Choosing a Source of Finance
A firm needs funds for a range of purposes, including wages, raw materials, promotional activities, research and development, and the acquisition of new machinery and equipment. Choosing a source of finance depends on the type of business, how long it needs the funds, and the risks involved. There are many types of sources of finance, from short-term working capital to long-term investment.
One type of source of finance is trade credit, where the business agrees to buy raw materials and stock from a supplier and then pay for these purchases later. Usually, payment is made after the business converts the raw materials into products and sells them to customers. Another type of source of finance is leasing, in which a business leases an asset from a lender. The company then pays the owner monthly in interest for the asset.
Internal sources of finance include profits, funds generated by the owner, and the sale of assets. These sources are not necessarily major players, but they are common forms of financing. They are more flexible than external sources of finance. However, they don’t always yield the best price. In some cases, selling assets can be a better option.
Another way to obtain capital is by issuing shares. This is the best option for businesses seeking to raise capital for expansion. The company can then use the funds to expand its business. This method carries a cost, as the shareholders demand a risk premium. Another option for financing a new asset is to sell an existing asset that is already operating, but which has exponentially increasing expenses. In this case, the source of finance is the risk premium demanded by the shareholders.
A business can also use retained profit as a source of finance. When retained profits are high, these profits can be reinvested to grow the business. Since there are no interest charges, the business can also use these funds to invest in new projects. It can even sell excess stock or machinery. This method is especially beneficial if the profits are higher than expected.
Another internal source of finance is to sell business assets. This is often the last resort for businesses that need funds quickly. This option is not recommended if you don’t have enough liquid assets. Furthermore, some fixed assets are very hard to sell, such as old manufacturing equipment. Moreover, there may be a limit to the number of fixed assets you can sell, which will have an impact on your operations.
A company may also issue new shares to raise capital. If the company has rights to issue new shares, it must issue new shares proportionate to the existing shareholders. However, new shares should not be sold at a low price. Existing shareholders can also waive their pre-emption rights.