Case Study On Long Term Sources Of Finance

Sources of Short-Term and Long-Term Financing for Working Capital

Sources of Short-Term and Long-Term Financing for Working Capital

A constant flow of working capital is an intrinsic component of a successful business. This is especially true considering the outflow that is a part and parcel of every cycle: salaries and wages need to be paid; raw materials need to be purchased and equipment need to be serviced; funds are needed for marketing, advertising, and other general overhead costs; reserves are required till the customers make their payment. Working capital is truly the lifeline for any company.

The question arises as to how does a business acquire funds for working capital. There are two types of financing: short term and long term.

Short Term Financing

Banks can be an invaluable source of short term working capital finance.

1. Overdraft Agreement:

By entering into an overdraft agreement with the bank, the bank will allow the business to borrow up to a certain limit without the need for further discussion. The bank might ask for security in the form of collateral and they might charge daily interest at a variable rate on the outstanding debt. However, if the business is confident of making the repayments quickly, then an overdraft agreement is a valuable source of financing, and one that many companies resort to.

2. Accounts Receivable Financing:

Many banks and non-banking financial institutions provide invoice discounting facilities. The company takes the commercial bills to the bank which makes the payment minus a small fee. Then, on the due date the bank collects the money from the customer. This is another popular method of financing especially among small traders. Businesses that offer large terms of credit can carry on their operations without having to wait for the customers to settle their bills.

3. Customer Advances:

There are many companies that insist on the customer making an advance payment before selling them goods or providing a service. This is especially true while dealing with large orders that take a long time to fulfill. This method also ensures that the company has some funds to channelize into its operations for fulfilling those orders.

4. Selling Goods on Installment:

Many companies, especially those that sell television sets, fans, radios, refrigerators, vehicles and so on, allow customers to make their payments in installments. Since many of these items have become modern day essentials, their customers might not come from well-to-do backgrounds or the cost of the product might be too prohibitive for immediate payment. In such a case, instead of waiting for a large payment at the end, they allow the customers to make regular monthly payments. This ensures that there is a constant flow of funds coming into the business that does not choke up the accounts receivable numbers.

Long-Term Financing

Relying purely on short-term funds to meet working capital needs is not always prudent, especially for industries where the manufacture of the product itself takes a long time: automobiles, aircraft, refrigerators, and computers. Such companies need their working capital to last for a long time, and hence they have to think about long term financing.

1. Long-Term Loan from a Bank:

Many companies opt for a full-fledged long term loan from a bank that allows them to meet all their working capital needs for two, three or more years.

2. Retain Profits:

Rather than making dividend payments to shareholders or investing in new ventures, many businesses retain a portion of their profits so that they may use it for working capital. This way they do not have to take loans, pay interest, incur losses on discounted bills, and they can be self-sufficient in their financing.

3. Issue Equities and Debentures:

In extreme cases when the business is really short of funds, or when the company is investing in a large-scale venture, they might decide to issue debentures or bonds to the general public or in some cases even equity stock. Of course, this will be done only by conglomerates and only in cases when there is a need for a huge quantum of funds.

Companies cannot rely only on limited sources for their working capital needs. They need to tap multiple avenues. They also need to constantly evaluate what their needs are, through analysis of financial statements and financial ratios, and choose their working capital channels judiciously. This is an ongoing process, and different routes are appropriate at different points in time. The trick is to choose the right alternative as per the situation.

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About the Author: Senthil Kumaran, Operations Manager - Finance and Accounting, Invensis Technologies

Senthil brings 11+ years of experience in the outsourcing/off-shoring domain. He has expertise in streamlining the accounting, auditing and financial management processes of companies across verticals. With in-depth knowledge of GAAP, he has efficiently managed the requirements of bookkeeping, invoice processing, bills processing, general ledger reconciliation, subsidiary business accounting, underwriting and MIS reports for diverse clients. For more information on how Invensis’ Finance and Accounting services and solutions can add value to your business, please contact Senthil at sales {at} Invensis {dot} net today.

Sources of finance such as equity, debt, debentures, retained earnings, term loans, working capital loans, letter of credit, euro issue, venture funding etc. These sources of funds are used in different situations. They are classified based on time period, ownership and control, and their source of generation.

Sources of capital are the most explorable area especially for the entrepreneurs who are about to start a new business. It is perhaps the toughest part of all the efforts. There are various sources of capital, we can classify on the basis of the time period, ownership and control, and source of generation of finance.

Having known that there are many alternatives to finance or capital, a company can choose from. Choosing right source and the right mix of finance is a key challenge for every finance manager. The process of selecting right source of finance involves in-depth analysis of each and every source of fund. For analyzing and comparing the sources, it needs the understanding of all the characteristics of the financing sources. There are many characteristics on the basis of which sources of finance are classified.

On the basis of a time period, sources are classified as 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. Let’s understand them in a little depth.

According to Time Period

Sources of financing a business are classified based on the time period for which the money is required. The time period is commonly classified into following three:

LONG TERM SOURCES OF FINANCE / FUNDSMEDIUM TERM SOURCES OF FINANCE / FUNDSSHORT TERM SOURCES OF FINANCE / FUNDS
Share Capital or Equity SharesPreference Capital or Preference SharesTrade Credit
Preference Capital or Preference SharesDebenture / BondsFactoring Services 
Retained Earnings or Internal AccrualsLease FinanceBill Discounting etc.
Debenture / BondsHire Purchase FinanceAdvances received from customers
Term Loans from Financial Institutes, Government, and Commercial BanksMedium Term Loans from Financial Institutes, Government, and Commercial BanksShort Term Loans like Working Capital Loans from Commercial Banks 
Venture FundingFixed Deposits (<1 Year)
Asset SecuritizationReceivables and Payables
International Financing by way of Euro Issue, Foreign Currency Loans, ADR, GDR etc.

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 funds. Long-term financing sources can be in form of any of them:

Medium Term Sources of Finance

Medium term financing means financing for a period of 3 to 5 years and is used generally for two reasons. One, when long-term capital is not available for the time being and second when deferred revenue expenditures like advertisements are made which are to be written off over a period of 3 to 5 years. Medium term financing sources can in the form of one of them:

  • Preference Capital or Preference Shares
  • Debenture / Bonds
  • Medium Term Loans from
    • Financial Institutes
    • Government, and
    • Commercial Banks
  • Lease Finance
  • Hire Purchase Finance

Short Term Sources of Finance

Short term financing means financing for a period of less than 1 year. The 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. Short term finances are available in the form of:

According to Ownership and Control:

Sources of finances are classified based on ownership and control over the business. These two parameters are an important consideration while selecting a source of funds for the business. Whenever we bring in capital, there are two types of costs – one is the interest and another is sharing ownership and control. Some entrepreneurs may not like to dilute their ownership rights in the business and others may believe in sharing the risk.

OWNED CAPITALBORROWED CAPITAL
Equity CapitalFinancial institutions,
Preference CapitalCommercial banks or
Retained EarningsThe general public in case of debentures.
Convertible Debentures
Venture Fund or Private Equity

Owned Capital

Owned capital also refers to equity capital. It is sourced from promoters of the company or from the general public by issuing new equity shares. Promoters start the business by bringing in the required capital for a startup. Following are the sources of Owned Capital:

  • Equity Capital
  • Preference Capital
  • Retained Earnings
  • Convertible Debentures
  • Venture Fund or Private Equity

Further, when the business grows and internal accruals like profits of the company are not enough to satisfy financing requirements, the promoters have a choice of selecting ownership capital or non-ownership capital. This decision is up to the promoters. Still, to discuss, certain advantages of equity capital are as follows:

  • It is a long-term capital which means it stays permanently with the business.
  • There is no burden of paying interest or installments like borrowed capital. So, the risk of bankruptcy also reduces. Businesses in infancy stages prefer equity capital for this reason.

Borrowed Capital

Borrowed or debt capital is the capital arranged from outside sources. These sources of debt financing include the following:

  • Financial institutions,
  • Commercial banks or
  • The general public in case of debentures

In this type of capital, the borrower has a charge on the assets of the business which means the company will pay the borrower by selling the assets in case of liquidation. Another feature of borrowed capital is regular payment of fixed interest and repayment of capital. Certain advantages of borrowing capital are as follows:

  • There is no dilution in ownership and control of the business.
  • The cost of borrowed funds is low since it is a deductible expense for taxation purpose which ends up saving on taxes for the company.
  • It gives the business a leverage benefit.

ACCORDING TO SOURCE OF GENERATION:

Based on the source of generation, the following are the internal and external sources of finance:

INTERNAL SOURCESEXTERNAL SOURCES
Retained profitsEquity
Reduction or controlling of working capitalDebt or Debt from Banks
Sale of assets etc.All others except mentioned in Internal Sources

Internal Sources

The internal source of capital is the capital which is generated internally by the business. These are as follows:

  • Retained profits
  • Reduction or controlling of working capital
  • Sale of assets etc.

The internal source of funds has the same characteristics of owned capital. The best part of the internal sourcing of capital is that the business grows by itself and does not depend on outside parties. Disadvantages of both equity capital and debt capital are not present in this form of financing. Neither ownership dilutes nor fixed obligation/bankruptcy risk arises.

External Sources

An external source of finance is the capital generated from outside the business. Apart from the internal sources of funds, all the sources are external sources of capital.

Deciding the right source of funds is a crucial business decision taken by top-level finance managers. The wrong source of capital increases the cost of funds which in turn would have a direct impact on the feasibility of project under concern. Improper match of the type of capital with business requirements may go against the smooth functioning of the business. For instance, if fixed assets, which derive benefits after 2 years, are financed through short-term finances will create cash flow mismatch after one year and the manager will again have to look for finances and pay the fee for raising capital again.


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