Finance is a crucial element when it comes to business and it is the heart and soul of business and hence financing of projects becomes important.
I believe that is right because a majority of businesses fail because of lack of finance and the bigger reason is the not managing the available finance properly.
The issue also comes when it comes to arranging for finance. Businesses struggle hard when it comes to arranging for finance.
Either they don’t know which source of finance to opt or they don’t know exactly how to go after that source of finance.
In our earlier post, we looked at what were the various sources of finance available and in this one, we will study the sources of finance discussed.
- Capital structure
- Sources of finance
Before going for financing of projects one must know about what is capital structure.
In simple words capital structure refers to the combination of types of capital that we maintain in our capital. It’s a structure that represents our combination of equity and debt that we have used for financing the project.
The choice of capital structure is very crucial for any business as it will determine how much finance will be our own and how will be debt. Therefore, a company wants to have a mix of both neither complete equity nor complete debt.
Total capital= Debt with the firm + Equity capital of the firm
Now we will learn more about the sources of finance in detail:
Sources of finance/ Financing of Projects
Equity Share Capital
Equity share capital also known as the owner’s fund is the capital which is being raised by selling the shares of a company.
So a share is the smallest unit of finance. Equity shareholders are the owners of the company. This type of capital is very prominent when it comes to the financing of projects.
These shareholders also enjoy the benefits of owners like the profits and are also in a risk-bearing situation. At the time of winding up of the company, the equity shareholders are the last ones who are to be paid from everything that is left.
The holders of equity share capitals have got voting rights in the company and also have rights to select the management of the company.
The rate of the equity share fluctuates on the basis of how the firm performs in the market. They have also got the right to participate in management decisions of the company.
Types of equity share capital are:
- Authorised share capital
- Subscribed share capital
- Issued share capital
- Right shares
- Sweat equity shares
- Bonus shares
- Paid-up capital
Another popular way of financing of projects is debenture capital.
Debenture capital is basically a loan for the company with the main aim to offer to the large public. This source of finance is generally available for large firms because raising finance using debentures requires a lot of trust of people towards the company.
No security is present with raising debentures but instead, a document is issued to the person giving funds and the person becomes a debenture holder.
A compulsory dividend is to be given on debenture holders. Also, the rate of interest is fixed while distributing debentures. Even if the company suffers losses debenture holders must be paid because it is a loan.
At the time of winding up of the company, the debenture holders are the first one to be paid back as it is a debt for the company.
Also Read: Source of Finance From Debenture
Preference Share Capital
These are the shares which have a preference over the equity shareholders. These shares also like dentures have to compulsorily pay a fixed dividend to the holder of the preference share.
The preference shareholders do not enjoy voting rights in the company as the equity one does.
They have comparatively low chances of risk because they enjoy a fixed rate of return. They also usually enjoy a higher rate to return over the debenture owners.
These shares are not for those investors who want to enjoy high rates of return by taking more risks.
A term loan basically is a loan that needs to be repaid over a period of time in regular intervals. The amount in a term loan remains fixed. The repayment schedule of a term loan is also fixed.
These are generally given as small business loans. Term loans are a great way for quickly raising finance.
The interest rate on term loans can be either fixed or floating. In a fixed rate of interest the rate at which loan is given never changes and in the floating rate of interest the rate of interest varies with changes in the market.
Term loans can be of a varying time period. It can be a short term loan ranging from 1-2 years, or medium-term loan ranging from 3-5 years, or long term loan which can go up to 25 years.
Term loans provide the flexibility of tenor to chose from. Also, it offers ease of repayment as money is to be returned back in instalments.
Deferred credit refers to the income which is not immediately considered as income in the book of accounts because it is not yet earned by the firm. The deferred credit may be a current liability. It is also reported as a liability in the books of accounts.
If a loan is given on more convenient terms then it is called a soft loan. The easy and simple terms can be in the form of low-interest rates, or long duration of the loan repayment terms. These are generally provided by government institutions.
It is a method in which one can obtain economic use of an asset for a specific time period without gaining ownership rights in the asset.
Some firms may find difficult to arrange for some assets by purchasing them because of the cost involved or any other factor so then can opt for leasing the asset.
In this way, they can enjoy using the asset with small finance available. In leasing the repayment is also done in fixed instalments.
Just like someone pays to rent the lease instalments go the same way but it’s just that the term for which leasing is done is generally very long.
Also known as seed money or seed funding and it involves a type of security offering which is given to startups by an investor in return of equitable stake in the company.
It is an initial form of funding used to establish a new business or launch a new product. It is the most popular young new-age startups which have less or no capital available.
Retained earnings refer to the accumulated profits from a business which are reinvested into the business to conduct its operations. It is generally the profits which are not distributed as dividends to the shareholders.
It is shown in shareholders equity in the name of retained earnings in the balance sheet.
The formula to calculate retained earnings is given as follows-
RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends
Also Read: Personal Finance
Public deposits are a type of unsecured deposits which are invited by companies from the public. The main aim of acquiring public deposits is to fulfil the working capital requirements of a business.
Unsecured loans are the loans which are issued by private investors to companies. The private investors are generally wealthy enough to lend money to people. As the name suggests no collateral is required against these loans.
These are given on the basis of the creditworthiness of the borrower. The rate of interest on unsecured loans is generally high because no collateral is involved in it.
These are also sometimes referred to as signature loans. These loans are popular when financing of projects is done in the unorganized sector.
A government subsidy also is known as a government incentive. It is a form of a financial aid which is given to businesses which aim to promote the economic and social welfare of the society.
A variety of sources from which finance can be arranged are available in the market. Different firms need to look at the different sources present and choose the source which best meets their needs.
Also, a source which is easy to acquire and has more liquidity is preferred over others. A company must maintain an optimal capital structure by balancing debt and equity.
Stay with us to get more such amazing stuff from our side. We will be meeting soon. Till then have a look at some FAQs;
Frequently Asked Questions
Internal sources of finance are those sources which are internally arranged by the company. They include retained earnings, sale of assets and reduction in working capital.
External sources of finance are those sources which are externally arranged by the company. Some of them are equity shares, debentures, loans etc.
Commercial Banks and Financial Institutions, Lease Finance and Public Deposits.