. Risk of borrowers is less and companies not legally bound to pay dividend or positive return. Preference shares are another type of equity financing. The lenders must have to paid fixed interest as dividend by the borrowers. Preference shareholders are more privileged than the ordinary shareholders in terms of dividend payment but they do not have right to participate in strategic decision making for the company. The companies are legally bound to pay dividend even in case of loss in business. They have less control over this financing (Fleming & McKinstry, 1991, p.141). Analyse the costs of different sources of finance Cost of finance is one of most important criteria to be considered by the companies. There are two parameters to evaluate a particular source of finance. One is cost and another is benefit. Generally cost of finance is high in debt financing as the interest is only the benefit of the lenders. But in equity financing the shareholders get benefit from rise in stock price and also from profit sharing in terms of dividend. Therefore, cost refers to only cost of dividend and the companies have full control on dividend payment decision. Preference share financing has higher risk than less control then equity financing. Best source of finance is personal finance where cost of finance is zero and also the owners have total control on it. Evaluation appropriate sources of finance for different business projects Sources of finance should be different on different requirement of finance. For purchasing assets like building or machineries personal finance would be best because, these assets provide intangible return that might not be estimated. Financing for short term projects should be done from medium term financing like bank loan, issuing of preference shares, debentures etc. Long term projects or business acquisitions can be done from issuing ordinary shares. Debt financing should be neglected for long term investments. Short term sources of finance are used for business operation in crucial period of business i.e. when current assets are not sufficient for paying current liabilities. Personal finance is also most suitable for business start up as at initial stage of a business, it might not able to pay cost of finance. Again, companies do not have to pay tax on cost of debt finance. So, large companies use this strategy to recue tax. Reference Fleming, A.M. & McKinstry, S. (1991). Accounting for Business. Taylor & Francis. Read More