SOURCES OF

FINANCE
 Lecture Overview
• https://efinancemanagement.com/sources-of-finance/
sources-of-finance
• Introduction
• Short term sources
– Trade credit
– Bank overdraft
– Bank credit
• Medium/long-term sources
– Equity
– Debt
– Leasing
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 Introduction
• Sources of finance are the most explored
area especially for the entrepreneurs about
to start a new business. It is perhaps the
toughest part of all the efforts.
• There are various sources of finance
classified based on time period, ownership
and control, and source of generation of
finance.

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 Introduction
• On the basis of a time period, sources are classified
into long term, medium term, and short term.
• Ownership and control classify sources of finance into
owned capital and borrowed capital.
• Internal sources and external sources are the two
sources of generation of capital.
• All the sources of capital have different characteristics
to suit different types of requirements.

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 Short-term sources of finance
• Short term financing means financing for
a period of less than 1 year. Need for short
term finance arises to finance the current
assets of a business like an inventory of
raw material and finished goods, debtors,
minimum cash and bank balance etc.
• Short term financing is also named as
working capital financing.

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 Short-term sources of finance
• Trade credit
• Bank credit
– Loans and advances
– Cash credit
– Overdraft
– Discounting of bills

• Customers’ advances
• Fixed Deposits for a period of 1 year or less
• Factoring services
• Instalment credit
• Loans from credit unions
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 Trade credit
• Trade credit refers to credit granted to manufactures
and traders by the suppliers of raw material, finished
goods, components, etc.
• Usually business enterprises buy supplies on a 30 to
90 days credit. This means that the goods are delivered
but payments are not made until the expiry of period
of credit.
• This type of credit does not make the funds available
in cash but it facilitates purchases without making
immediate payment.
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 Bank credit
• Commercial banks grant short-term finance to
business firms which is known as bank credit.
When bank credit is granted, the borrower gets
a right to draw the amount of credit at one time
or in instalments as and when needed.
• Bank credit may be granted by way of loans,
cash credit, overdraft and discounted bills.
• Banks sometimes require securities on credits
granted.

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 Bank credit: Loans
• When a certain amount is advanced by a
bank repayable after a specified period, it
is known as bank loan. Such advance is
credited to a separate loan account and the
borrower has to pay interest on the whole
amount of loan irrespective of the amount
of loan actually drawn.
• Usually loans are granted against security
of assets.
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 Bank credit: Cash credit
• It is an arrangement whereby banks allow the borrower to
withdraw money up to a specified limit. This limit is known as
cash credit limit. Initially this limit is granted for one year.
• This limit can be extended after review for another year.
However, if the borrower still desires to continue the limit, it must
be renewed after three years. Rate of interest varies depending
upon the amount of limit. Banks ask for collateral security for the
grant of cash credit.
• In this arrangement, the borrower can draw, repay and again draw
the amount within the sanctioned limit. Interest is charged only on
the amount actually withdrawn and not on the amount of entire
limit. It operates in the form of a credit card. Example Barclays
Bank Credit Card.

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 Bank credit: Overdraft
• When a bank allows its depositors or account holders to
withdraw money in excess of the balance in his account
up to a specified limit, it is known as overdraft facility.
• This limit is granted purely on the basis of credit-
worthiness of the borrower.
• In this system, the borrower has to show a positive
balance in his account.
• Interest is charged only on the overdrawn money. Rate of
interest in case of overdraft is less than the rate charged
under cash credit.

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Bank credit: Discounting of bills
• Banks also advance money by discounting bills
of exchange, promissory notes etc. When these
documents are presented before the bank for
discounting, banks credit the amount to
customer's account after deducting discount.
• The amount of discount is equal to the amount
of interest for the period of bill.
• Sometimes it could be in the form of invoice
discounting. Taking a credit on the face value
of outstanding credit sales.
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 Types of securities required for bank
credit
• Loans and advances are granted by bank
on personal security of the borrower as
well as on the security of some tangible
assets, besides the standing of the firm.
Securities against credit may be of two
types
– Personal security
– Security of tangible assets
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 Personal security

• Personal security means the credit-

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 Security of tangible assets

• Moveable goods
• Shares
• Documents of title to goods e.g. bills of lading
• Fixed deposit receipts
• Life insurance policies
• Precious metals

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 Customers advance
• Sometimes businessmen insist on their customers to make
some advance payment.
• It is generally asked when the value of order is quite large
or things ordered are very costly.
• Customers’ advance represents a part of the payment
towards price on the product(s) which will be delivered at
a later date.
• Customers generally agree to make advances when such
goods are not easily available in the market or there is an
urgent need of goods.
• A firm can meet its short-term requirements with the help
of customers’ advances.
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 Instalment credit
• Instalment credit is now-a-days a popular source of finance for
consumer goods like television, refrigerators as well as for
industrial goods.
• Only a small amount of money is paid at the time of delivery of
such articles. The balance is paid in a number of instalments. The
supplier charges interest for extending credit. The amount of
interest is included while deciding on the amount of instalment.
• Another comparable system is the hire purchase system under
which the purchaser becomes owner of the goods after the payment
of last instalment. Sometimes commercial banks also grant
instalment credit if they have suitable arrangements with the
suppliers.

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 Loans from credit unions
• Credit unions are a good source to procure short-term finance. Such
unions have been established at local, district and
• national levels. These unions are usually formed among workers in a
particular organization. Some of these unions or micro-finance
institutions like UT Financial Services was initially established as a
co-operative society and later converted into a bank.
• These unions grant loans for personal as well as business purposes.
Membership is the primary condition for securing loan. The
functions of these unions are largely comparable to the functions of
commercial banks.
• We can take the case of UCC Credit Union.

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 Factoring services
• Factoring companies offer a range of services in the area of sales
administration and the collection of amounts due from trade
receivables. A factor can take over the administration of sales
invoicing and accounting for a client company, together with
collecting amounts due from trade receivables and chasing up any
slow payers.
• A factor can offer a cash advance against the security of trade
receivables, allowing a company ready access to cash as soon as
credit sales are made. For an additional fee, a factor can take on any
bad debts that may arise through non-payment. This is called non-
recourse factoring, since here the factor does not have recourse to
the company for compensation in the event of non-payment.

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 Long-term sources of finance
• Long-term financing means capital requirements for a
period of more than 5 years to 10, 15, 20 years or
maybe more depending on other factors.
• Capital expenditures in fixed assets like plant and
machinery, land and building etc. of a business are
funded using long-term sources of finance.
• Part of working capital which permanently stays with
the business is also financed with long-term sources of
finance.

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 Long-term sources of finance
• The sources of long-term finance refers to the
institutions or agencies from which, or through
which finance for a long period can be
procured.
• In the case of sole traders and partnership firms,
long-term funds are generally provided by the
owners themselves and by retained profits. But
in companies whose financial requirement is
rather large, the following are the sources from,
or through which long-term funds are raised.
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 Long-term sources of finance
• Capital markets
• Equity financing e.g. shares
• Debt financing e.g. debentures and bonds
• Leasing
• Mortgage
• Venture capital
• Angel investors
• Government grants
• Special financial institutions
• Mutual funds
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 Capital markets
• Capital market refers to the organization and
the mechanism through which the companies,
other institutions and the government raise
long-term funds.
• So it constitutes all long-term borrowings from
banks and financial institutions, borrowings
from foreign markets and raising of capital by
issuing various securities such as shares,
debentures, bonds, etc.

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 Capital markets
• For trading of securities there are two different
segments in capital market. One is primary
market and the other is, secondary market.
• The primary market deals with new/fresh issue
of securities and is, therefore, known as new
issue market.
• The secondary market on the other hand,
provides a place for purchase and sale of
existing securities and is known as stock market
or stock exchange.
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 Capital markets
• The new issue market primarily consists of the
arrangements, which facilitates the procurement of
long-term finance by the companies in the form of
shares, debentures and bonds.
• The companies usually issue those securities at the
initial stages of their formation and so also later on for
expansion and/or modernization of their activities.
• However, the selling of securities is not an easy task,
as the companies have to fulfill various legal
requirements and decide upon the appropriate timing
and the method of issue.
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 Mutual funds
• Mutual fund refers to a fund established in the form of
a trust by a sponsor to raise money through one or
more schemes for investing in securities.
• It is a special type of investment institution, which acts
as an investment intermediary that collects or pools the
savings of a large number of investors and invests
them in a fairly large and well diversified portfolio of
sound investments.
• This minimizes their risk and ensures good returns to
the investors.

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 Features of a mutual fund
• The essential features of mutual funds are as follows:
1. It is a trust into which a number of investors invest their money in the form
of units to form a large pool of funds.
2. The amount is invested in securities by the managers of the fund.
3. The amount is invested in different securities of reputed companies to ensure
definite and regular income. Thus, it helps in minimizing the risk.
4. The mutual fund schemes often have the advantages of high return, easy
liquidity, safety and tax benefits to the investors.
5. The net income received on the investments of the fund is distributed over
the units held.
6. The managers of the fund are obliged to redeem the units on demand or on
the expiry of a specified period.

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 Leasing companies
• This method has become quite common among the manufacturing
companies. Leasing facility is usually provided through the
mediation of leasing companies who buy the required plant and
machinery from its manufacturer and lease it to the company that
needs it for a specified period on payment of an annual rent.
• For this purpose a proper lease agreement is made between the
lessor (leasing company) and lessee (the company hiring the asset).
Such agreement usually provides for the purchase of the machinery
by the lessee at the end of the lease period at a mutually agreed and
specified price. It may be noted that the ownership remains with
the leasing company during the lease period.

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 Leasing companies
• Sometimes, a company, to meet its financial
requirements, may sell its own existing fixed asset
(machinery or building) to a leasing company at the
current market price on the condition that the leasing
company shall lease the asset back to selling company
for a specified period. Such an arrangement is known
as ‘Sell and Lease Back’.
• The company in such arrangement gets the funds
without having to part with the possession of the asset
involved which it continues to use on payment of
annual rent for the lease.
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 Special financial institutions
• A number of special financial institutions have
been set up by the central governments to
provide long-term finance to the business
organizations.
• They also offer support services in launching of
the new enterprises and so also for expansion
and modernization of existing enterprises.
Some of the important ones are YEF and
MASLOC.
• Names some of these funds you know.
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 Venture capital
• Venture capital refers to financing that comes from
companies or individuals in the business of investing
in young, privately held businesses. They provide
capital to young businesses in exchange for an
ownership share of the business.
• Venture capital firms usually don’t want to participate
in the initial financing of a business unless the
company has management with a proven track record.
• Generally, they prefer to invest in companies that have
received significant equity investments from the
founders and are already profitable.
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 Angel investors
• Angel investors are individuals and businesses that are
interested in helping small businesses survive and grow. So
their objective may be more than just focusing on economic
returns. Although angel investors often have somewhat of a
mission focus, they are still interested in profitability and
security for their investment. So they may still make many of
the same demands as a venture capitalist.
• Angel investors may be interested in the economic development
of a specific geographic area in which they are located. Angel
investors may focus on earlier stage financing and smaller
financing amounts than venture capitalists.

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 End of Lecture

Thank you
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