Classification of Sources of Business Finance

Because businesses need funds for different purposes, for different durations and from different quarters, the many sources of business finance are usually grouped under three broad classifications. Learning these classifications helps a student see the same source of finance from three different angles, which is very useful when comparing sources or deciding which one suits a given situation.

The first basis of classification is the period for which the funds are required. Long-term sources are those which are needed for more than five years and are typically used to finance fixed assets or permanent working capital; examples are equity shares, preference shares, debentures and long-term loans from financial institutions. Medium-term sources are required for a period of roughly one to five years, and typically finance a modernisation programme or a moderate expansion; examples include medium-term loans from commercial banks and public deposits accepted for a few years. Short-term sources are needed for less than one year, mainly to finance working capital needs like purchase of raw materials and payment of short-term expenses; examples include trade credit, bank overdraft and commercial paper.

The second basis of classification is ownership. Owned funds are contributed by the owners of the business themselves and remain with the business as long as it exists; they include equity share capital, preference share capital and retained earnings (profits ploughed back into the business). Owned funds do not create a fixed, compulsory outflow of interest, and equity shareholders bear the ultimate risk and reward of the business. Borrowed funds, on the other hand, are raised from outsiders — lenders and creditors — who must be repaid according to agreed terms, with interest or other fixed charges, regardless of whether the business makes a profit. Debentures, term loans from banks and financial institutions, public deposits and trade credit are all borrowed funds. Borrowing increases the financial risk of the business because interest and repayment obligations are fixed, but it also allows owners to expand the business without diluting their ownership and control. …