Legal capital (LC) is the amount of capital that can’t leave the
Table of Contents
Sources of finance for business are 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. It is ideal to evaluate each source of capital before opting for it.
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 capital sources, we can classify on the basis of different parameters.
Having known that there are many alternatives to finance or capital, a company can choose from. Choosing the right source and the right mix of finance is a key challenge for every finance manager. The process of selecting the 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 and borrowed capital. Internal sources and external sources are the two sources of generation of capital. All the sources 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 the following three:
|LONG TERM SOURCES OF FINANCE / FUNDS||MEDIUM TERM SOURCES OF FINANCE / FUNDS||SHORT TERM SOURCES OF FINANCE / FUNDS|
|Share Capital or Equity Shares||Preference Capital or Preference Shares||Trade Credit|
|Preference Capital or Preference Shares||Debenture / Bonds||Factoring Services|
|Retained Earnings or Internal Accruals||Lease Finance||Bill Discounting etc.|
|Debenture / Bonds||Hire Purchase Finance||Advances received from customers|
|Term Loans from Financial Institutes, Government, and Commercial Banks||Medium Term Loans from Financial Institutes, Government, and Commercial Banks||Short Term Loans like Working Capital Loans from Commercial Banks|
|Venture Funding||Fixed Deposits (<1 Year)|
|Asset Securitization||Receivables and Payables|
|International Financing by way of Euro Issue, Foreign Currency Loans, ADR, GDR etc.|
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 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 the form of any of them:
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:
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 CAPITAL||BORROWED CAPITAL|
|Preference||Commercial banks or|
|Retained Earnings||The general public in case of debentures.|
|Venture Fund or Private Equity|
Owned capital also refers to equity. 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 money for a startup. Following are the sources of Owned Capital:
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:
Borrowed or debt capital is the finance arranged from outside sources. These sources of debt financing include the following:
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 the borrowed fund is a regular payment of fixed interest and repayment of capital. Certain advantages of borrowing are as follows:
ACCORDING TO SOURCE OF GENERATION:
Based on the source of generation, the following are the internal and external sources of finance:
|INTERNAL SOURCES||EXTERNAL SOURCES|
|Reduction or controlling of working capital||Debt or Debt from Banks|
|Sale of assets etc.||All others except mentioned in Internal Sources|
The internal source of capital is the one which is generated internally by the business. These are as follows:
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 and debt are not present in this form of financing. Neither ownership dilutes nor fixed obligation/bankruptcy risk arises.
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.
Deciding the right source of funds is a crucial business decision taken by top-level finance managers. The usage of the wrong source increases the cost of funds which in turn would have a direct impact on the feasibility of the 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.
Legal capital (LC) is the amount of capital that can’t leave the
A Bond Indenture (or bond resolution) is basically a contract between the
Debt Market is a market place, where buying and selling of debt market financial instruments take place. These financial instruments are fixed-income securities, giving fixed returns to the investors.
Industrial Revenue Bond or IRB is one of the methods in which
“In substance” means in essence and in business or commercial transactions. And that may not be in exact legal form. While “Defeasance” means retirement from liability i.e extinguishment of the liability. In other words, in the corporate and commercial world, it is one of the provisions in the loan. Whereby the loan obligations can be taken off or removed from the balance sheet, in substance.
Hell or high water clause is a provision in a contract directing the buyer to continue making the payment to the seller. The buyer must make the payment irrespective of any difficulties.
Senior Debt and Junior Debt (Subordinated Debt or Mezzanine Debt), both are long term liabilities or non-current liabilities of the company. They are an important source of finance in debt financing.
Junior Debt is a source of finance issued by the company with a lower repayment priority. It is a type of debt issued by the company which gets lesser repayment priority than the senior debt at the time of default. Junior Debt can be in the form of bonds, debentures, or any other debt instrument. Since this debt gets a lower preference in repayment, they are very risky in nature.
Gray Market or Grey Market is a marketplace where goods and/or financial securities are traded in an unofficial manner. It is not an illegal market place but it is just an unofficial marketplace. In the case of the goods market, this market supplies goods of the authorized brands from authorized manufacturers but through an unauthorized delivery channel. In the case of the financial securities market, all those securities which are either barred from trading on the exchange or are yet not up for even an IPO, are traded in this market. All transactions in Gray Market are in cash terms without any regulatory or governing authority.
Subordinated debt is a debt that ranks lower than most other types of debt and securities in terms of claim on the borrower’s assets. In simple words, we can say that if a borrower defaults, the lender of the subordinated debt will get the payment only after the payment is made to all other debt holders. We can also call it a junior debt, subordinated bond, or subordinated debenture. It is the opposite of unsubordinated debt.
An equity market is a market place where shares of public companies are bought and sold. It is commonplace where the issuers of the shares (Companies) and the subscribers of the shares (Investors) come together. The trading takes place on a stock exchange or on the over-the-counter (OTC) markets, depending on the type of issue. After the listing of stocks takes place, there is a substantial number of buyers and sellers.
IPO Underwriters: Meaning IPO Underwriters are the ones helping the companies in