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The importance of finance in business and the different types of capital requirements. It also discusses internal and external sources of finance, including equity financing, debt financing, trade credit, lease financing, public deposits, and commercial paper. definitions and examples of each source of finance and their benefits. It also explains the concept of working capital and how it can be reduced to generate internal finance. useful for students studying finance, accounting, or business management.
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Used for Internal sources are generally used for funding day-to-day business operations. High-profit making entities can however use these for growth plans as well if the funds generated are sufficient. External sources are generally used for setting up a business or at later stages for growth and expansion , when funds generated from internal operations do not suffice. Loss making companies may also use these sources for business revival or to keep their operations going. Process for obtaining Raising funds from internal sources generally do not involve any formal process. It is a more automatic process where funds generated from business operations are re-applied in the business. Raising funds from external involves a more structured and formal process. This includes deliberation of the management, Director and shareholder resolutions, holding meetings with financers, discussing terms and finalizing documentation Parties involved Raising funds through internal sources generally does not involve any third party except where business assets are sold to generate funds. Raising funds through external sources necessarily involves one or more external third parties. Tax benefits Internal sources of finance do not have any specific tax benefits. External sources of finance may involve incurring of tax-deductible financing costs such as interest. This can help reduce tax incidence on profits of the entity. Conclusion â internal vs external sources of finance The choice of source of finance depends on several parameters. Probably the first and foremost, being the quantum of finance required. Where sufficient funds can be generated through internal sources, entities may prefer it as it is simpler and generally less expensive than seeking external sources. However, where these funds are not sufficient for the business requirements, businesses have to turn to outside entities to raise funds. Tax considerations may also make entities choose between internal and external sources of finance.
A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. This is known as retained earnings. It is a source of internal financing or selffinancing or âploughing back of profitsâ. The profit available for ploughing back in an organisation depends on many factors like net profits, dividend policy and age of the organisation.
Another internal source of finance is the sale of assets. Whenever business sells off its assets and the cash generated is used internally for financing the capital needs, we call it an internal source of finance by the sale of assets.
It is interesting to know how a reduction in working capital can work as an internal source of finance. Working capital has broadly two components. One, Current Assets, which include Stock / Inventory, Account Receivables â Debtors and Cash / Bank Balances. Second, Current Liabilities, which include Account Payables â Creditors and Bank Overdraft. Normally, a business requires two types of finance viz. long-term finance for capital expenditure and working capital finance for day to day needs. Reduction in working capital can be achieved either by speeding up the cycle of account receivables and stock or by lengthening the cycle of account payables. In essence, both will reduce the working capital requirement and therefore the funds invested for working capital can be utilized for the other finance or capital requirements. This source has a little different analytics. This source is generated out of the efficient management of working capital and appropriate usage of working capital management techniques.
Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. Such credit appears in the records of the buyer of goods as âsundry creditorsâ or âaccounts payableâ. Trade credit is commonly used by business organisations as a source of short-term financing. It is granted to those customers who have reasonable amount of financial standing and goodwill. The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market. Terms of trade credit may vary from one industry to another and from one person to another. A firm may also offer different credit terms to different customers.
A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right to use the asset in return for a periodic payment. In other words, it is a renting of an asset for some specified period.
The person holding the share is known as shareholder. There are two types of shares normally issued by a company. These are equity shares and preference shares. The money raised by issue of equity shares is called equity share capital, while the money raised by issue of preference shares is called preference share capital. Equity Shares: Equity shares is the most important source of raising long term capital by a company. Equity shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or ownerâs funds. Equity share capital is a prerequisite to the creation of a company. Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company. They are referred to as âresidual ownersâ since they receive what is left after all other claims on the companyâs income and assets have been settled. They enjoy the reward as well as bear the risk of ownership. Their liability, however, is limited to the extent of capital contributed by them in the company. Further, through their right to vote, these shareholders have a right to participate in the management of the company. Preference Shares: The capital raised by issue of preference shares is called preference share capital. The preference shareholders enjoy a preferential position over equity shareholders in two ways: (i) receiving a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders; and (ii) receiving their capital after the claims of the companyâs creditors have been settled, at the time of liquidation. In other words, as compared to the equity shareholders, the preference shareholders have a preferential claim over dividend and repayment of capital. Preference shares resemble debentures as they bear fixed rate of return. Also as the dividend is payable only at the discretion of the directors and only out of profit after tax, to that extent, these resemble equity shares. Thus, preference shares have some characteristics of both equity shares and debentures. Preference shareholders generally do not enjoy any voting rights. A company can issue different types of preference shares
Debentures are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures, which bear a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date. Debenture holders are, therefore, termed as creditors of the company.
Debenture holders are paid a fixed stated amount of interest at specified intervals say six months or one year. Public issue of debentures requires that the issue be rated by a credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.) on aspects like track record of the company, its profitability, debt servicing capacity, credit worthiness and the perceived risk of lending. A company can issue different types of debentures. Issue of Zero Interest Debentures (ZID) which do not carry any explicit rate of interest has also become popular in recent years. The difference between the face value of the debenture and its purchase price is the return to the investor. Difference between Shareholder and Debenture holder