Sources of finance can be internal (from inside the business) or external (from outside the business). They can also be separated into debt and equity. Debt finance is when the business has to repay the money back, whereas equity finance does not need to be paid explicitly.

They can also be classified in terms of time periods:

• Short-term finance

  • Day-to-day (less than 1 year)

  • Used for working capital

  • Used to fund expenses, like wages and utilities, and current assets, such as inventory

• Medium-term finance

  • 1-5 years

  • Used to finance current and medium-term assets

• Long-term finance

  • More than 5 years

  • Used for capital expenditure

Internal Finance

Retained Profits

This is unspent profit that has been re-invested back into the business or kept for specific objectives. It is good for financing capital goods. There is no external cost to using retained profits, however, there is only a limited amount available.

External Finance

Debentures

These are medium/long term borrowing from the public at a fixed rate of interest. They need to be repaid back by the business at the maturity; this makes it a debt form of finance.

Debentures can be traded and tend to have high liquidation rights. However, the owners of the debentures do not get any voting power in the business.

If the business closes down, the public receives their money back.

Share Capital

Share capital is when the business issues shares to shareholders. These shareholders have the ability to partake in the decision-making process of the business.

It is an optimal source of finance for raising large amounts of money and is mainly used once especially by smaller firms, to avoid extreme dilution of the company.

This external source of finance can be categorised as equity. This is because the money does not need to be repaid, however, businesses tend to give dividends to their shareholders.

As it deals with large amounts of money, it is considered a long-term source of finance.

Trade Credit

This is a debt source of finance and is in the short-term. This occurs when a business buys inventory but pays for it later. Often, a business can use the revenue generated from the inventory to pay for it.

For a business to benefit from trade credit, they need to ensure good trading relationships with their suppliers and develop a mutually-trusting relationship.

Venture Capital

This is an example of equity finance. Venture capitalists finance new businesses or new products. This is what is seen on Dragons Den and Shark Tank. However, there is a very high risk for the angel investor (e.g., the Dragon or the Shark).

Secured Loans

Secured loans are a long-term, debt source of finance. A secured loan involves collateral, which refers to assets used to secure a loan. This gives reassurance to the bank that if the business does not pay the money back, the bank has the right to the collateral.

A business approaches a bank and asks for an amount of money. If the bank agress, the borrower receives the money and repays the money back over time. They also have to pay some level of interest, which can be applicable at fixed or variable interest rates.

Financial Institutions

Government

To support certain industries, governments provide financial aid. This can include government grants, which is an equity source of finance. Once a business receives a grant, they can use it for the relevant operations.

This makes grants a very attractive source of finance. However, a grant is difficult to obtain due to the specificity of the grant itself and the associated paperwork, which tends to be lengthy and tedious.