Starting a business is an exciting time, but it can also be risky. That’s why it’s important to have a solid plan for funding your company and to know where to turn when things get tough.
In this article, we’ll introduce you to some of the most common sources of funding for businesses, and explain what each one offers.
We’ll also give you tips on how to choose the right funding option for your business, and on how to manage and monitor your finances. Ready to get started? read on to learn more!
Introduction Of Sources Of Funding
The selection of the source of funds needed to start any business and run the day-to-day business is an important decision of financing management. Because the cost of different fund sources is also different and the advantages and disadvantages of different term funds are also different. The organization raises funds from a combination of sources of funding that provide the most benefits and the least cost by comparing different sources. The main purpose of investing funds is to make a profit. Note that if the total income of an organization is more than the total expenditure, it usually means the total profit.
Excluding expenses or expenses and taxes for the source of funds from the total profit, net profit is obtained. Therefore, in order to maximize the amount of profit, it is essential that the cost of the source of funds be kept to a minimum.
The idea of the source of different types of funds
Business financing refers to the provision of funds needed to run a business. Mr. Rahman owns a tailor shop. He bought some machines at the beginning of the business. The trader usually tries to raise money for permanent investment in the purchase of machines from his own savings. Because he can use this money in any term.
But if he calculates that his own savings are not enough to buy a machine, he raises funds by borrowing at fixed interest rates from various commercial banks such as Janata, Rupali, or other lending financial institutions. Such loans he usually takes for a fixed period. Funds can also be provided by taking mortgage loans from banks and non-institutional sources against the real estate of the trader such as building factories, immovable property such as raw materials, salable goods, etc. Besides, Mr. Rahman can meet the need for financing by investing in the business without withdrawing the profit earned by the business.
If during the course of the business Mr. Rahman faces a shortage of funds for daily expenses such as machine repairs, house rent, payment of salaries to employees, payment of electricity bills, etc., he can take an advance against future sales for the provision. Again, it is possible to finance the rest by purchasing goods. Many times valuable machineries, large equipment, buildings or land, etc. are not purchased but can be rented from different institutions for a fixed period of time, which also saves the trader from the risk of investing a lot of money at once.
Large trading companies such as Kohinoor Chemicals, Beximco Pharmaceuticals, Square Textiles, and Singer Bangladesh raise funds through the sale of shares and bonds. The money raised from such sources is usable in the long run. Thus, due to differences in the structure, nature, and purpose of the business, the organization raises funds from different sources. Any business organization has two different sources of funding.
One owner is the other lender. The funds provided by the owner are called internal and the funds provided by the lender are called external funds. Most organizations usually use both sources.
Internal funding
The fund that the business owner invests in the business needs through his accumulated profits or unutilized profits is called an internal fund. Internal funding sources can be divided into two parts.
A) Ownership based
B) Profit based.
Internal Resource Ownership Classification:
The nature of the internal funding of different types of business organizations is also different. As we know, business on the basis of organization can be a monopoly, partnership, or joint venture. In a proprietary business, the source of this fund may be the instrument of any production measured by the owner’s own money or money. Such as: land, labor, capital, and organization that are used in production. If the organization is a partnership, then the funds invested by the partners in the business are considered their capital.
On the other hand, if the company is a joint-stock business, the funds raised through the sale of shares will be considered internal funds of the business. Mutual capital transactions can be private limited and public limited.
The entrepreneurial membership of a private company can range from 2 to 50 and the entrepreneurial membership of a public limited company can be any number limited to shares below 8 and above. Both public limited and private limited companies raise capital through the sale of shares.
However, private limited companies do not sell their shares in the stock market but sell them to designated owners. An important source of raising funds for a public limited company is the sale of shares.
Profit classification of internal sources:
Businesses make money by providing manufactured goods or services. Excluding production costs, sales costs, etc. from this earned income, the remaining money is the profit earned by the organization. After deducting interest on the loan and taxes payable to the government from these profits, the rest can be used as a source of funds in various ways, which are discussed below. In the case of loans, the payment of installments does not have to be compulsory with the use of internal resources, thus reducing the risk of the inability to repay the funds. We will now briefly introduce some of the sources of profit.
A) Unallocated profits and reserve funds
The part of the net profit that is invested in the business without being distributed among the shareholders is the undistributed profit. When this undistributed profit is set aside in a fund for future business expansion, it is called a reserve fund. Again, this accumulated fund can be created to deal with any future financial disaster.
B) Dividend Equilibrium Fund
The shareholders of the company usually receive regular dividends from the company. The company’s reputation is involved in paying these dividends. If the amount of profit is less in a year, it is not possible to declare a dividend in that year. But because this situation can tarnish the business’s reputation, many businesses set aside a portion of the net profit in the year in which the profits are higher, which can be used later when the profits are insufficient. The company can pay regular dividends at a fixed rate every year.
External funds
External funding refers to the collection of funds from a source outside the organization, such as a loan from a bank. It is a popular source of funding. Bank loans have several features. Firstly: Bank loans have a fixed term, within which the loan is repaid using interest.
Second, interest rates are fixed, and do not change over a long period of time. Thirdly: It is mandatory for the business to pay interest and installments regularly and pay the principal on time.
Even if the business is not profitable, all this money has to be paid. Similar funds can also be raised by selling debentures or bonds to banks. Fundraising by selling preferred shares is also known as an external source of fundraising. External sources of fundraising are quite popular. Two reasons for this are significant
1) In the case of external financing through a loan, tax has to be paid on the profit which remains after paying the interest of the loan from the total profit. As a result, the amount of tax payable is less.
2) For small organizations, internal financing is often less than the required investment, so external financing is the main source of funding.
However, one of the disadvantages of external funds is that it is mandatory to pay interest. It has been said before that whether the business is profitable or not, the interest and installments of the loan must be paid. Raising funds from internal sources does not create this problem.
There are generally 3 types of external funds based on term:
A) short-term,
B) Medium-term and
C) Long term.
This time we will get an idea about these three types of financing.
Short-term source of External Funds
Short-term means less than 1 year. Most of an organization’s financing is basically collected from short-term sources, which are repayable over a period of one year or less.
The organization has some special benefits in the case of short-term financing. Such as:
First, the cost of financing from a short-term source can be both relatively high and low.
For example, for a loan taken from a commercial bank, the interest rate has to be higher in the short run. Businesses can raise money for a short period of time through various debt-free sources such as: purchase of remaining goods, and arrears of wages. Which has no capital cost.
Second, short-term money transfer is the fastest and simplest process. In contrast, medium and long-term money transfers require a lot of time and effort.
Third, long-term production and financing cannot be planned in businesses whose demand for goods fluctuates rapidly over a period of one year. For example, fashion houses take short-term plans to produce products due to the rapid fluctuations in demand, which results in less investment as they produce less at the same time. It is convenient to finance such a business from a short-term source.
This time we will discuss the sources of short-term financing. The sources of funding for this period can be divided into institutional and informal. Below we will discuss institutional sources of short-term funding first and then informal sources.
1. Institutional source of short-term financing
A) Receivable bill discount
When the rest of the goods are purchased, the purchasing company promises the seller in a deed that a certain amount of money will be paid for the purchase of the goods at the end of the specified period (usually three months). This document is called an exchange bill. This bill is a due bill to the seller. Cash can be collected by breaking or discounting such bills in commercial banks.
Suppose a buyer buys the remaining goods of Rs.500 on January 1 and promises the seller in a document called exchange bill that he will be obliged to pay Rs.500 to the seller by March 30. In this case, if the seller needs money now, the seller can sell the exchange bill to any bank before maturity and collect cash of Rs.
B) Bills payable
The exchange bill in the example above is a bill due to the seller, a bill payable to the buyer, and a source of short-term financing. When the business organization buys the rest of the raw materials, manufacturing materials, etc., the business is financed for a temporary period.
Because if you don’t get the benefit of buying the rest Money was needed to buy goods in cash, for which a loan from a bank had to be repaid with interest.
C) Short-term bank loan
Unsecured bank loans are a major source of short-term financing. Such bank loans can be of different types. For example, in the case of short-term bank loans, the principal is repaid together with interest over a period of time. Banks often offer some discounts on the total amount to encourage the borrower to repay the entire portion of the loan before the due date.
For example, if a borrower pays Rs 6,000 after 6 months, the borrower can pay 2% less to the bank, i.e. the borrower will pay Rs 5.60 to the bank. In addition, if the borrower takes a loan on the condition of repaying the loan as soon as the bank asks for it without committing to repaying the loan on a fixed time basis, it is called a loan on demand. Organizations that have alternative sources of funding can use these sources at low cost.
D) Bank overdraft
Another source of short-term bank loans is bank overdrafts. All the institutions basically collect the debts and pay the debts through current accounts. Such bank accounts usually provide the client or institution with the opportunity to withdraw additional deposits, but the bank limits the maximum amount of additional withdrawals on deposits.
Financing from such sources is a common practice in organizations that typically reduce sales at certain times of the year. For example, an ice cream factory spends all year round on its production, warehousing, management, etc., but mainly sells ice cream in the summer, so this source is used for financing at other times of the year. Normally in the case of other loans, the interest of the loan has to be paid till the loan is repaid, but the interest of such loan has to be paid only from the time when the overdrawn money is used. However, the interest rate on such loans is higher than other short-term sources and the borrower has to pay it as soon as the bank asks for it.
E) Small loans
Such loans are usually provided to meet the working capital needs of agro-based and small cottage industries. Such as cottage industry management, purchase of agricultural inputs, hatchery or farm management, etc. Grameen Bank, Youth Development Bank, and Cooperative Banks provide such loans. These loans are disbursed on a step-by-step basis.
Informal source of short-term financing
A) Commercial letter
The merchant sells the commercial paper with a commitment to pay back the original money with a profit within a certain period of time for financing. In this case, the reputation of the organization acts as a guarantee for the sale of commercial papers. Usually, people who have some unutilized money for a temporary period of time buy these trading letters as an alternative to investing in the stock market. Generally, celebrities, commercial banks, insurance companies, etc. can provide temporary financing by selling commercial papers.
B) Receipt of advance from the buyer
In many cases, faithful and permanent buyers pay in full or part of the total value of the future purchase in advance so that the seller can raise money for a temporary period.
C) Mortgage of stocks
Stockpiles can be used for short-term financing. Financing through stocks is when an institution borrows money from a reputed person or organization by pledging its stocks. In the case of such financing, the lender retains control and authority over the stock until the loan is repaid.
D) Rural moneylenders
For a long time now, the rich people of the village have been providing short-term loans to the poor. In this case, if the repayment period of the loan has expired, the borrower has to pay a large amount of interest. And if they fail to pay interest, the moneylenders take possession of the movable and immovable property of the borrowers. Rural moneylenders calculate interest on this loan on a day-to-day, week-by-month, or month-by-month basis.
Medium-term financing
Funds raised for a period of one to five years are treated as medium-term financing. An organization uses medium-term funds to meet the long-term needs of running business capital. The cost or interest rate of this fund is higher than the cost of short-term funds and less than the cost of long-term funds. Its origins are discussed in different features:
A) Loans given by commercial banks
The loans provided by commercial banks for the medium term are usually against collateral. Working capital or fixed assets as collateral and usable. Excessive lending can be risky for a commercial bank. As a result, in the case of large-scale lending, many commercial banks come together and take the risk of providing large-scale lending through a group banking system in a syndication process. Commercial banks set interest rates at a fixed rate after judging and analyzing the interest rates and loan requirements set by Bangladesh Bank before granting loans.
B) Specialized financial institutions
In the public sector, special financial institutions are usually set up, which are engaged in the development of special sectors. These institutions provide term loans to the business establishments of the respective sectors on relatively favorable terms. For example Shilpa Bank, Krishi Bank, Bangladesh Small and Cottage Industries, etc. are notable.
C) Non-governmental organizations
There are several NGOs established and operating in Bangladesh as non-governmental organizations which provide medium-term loans to business entities. For example, Midas, BRAC, Grameen Bank, etc. are doing business here by gaining legal status as NGOs. In addition to providing funding to these organizations. It also helps the business organization in providing counseling, training, skills enhancement, etc.
D) Capital market institutions
Different types of capital institutions such as insurance companies, investment banks, financial intermediaries (underwriters) and medium-term loans are provided.
Long-term funding
The term of long-term financing is from 5 years to any period above. Sources of long-term funding have some special characteristics. We will now discuss these features.
The first feature is that the size of funds raised through long-term financing is usually larger than that of short-term and medium-term sources, so these funds are used to purchase various fixed assets such as land, buildings, machinery, etc. Another feature is the payment method.
If the long-term fund is taken through a loan, it has to be repaid as per the agreement. And if the fund is raised through the sale of shares, it is considered the owner’s fund and is not required to be paid until the business is dissolved.
In a monopoly and partnership business, the owner’s own capital can also be used indefinitely in the long run. The income tax-related feature is that dividends on shares are taxable but interest on debentures is not taxable. For this reason, the cost of long-term financing by selling shares is relatively low, while the cost of long-term borrowing is relatively low. This time we will discuss the source of long-term funding.
a) Debt
Any organization usually borrows large sums of money against long-term collateral to meet the necessary expenses of valuable equipment, machinery, construction of buildings, purchase of land, etc. In the case of long-term lending, banks analyze the company’s income, reputation, fixed assets, past borrowing, and repayment data. Long-term loans are taken out for permanent investment. Such as: increasing the scope of the business, construction of factories, construction of buildings, purchase of large size machinery, etc.
Before making all these investment decisions, the concerned business organization makes an estimate, which is known as Capital Budgeting. There is a review of the future profit and loss from the investment. The loan is given only if the lender is satisfied considering this estimate of profit and loss.
B) Debentures
In the case of debentures, funds are raised by selling large chunks of debt in small chunks. This is an option to share. But the bond mentions an interest rate at which the borrower is obliged to pay interest. Loans are taken for any period from 5 years to long term.
Even if the company is not profitable, the business is obliged to pay the debts (interest) to the creditors first. The main advantage of financing through the sale of securities is that long-term interest rates are fixed and predetermined so financial managers can plan to finance efficiently.
C) Leasing
Leasing is a fancy method of long-term financing. If an organization needs expensive machines, equipment, vehicles, etc., then they have to be purchased directly or can be used by renting from a leasing company without leasing directly. In that case, the company is the machine that does not get ownership.
The machine is owned by a leasing company. The right to use the leased property is acquired in exchange for paying a fixed rate of rent (like interest) to the leasing company for leasing.
Suppose a business leases a photocopy machine from a leasing company for 3 years without purchasing a photocopy machine and returns the photocopy machine back to the leasing company at maturity. That is, as a result of leasing, the ownership of the property remains with the leasing company. Leasing does not require the company to take out long-term loans or use reserve funds. For this reason, leasing is a source of long-term financing. New or small companies with less capital can also use expensive machines through leasing. Leasing companies repair and maintain the leased property.
International Monetary Fund:
It is an international economic organization. It was established in 1945 on the recommendation of the Bretton Woods Conference in the United States. It currently has 169 members (most recently the Republic of Nauru). This organization helps in the economic restructuring of different countries. Its head office is located in Washington.
Considerations in source selection
Organizations raise funds from a variety of sources to meet their financial needs. In the selection of sources, it is necessary to consider the advantages and disadvantages of different sources, the cost of raising funds, the nature of the organization, the type, and purpose of the funds required, etc. Creating the right mix of funding sources is an important decision in financing management. Here are some things to look for when selecting the right funding source:
A) Type of business
In the case of monopoly and partnership business, funds are usually raised through own savings, business profits, and loans taken from relatives. Leasing is also a good source of funding for large purchases. In the case of public limited companies, issuing shares and debentures without these
Most of the funds are raised.
B) Insufficiency of the collateral property
Generally, in the case of a newly established business, it is not possible to take a loan on the basis of fixed asset collateral. Because in the initial stage there is no collateral fixed asset. The sale of shares and debentures for new companies is also very uncertain. In this situation, if long-term funds are needed, it is more reasonable to raise funds through leasing.
C) Type of funding required
If the organization wants to purchase valuable equipment, machinery, land, buildings, etc., then the use of long-term sources such as: issue of shares and debentures, leasing, borrowing through collateral, etc. is effective. If the organization is short of funds to meet the expenses of purchase of raw materials, payment of wages, payment of rent, etc., then short-term loans can be taken through other sources such as purchase, outstanding bill security, bank overdraft etc.
D) Cost of a source of funds
Money can be raised from many sources. But the organization collects funds from a source whose cost is minimal by judging and analyzing the advantages and disadvantages between the income earned from the use of funds and the cost of raising funds. Suppose an organization wants to purchase a factory to run its operations.
As a result, the company issues shares to raise funds. But in order to raise funds through shares, shareholders have to pay dividends, which is the cost of the source. Again the company may mortgage the property for the purchase of a new factory. If you take a long-term loan through such a mortgage, the lender has to repay the installment with interest until the loan is repaid.
As a result, this source is also very expensive. Whichever of the two costs the least, the source can be adopted by the organization. Or it can raise funds through a profitable mix between the two sources. Dividends on shares are taxable but interest on debentures is not taxable.
Therefore, it is better to borrow from banks or other sources on an interest basis to raise funds from internal sources to reduce the tax burden. In many cases, there is more benefit to mixing sources than using a specific source and it is also possible to reduce costs.
E) Risk of funding source
If an institution takes a secured loan, the lender has to keep the property as collateral with the institution. If the loan cannot be repaid within the stipulated time, the company is forced to repay the loan by selling the secured property. As a result, in selecting the source of funds, the associated risks of the respective sources have to be considered.
Final Words sources of funding for businesses
The list of sources is just not exhaustive. If you want to make an investment in something, talk to a financial advisor about your choice. They can help you plan for the long-term and even help you decide whether it’s better to wait or take a leap of faith now.
While some people are willing to risk everything on an idea and put their entire savings on the line, others prefer taking more conservative steps first. Such decisions depend entirely on what motivates you!
