Have you thought of the next business idea that you want to launch? Congratulations! But are the sources of finance for your business, keeping you awake at night? In your entrepreneurial journey, finding the source of funding is perhaps the most challenging aspect. As the famous saying goes, you need money to make money. Therefore, finding the initial capital is critical and may change the entire course of your business.
Similarly, meeting the operational expenses of your business will also require funding. Unless you are sure of the source of finance for the business, the business idea, no matter how good it is, may fail to take off.
Therefore, understanding the various sources of finance that you can tap into is a good starting point before you take the other actionable steps. Sources of finance could be from a variety of avenues: pure equity, debt, a mix of debt and equity, working capital loans, letter of credit facilities, etc. But you must be wondering: how do you decide which source of finance is best suited for your needs?
How to arrange funds for Business?
The decision to select the right source of finance depends on several factors. Foremost, the financial strength and ability of the company to repay any financing or promise the assured returns. If the financial position of the company is not stable, it is a challenge to attract the right source of finance. Secondly, irrespective of the scale of the business, it is vital to assess the risk profile of the company as well as the source of finance that it is considering. Specific sources of finance may also impact the creditworthiness of the company. If a company seeks to finance itself by issuing secured debentures, it may affect the unsecured creditors who may not be keen on extending another line of credit.
Various sources of finance
Based on the parameter of classification, there seem to be various sources of finance available. The standard parameters for classification are time, source and ownership. It is essential to understand each of the sources well enough to make the right choice.
Long term and short term finance:
Based on time, the sources can be divided into long term, short term, and medium-term finance. Long term sources of finance are not repaid within one year and often become a part of the founding capital of the company.
Long term sources of finance are particularly useful when the business is looking to scale up and expand. Equity, term loans, and venture capitals are all examples of long term sources of finance. Long term sources of finance can be either linked to the ownership of the company (as is the case with equity or venture capital) or a debt (term loans) or a mix of both. The advantage of going in for long term finance is the large volume of funds that can be raised through it.
A short term source of finance is typically repayable within one year or less. The primary objective behind getting short term finance is to meet any temporary shortfall in the funds. However, the constraint of short term finance is the limited amount of funds that can be raised. Trade credits and commercial papers are good examples of short term source of finance.
Medium-term finance refers to funding, which is repaid after one year but before the completion of five years from when the debt was availed. Term loan borrowings from commercial banks and financial institutions are typical examples of medium-term finance.
The avenues of raising finance may also depend on the source of generation. These can be further divided into internal and external sources of finance. Internal sources of finance are generated within the business – the most common example of this is the profits made by a company. In contrast, external sources of finance are outside the company – these could be borrowings from lenders or funds provided by investors. Internal and external sources of finance could supplement other sources of financing availed.
Based on ownership:
Based on ownership, the finance could be either owned or borrowed. All internal sources of finance are owned, whereas any external source is borrowed finance.
Alternative sources of finance
After having looked at the different sources of finance above, it would be useful to take a look at the various alternative sources of finance available. In today’s age, a new and upcoming business can go beyond the traditional sources and explore alternative sources of finance such as crowdfunding, peer to peer loans, pension backed loans and early-stage loans. Of course, any source of funding must comply with the legal and regulatory requirements of the country where such financing is sought.
The long term and short term sources of finance are typically the most preferred source of financing business over the other options available. Based on the exact needs of the business and financial strength of the company, you are likely to be better off by going ahead with long term and short term sources of finance. But if sticking to the traditional sources do not excite you, there is a world of alternate sources of funds that you could explore.