External Sources Of Finance 2

External Sources Of Finance

External Sources Of Finance

Introduction

A company has a wide range of sources to finance different activities in the business. The company can choose from various sources of finance depending upon the amount of capital required by them and also the time period for which the capital is needed. Companies mainly need capital to finance their expansion plans, to buy new machinery or to enter the new market. Before taking the finance the company must evaluate various parameters because it will help in selecting the best available source of finance (Rigby, 2011). Some of the parameters that should be considered are as follows:

  • Finance cost of the fund
  • Tenure (Time period for which the fund is needed)
  • Amount of leverage fund
  • Financial conditions prevailing in the economy
  • The risk associated with the company, as well as, with the industry in the company functions.

The Financial sources of business can be classified by the following basis:

  1. According to period
    1. Long term sources
    2. Medium-term sources
    3. Short term sources
  2. According to ownership
    1. Owner’s capital or equity capital retained earning
    2. Borrowed capital, such as debentures, public deposits, loans
  3. According to the source of generation
    1. Internal sources
    2. External sources

There are mainly two sources of finance in the business i.e. Internal Sources of Finance and External Sources of finance. In the Internal Sources of finance, the fund is obtained from inside the business. Financing from this option is very cheaper as compared to the external sources of finance (Read, 2002). In the case of the external sources of finance, money if generated from outside the business and on this amount of finance, the company has to pay some amount of interest that can be fixed or variable. The various finance options in each source are as follows:

Internal Sources of Finance

  • Retained Earning
  • Owners Capital (Generated from internal sources)
  • Current Assets
  • Sale of Fixed Assets

External Sources of finance

  • Bank Loan or Overdraft
  • Share Issue
  • Leasing
  • Hire Purchase
  • Mortgage
  • Trade Credit
  • Government Grants

External Sources of finance

An external source of finance is the method of raising funds from outside the business. In this source of finance, the company buys money from the financial institutions or from any other medium like shareholders, government, etc. On these funds, the company has to pay an agreed amount of interest at the fixed interval over a set period of time. These sources can be for medium or long term period. Medium term finance refers to the funds which are required for the period exceeding one year but not more than five years, and long term finance refers to the funds that are required for the period exceeding 5-10 years (Dlabay & Burrow, 2007). Generally, these funds are required for the investment in fixed assets like plant, machinery, starting the new business, entering the new market or for expansion purposes.

Different External finance sources in detail are as follows:

Shareholder’s Capital

This is the most commonly used source of finance, used by all listed companies. Large companies typically generate the finance both publicly and privately. Companies issue their stocks in the open market and these shares are taken by the general public at a predefined price. In this way, people who have invested in the company become the shareholder of the company and these shareholders ultimately become the owner of the company. As per an expert opinion, shareholders capital is one of the best ways to generate long term finance (Moynihan & Titley, 2001). The big advantage of this source of finance is that companies don’t have to repay the interest on the amount collected. The individual or group of people, who had subscribed to shares of the company become the owner of the business and also gets the rights in the part of the distributed profits of the company. Companies can issue two types of shares in the open market i.e. Common stock, also known as owner’s capital, and preferred stock.

Common Stock or Owner’s capital

A quoted company can raise funds for long term purpose by issuing common stock in the general public. Some of the characteristics of this type of capital are as follows:

  • It is the source of permanent capital and equity shareholders are the ultimate owners of the company as they are only who bear the risk.
  • Common stockholders are entitled to dividends after all the other claims of stakeholders are paid. So, dividends to common stockholders are paid from the appropriation of profits and not charge against the profit.
  • Generally, the capital cost of common stock is high because the fact is that such shareholders invest only in those companies, where there is a higher rate of return and low risk (Albrecht, Stice & Stice, 2010).

Advantages and disadvantages of raising funds by the issue of common stock are as follows:

  • In this source of finance, the capital raised is not to be paid back to investors. So, the company does not have any liability for cash outflow regarding the redemption of this capital.
  • This source of finance builds up the financial base for the company that helps further to buy the other sources of finance.
  • Companies are not legally liable to pay dividends to the common shareholders. So, at the time of uncertainties or when the company is not doing well, the dividend amount can be reduced or even postponed.
  • By this source of finance, the company can raise more funds by making the right issue.
  • The company can also buy back the shares in the open market or announcing the buyback, which will reduce the amount of extra capital not required by the company.

Apart from the above-mentioned advantages, there are also some disadvantages that are explained below:

  • This source of finance has a high cost because dividends do not involve any tax deduction and also the floatation cost (expenditure at the time of raising the capital) of such issue is higher.
  • This source of finance is regarded as the riskiest as there is uncertainty in the number of dividends and the capital invested.
  • The issue of further common stock reduces the earning per share amount of older stockholders until the profits are distributed according to the proportion of the existing and recently issued stock.
  • The right issue also reduces the proportionate ownership of the existing shareholders and ultimately dilutes the control power of the previous investors.

Preferred Stock

This type of stock is somewhat similar to the common stockholders. The major difference in both types of stocks is that in the common stock, it is not legally compulsory to pay any dividends, but in case of the preferred stock, it is compulsory to pay a fixed amount of dividend (Megginson & Smart, 2008). Characteristics of the preferred stock are as under:

This is the long term source of finance and can be raised by issuing the preferred stock in the common public.
  • The dividend payable on this stock is Cumulative in nature i.e. dividend which is to be paid in any particular year but unfortunately, due to the loss it remains unpaid, then such dividends carried over to the next year till there are adequate profits.
  • The rate of dividend is generally higher than other rates of interest on bonds and loans.
  • The fund received on the issue of this stock has to be repaid after a particular time period.

There are some advantages of the preferred stock like these stock does not attract ownership in the company and the dividend amount is fixed. Therefore, the preferred stockholders do not participate in the surplus profits as in the case of the common stockholders. This type of capital can be redeemed after the specified time period and also it does not affect the EPS on further issue of stock. There are mainly two disadvantages associated with this type of finance, one is that there is no tax advantage on the amount of the dividend paid and the other one is that the preferred dividends are cumulative in nature.

Bonds

In this type of financing, funds can be raised by issuing bonds in the name of the listed company. Generally, these bonds are issued to the general public, but they can also be issued to the financial institutions in lieu of the equivalent amount of loans. Basically, bonds are issued in different market rates, but the face value carries the fixed amount, which is defined before issuing the bonds. These bonds are issued on the basis of the bond trust deed that contains the terms and conditions on which the bonds are floated. Bonds can be secured or unsecured. Secured bonds are those bonds that have a charge on the Non-current assets of the company and carries a low rate of interest. On the other hand, unsecured bonds are those bonds that are issued at a high rate of interest but do not create the charge on the non-current assets of the company (Nevitt & Fabozzi, 2000). This source of finance is more favorable to investors as compared to the preferred stock because interest on bonds is payable whether or not the company makes earnings. The cost of the bond is much lower than the cost of preferred stock as the tax is deducted on the amount of interest paid on bonds. Also, investors consider this source of finance as the safest to invest because bondholders receive their amount prior to the preferred and common stockholders. The main disadvantage of bond financing is that the interest and capital repayment are obligatory payments. This source of finance also enhances financial risk as the amount of debt is increased (Mayo, 2011).

Loan from Banks or financial institution

The easiest source of finance is financing through commercial banks or financial institution. The main purpose of banks is to provide loans to the needy persons and earn interest on the amount of the loan given. Generally, banks provide short term loans, but now banks have started taking interest in the long term source of finance. The loans provided by banks or finance institutions are available at different rates of interest under different schemes and these are to be repaid according to the defined payment schedule. Generally, banks provide for the purpose of expansion or for setting up the new units (Werner & Stoner, 2010).

Apart from the bank loan facility, there is another type of financing called as Venture capital financing. In this type of financing, capitalists finance the high risky venture promoted by the qualified entrepreneurs. The venture capitalist makes the investment to purchase the common stock and bonds issued by the company. In this way, they become the partial owner of the company (Coyle, 2000).

Lease Financing

Lease financing is the general contract between the owner and the user of assets for the specified time period. In this type of financing, the lessor initially purchases the assets and thereafter, leases it to the lessee company. The lessee company pays a fixed amount at the periodical interval for the specified time period (Graham, Smart & Megginson, 2009). Lease financing is divided into two categories on the basis of the ownership, one is the operating lease and the other one is the financing lease.

Conclusion

At last, it can be concluded that there are several sources of finance available to the company. Sources of finance mainly depend upon the need of the company. In this way, these sources of finance can be subdivided into internal and external sources of finance. To meet the long term financial needs, there are many sources of finance available to the company. Some of the sources are share capital (common and preferred), bonds, venture capital financing, lease financing, etc. All these sources of finance have some advantages and some disadvantages, which is judged on the basis of the term these sources can be used, cost of capital, tax benefits, ownership, tenure of the finance and most important on the basis of the amount of money outflow for raising the funds.

References

Albrecht, W. S., Stice, E. K. & Stice, J. D. (2010). Financial Accounting. Mason: Cengage Learning.
Coyle, B. (2000). Venture Capital and Buyouts. USA: Global Professional Publishing.
Dlabay, L. R. & Burrow, J. L. (2007). Business Finance. Mason: Cengage Learning.
Graham, J. R., Smart, S. B. & Megginson, W. L. (2009). Corporate Finance: Linking Theory to What Companies Do + Thomson One – Business School Edition 6-month and Smart Finance Printed Access Card. Mason: Cengage Learning.
Mayo, H. B. (2011). Basic Finance: An Introduction to Financial Institutions, Investments, and Management. Mason: Cengage Learning.
Megginson, W. L. & Smart, S. B. (2008). Introduction to Corporate Finance. Mason: Cengage Learning.
Moynihan, D. & Titley, B. (2001). Advanced Business. New York: Oxford University Press.
Nevitt, P. K. & Fabozzi, F. J. (2000). Project Financing. London: Euromoney Books.
Read, L.H. (2002). The Financing of Small Business: A Comparative Study of Male and Female Small Business Owners. New York: Routledge.
Rigby, G. (2011). Types and Sources of Finance for Start-up and Growing Businesses. Britain: Harriman House.
Werner & Stoner (2010). Modern Financial Managing; Continuity and Change. Freeload Press, Inc.
Griffiths, M. 2013. Agile Requirements Uncertainty. [Online]. Available at: https://leadinganswers.typepad.com/ [Accessed on: 30 August 2014].
Kumar, M., Antony, J., Singh, R.K., Tiwari, M.K. and Perry, D. 2011. Implementing the Lean Sigma framework in an Indian SME: a case study. Production Planning & Control 17(4), pp. 407-423.

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