Sources of Business finance

Sources of Business finance

Jennifer Gathoni Njaramba

(Institution)

Argumentative Essay

Sources of Business Finance

Introduction

Entrepreneurs need finances to start a business or ramp already started business in order to achieve profitability. In order to start up a venture or ensures that the business thrives, the businessperson has several avenues from which the funds can be sourced. Categorically, sources of business funds are either internal or external. Whether a business is new, small, old, or large, financing is crucial for it to grow, thrive, expand, and realize new organizational strategies. Therefore, business owners should not be obliged to a particular source(s) of finance; instead, they need to understand their own business and the sources that best suit their venture’s needs. In a nutshell, no business can succeed by confining itself to a particular financial source; that is, all the possible sources should be used provided that they augur well with the business needs and ambitions.Kirkwood (2003) reported that both small and large-scale businesses have several source of finance, which has to be exploited if the benefits outdo the costs. He adds that all the variant sources of business funds have both advantages and disadvantages, which determines whether a particular enterprise should source its funds from a given source or not. Sherman (2005) complimented that, from all the internal and the external sources, it is essential for entrepreneurs to evaluate their specific requirements or needs carefully in order to determine the best source. Evaluation helps the company to realize a wider avenue for funding as contrast to those firms that inclines there funding to one side, either internal or external. Notably, it is not feasible for firms to fund their activities strictly from internal sources since it limits the transferability; therefore, external sources should also used to allow flexibility.According to Acs, and Karlsson (2002), financial resources are scarce and every source of business funds has its benefits and costs. However, such premise should not deter starting and continuing businesses from embracing multiple sourcing of finance. Instead, a proper evaluation of two parameters, the source and the business, heralds a precise mechanism of soliciting for business money. Thus, this paper suggests that business persons should explore all the possible avenues to sources funds rather than depending on one or few sources that may limit their operations. Nonetheless, as Charantimath (2006) puts it, the selected source must conform to the firm’s demands. The paper first acknowledges the inevitability of firms to source their finances from many avenues provided that they best suit the needs of the business. In addition, the report explains the factors that influence the choice of the sources and how they differ according to business dualities, new or old, small or large. Furthermore, the paper details on the primary internal and external financial sources and rationally highlights their advantages and disadvantages. With that, the audience will have an easy time understanding that firms must depend on the various financial sources that suit different situations, business status, or factors.Factors that Influence the Choice of Business FinanceAs McLaney (2006) reported that it is crucial for a firm to know the amount of money they need together with the period required in order to choose the right source. Since any business has a wide range of areas to source finance from, it might be challenging and confusing to choose. Again, Du and Girma (2012) added that choosing a particular mechanism of sourcing finance is a decision making process that every business has to make. Moreover, choosing from the two options, equity and debts, involves benefits and drawbacks. By understanding certain business variables; for example, time, financial sourcing can be based on aspects such as short, medium, or long term demands. Before funding, enterprises should consider the following factors. Cost of FinancingMoney is not free. Dlabay and Burrow (2007) asserts that if the business cannot afford payments of interest, then a loan is a bad option. For example, young starting businesses might face hurdles in paying back loans with high interest; therefore, they should focus on viable internal sources such as donations from friends, family, and personal savings. Again, loans do require an application fee that might deter some firms from using it. Thus, without the loans, the businesses do not incur interest expense. On the contrary, some large scale businesses with good economic base do not have a problem in paying pack the loans, in such case, bank loans serve as their primary source of finance. As McLaney (2006) puts it, the interest owed to the creditors depends on the amount borrowed from the financial institutions. Hence, small or medium enterprises (SMEs) and large firms have proportional chances of sourcing for funds from the financial institutions. Amount of Money Needed.Businesses should consider the quantitative value of the fund they need since it limits the options. For example, SMEs, which require money worth between $ 5,000 and 100,000 for their capital, can go for loans or credit cards from micro-financial institutions. However, some venture capital firms inject millions of dollars, which are inappropriate for small sources of finance. Evidently, some sources do not offer large amounts of finances while other institutions provide enough flexibility in terms of a smaller amount. As a result, businesses go for the sources that are concurrent to the amount of their financial need. IndependenceAccording to Timmons, Spinelli, and Zacharakis (2005), the source of finance determines the type of ownership or the number of stakeholders that a business has. Because of this, if an investor wants to maintain independence or autonomy in the management and ownership, loaning is the better option. For example, a company started through partnership, the ownership is pegged on a board basis, where decision making and managerial roles are shared. Conversely, lenders only have a contract with the investor when the loan has not been paid. Once the debt is cleared, the relationship of the investor and the lender ceases. Henceforth, the investor has all the mandates concerning the company, probably until he/she sells it or the company is nationalized. Therefore, how the company gets the finance determines ownership and control (Kirkwood, 2003). AssetsAssets act as collaterals or security, which are safety backups for financiers. For instance, firms with many valuable assets are entitled to substantial amounts of funds from lenders since the financier is sure that if the firm dishonors their deal, the assets can be liquidated to pay for the debt. Unfortunately, SMEs with limited or no substantial assets do not enjoy much from loans; instead, they source finances from retained profits, personal investments amongst other internal sources. Conversely, Dlabay and Burrow (2007) opinioned that, the most important assets for investors are the propriety or rather, the intellectual property, that do not depreciate. Obviously, the value of assets that a business has is a proxy about its size, which reflects the amount of money the business might need and its ability to pay back. Risks InvolvedA report by Kirkwood (2003) reiterated that any financial source seeks to help businesses to start and grow while also generating profits for themselves. There are risks involved when businesses choose certain funding sources amongst the varied alternatives. Evidently, lenders ensure that by availing money to the firm, they do not incur the cost; however, if it occurs, the cost is always passed to the companies. Supportively, Sherman (2005) adds that financial institutions that demand high valued business assets such as premises, cars, land, and so forth are very risky for SMEs. Nevertheless, most companies at maturity stages do not experience many problems. Time FactorIf company needs short-term money for settling its essential bills or facilitating some trading activities, there is less likelihood of finding the cheapest deal of finance. On the contrary, long-term financial needs; for example, investments in bigger premises, machineries or equipment give firms an ample time to evaluate the sources available, which ultimately lead to exploring the best option. In essence, as Charantimath (2006) postulated, investors enjoy better repayment terms when dealing with long-term financing than the short-term funding. Therefore, it is paramount to assess the type of project that a business wants to venture in and the time bounds in order to rigor on the suitable financial source.Acs and Karlsson (2002) pointed out that investments that are gears towards earning long-term future profits need long-term finance. For example, huge projects like capital investments or planning to venture into a new market calls for funding sources whose terms are long. Explicitly, such finances carry greater risks due to collateral guarantee or security demanded since the dividends are less short-term. Du and Girma (2012) highlighted the examples of long-term finance as hire purchase, mortgages, share issuance, debentures, retained profits, and bank loans.Conversely, Sherman (2005) explained that for firms to cater for day-to-day operations such as employee remuneration and renter suppliers when there is a shortfall in cash flow, short-term finances are more suitable. In addition, the short-term finances need less extensive security and envisage shorter repayment terms that involve fewer risks. Gustafson (2004) emphasized on short-term finances such as credit card borrowing, bank overdrafts, and provision of credits by the suppliers.Evaluation of the Suitability of the Different Sources of Business FinanceBusiness ventures need money so as to operate their short and long-term activities. As aforementioned, the finance can be used to start, run, or expand the business. According to McLaney (2006), he categorized sources of business finances into either internal (from within) or external sources (from outside). He again illustrated that, three classes of business finance results when time dimension is taken into account. Explicitly, short-term sources are bound to the current tax year, medium-term ranges between one and five years, while long-term source suit business activities that run for more than five years. Kirkwood (2003) admits that, just like people, businesses need several funding for a variety of purposes.

Fig 1: illustrates the various categories of business finance.

In details, the internal sources of finance are derived from the investors or their acquaintances and from the business itself. For example, contributions from the owner and his/her immediate relations may be used to start or expand an enterprise. Additionally, when the firm starts to generate profits, some can be ploughed back into the business. In contrast, external sources are outside of the business; thus, entails future repayments according to the terms of agreements. Further, Dlabay and Burrow (2007) added that external sources could be public, debt, or equity finance. Debt financing involves getting loans that put the business liable to repayments; however, the owner enjoys full ownership of the company. But, in equity financing, partnership and personal investments are not repaid; however, the angel investors share the profit with the venture capitalist. Also, equity finance sources increase the number of stakeholders, who influence decision making and managerial roles (Kirkwood, 2003).

Figure 2: Shows how the internal and external sources of business finance trickle down

Internal Sources of Business Finance

There is a variety of internal sources of funding such as retained profits, personal investments, asset sales, depreciation, and so forth. Internal financing has no interest payments and is without procedures of evaluating creditworthiness. Additionally, the money is easily available since the third party has no influence (Kirkwood, 2003).As Du and Girma (2012) suggested, internal financing are limited in volume and not flexible compared to the external sources. Again, internal finances are non-tax-deductible, making them expensive, and results to shrinking capital. Main examples include: (i) Retained ProfitsKirkwood, (2003) again opined that retained profit represents an important source of finance for business as the profits gained from sales can be ploughed back. As a result, a company source for funds for immediate or future operations. As termed by Dlabay and Burrow (2007), ploughed-back profits may be used to upgrade or purchase fixed assets or kept as contingency funds for future unforeseeable expenditure and emergencies. Despite the potentials, profits can only be calculated after the business has paid for government taxes, shareholders’ dividends or repaid loans from lenders who offered prior funds (Kirkwood, 2003). Advantages of Retained ProfitsPloughed back earnings do not need interest payments; thus, the liabilities and gearing of the firm are minimized. In addition, shareholders’ stature is not diluted since the lenders do not vet for business decision. Contrary to issuance of shares, retained earnings do not lead to incurring of issue costs. DisadvantagesOwners of a business may re-invest all of the profits, which puts the company susceptible to cash insufficiency in emergencies cases or when new market opportunities arise. Also, most companies are lax when using retained earnings as opposed to borrowed money (Du & Girma, 2012). In businesses run by an individual or family, no external person is accountable in the event of loss. Additionally, firms can only retain profits if the earnings are substantial.(ii) Sale of AssetsBusinesspersons may deem it worthwhile to sell underused, old, obsolete, or excess assets in order to generate some funds for the operations. For example, banks and supermarkets are large retail businesses which often sell off their property or assets to pension companies after which they lease them back for a specified period and rent. AdvantageSelling assets do not result to borrowing debts or cost; instead, the business retrieves money from the purchaser. DisadvantagesAfter the sale of the assets, appreciation of their value leads to a loss or the business might lack sufficient collateral in order to secure a loan. Again, transferability of the assets cost the business. Large retailers may also not agree on terms of sales and leaseback since adequate notices and business flexibilities have to be achieved (Du & Girma, 2012). (iii) Owner’s InvestmentStart up or additional capital may be from the owner’s savings, which are long-term financial source. Fortunately, the fund has minimal acquisition cost, not necessarily repaid, and has no interest; however, there is a threshold of the amount which the owner can invest. Also, such investments put the owner’s money or assets into risk in case the business fails. (iv) Sale of StocksThroughout the January sales, most firms sell off the unsold stock to generate short-term finances. It is a quick mechanism of raising finance and through stock selling, the business minimize the expenses associated with holding the stock. However, the business is often forced to sell at lower prices. Selling stock suits businesses that did not realize many sales in the previous year and if the current trends depict continued depreciation of prices. (v) Debt CollectionWhen a business has run short of operating cash, it ought to collect all the money owed from the debtors in order to achieve short-term strategies. Obviously, no additional expense is incurred when collecting the debts as these are part of the normal operations of the business (Sherman, 2005). Unfortunately, not all businesses are owed and even the owed, the debts can go bad if the debtors refuse to repay. Persuasively, businesses owed must create a good rapport and communication with their debtors so as to necessitate timely repayment (Charantimath, 2006). External Sources of Business FinanceAccording to Timmons, Spinelli, and Zacharakis (2005), external sources are mainly used for business expansion, but some entrepreneurs use them as startup capital. The work reaffirms that businesses have multiple external sources such as hire purchase, bank loan, share issuance, overdraft, leasing, mortgage, trade credit, and government grants (Sherman, 2005). Gustafson (2004) also supplemented the concept of various financial purposes concurring to multiple sources. All the forms of external financing are flexible than the internal sources, few of which are discussed below: Bank LoansMoney borrowed from the bank provides medium and long-term finance. The loans with well spread repayments are useful for budgeting. However, SMEs with limited security are less guaranteed to loans and sometimes expensive interest rates deter borrowing (Du & Girma, 2012). Bank OverdraftOverdrafts are short-term sources, which allow businesses to overdraw from its account if they do not have enough money. Bank overdrafts are usually cheaper; however, if long periods are involved, they prove to be expensive. Therefore, firms should rely on overdrafts in situations of urgency, where short-term funds are in need to cater for business activities. Additional PartnersInvolves partnership, where new players or partners help to contribute for an extra capital. Such money is not necessarily paid and has no interest. But, business control and ownership dilutes coupled with shared dividends. Partnership, thus, plays a key role when the original investor wants to share costs and to uphold the management of the business (Sherman, 2005). Share IssueShare issue construes long-term finance, where limited companies distribute shares to the public or any other targeted group. The issuance does not need repayments or interests; however, the issuance further divides profits to many stakeholders and alters ownership of a company. Selling of shares best suit limited companies that would like to expand their stakes (Charantimath, 2006).External sources of business finance are mainly crucial for business expansion. Due to their variability, firms enjoy flexibility by rationally analyzing the ones that best suit them. However, most SMEs have limited guarantee to raise fund from the external sources, maybe due to interest repayments and security needs (Charantimath, 2006). Business Financing has to be MultipleIn line with the papers proposition; businesses should raise their financial needs from the diverse avenues in order to satisfy their varied goals. Thus, this paper opposes the reliance on one or few funding sources so as to enhance flexibility. From the many sources, firms should carry out cost benefits analysis to ensure that the source exploited best suits the business’s goals, purpose, time bound, size, and ownership (Sherman, 2005).

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Business financing

Fig 3: shows the multiple sources of business finance

Conclusion

Entrepreneurs strive to source for finance to start, run, or expand their businesses. Evidently, firms have a wide array of sources, which are classified as internal or external. In relation to time, short, medium, and long-term financing are essential for the operation of the business. The paper opinions that, businesses should not confine themselves to limited sources, but they should use all the sources that best suit them. Notably, various factors influence the source of particular funding, which forms the basis for carrying out the cost-benefit analysis of the varied financing.As a recommendation, all businesses ought to have personnel that are specialized in conducting cost benefit analysis for financing in order to avoid haphazard investments. Again, to benefit all the business dualities, small or big, old or new, external financiers should waive the stringent terms and conditions that deter some businesses from raising their finances. All told, businesses should not limit or incline themselves to one or few sources of finance; instead, evaluation of the several sources ought to be a determinant of embrace or exclusion of any financing mechanism.

References

Acs, Z. J., &Karlsson, C. (2002). Institutions, Enterpreneurship and Firm Growth. Dordrecht: Kluwer Academic Publishers.

Charantimath, P. M. (2006). Entrepreneurship development and small business enterprises.New Delhi: Pearson Education.

Dlabay, L. R., & Burrow, J. (2007). Business finance. Mason, Ohio: South Western.

Du, J., &Girma, S. (2012). Firm Size, Source of Finance, and Growth – Evidence from China. International Journal of the Economics of Business, 19(3), 397-419.

Gustafson, C. R. (2004). Rural Small Business Finance: Evidence from the 1998 Survey of Small Business Finances. Agricultural Finance Review, 64(1), 33-43.

Kirkwood, H. P. (2003). Finance and Investments.Journal of Business & Finance Librarianship, 8(3-4), 153-166.

McLaney, E. (2006). Business finance: Theory and practice. Harlow: Prentice Hall, Financial Times.

Sherman, A. J. (2005). Raising capital: Get the money you need to grow your business. New York: AMACOM.

Timmons, J. A., Spinelli, S., &Zacharakis, A. (2005). How to Raise Capital: Techniques and Strategies for Financing and Valuing your Small Business. New York: McGraw-Hill

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