The three sources of finance

No business can be carried without funding. In identifying suitable sources of finance, there are three broad categories. These are short, medium and long-term.

Short-term refers to funds that generally have to be paid back within a year. Medium-term financing usually requires funds to be paid back between one and five years; whilst long-term finance is generally anything that is paid back after five or more years.

Let us now look at examples of each of these to gain a better understanding of their uses.

1. Short-term financing

Short-term financing may be in the form of a bank overdraft, where the bank allows a business to take out more money than is present in their account.

This is not uncommon, because businesses often operate on a tight cash flow where they have to wait for the sale of products before being able to pay their bills. The rate of repayment for overdrafts tends to be higher than a more long-term loan.

Trade credit

A supplier may also lend money to a business in the form of trade credit. The business will not always pay for its stock immediately because it needs time to sell it and make money first.

If a business has a good record of making repayments under these terms; suppliers are often willing to offer trade credit.

Personal savings

Personal savings of business owners can also be a source of short-term finance, where the owner lends money to the business and is repaid after a short period of time. This is different to buying shares as the money given is usually written into a loan contract.

2. Medium-term financing

In relation to medium-term sources of finance, a business may take out a bank loan. The repayment terms on bank loans are usually quite strict but banks can offer significant amounts of funding to a business.

This provides businesses with the opportunity to expand and grow.

Venture capital funding

Venture capital funding may also be a viable option for growth. Unlike with a bank loan, venture capital funding may not need to be repaid.

Instead, the venture capital firm is actively looking for businesses they can invest in with the hope of making a return through profits a business makes. They will normally look to cash out within 2-5 years.

3. Long-term financing

Longer-term funding offers the cheapest borrowing terms for businesses. However, they tie a business into a contract for a longer period of time.

Banks can offer such loans to a business but will require more significant collateral as security for the money they are lending.

Debentures

A company may also raise long-term finance through more creative means such as issuing debentures. A debenture is where a business makes a request for funding that is secured against assets and yields a fixed rate of return for the lender for a specified period of time.

Unlike a bank loan, the terms of the debenture can be set by the business looking to raise finance.

At the end of the loan period, a debenture holder may have the opportunity to convert their debenture into shares in the business. In this situation, the business would not have to pay back the remaining amount of the debenture loan. However, this option is not always made available with debentures.

Selling ordinary shares in the business is another way of raising finance without having to repay the amount of money raised.

Limited liability

The shares can be sold privately to individuals or publicly if the business decides it wants to be listed publicly on a stock exchange and become a PLC. This option is also only available to companies with limited liability. Companies with unlimited liability will have to change their legal structure before they can offer shares for sale.

The purpose of the loan

Deciding on the source of finance depends very much on the purpose of the loan and the amount being borrowed. For example, for paying a bill or employee wages, a business will use its own profits or look at other short-term sources of finance such as overdrafts.

It does not make sense to take out a 5-year bank loan to pay a monthly bill. If a business wishes to expand and requires an amount of capital that exceeds what it is capable of generating through sales; a longer-term option may be preferable.

The level of risk

The level of risk involved is also a factor in deciding how to finance the business. If a business is perceived as too risky, this may limit where they can raise finance from and would have to depend on personal sources.

The owners themselves may not want to lose control over a business and would therefore be reluctant to issue shares. However, at the same time, they might welcome advice that could come from a venture capitalist.

It is always a good idea to carry out a full assessment of options before deciding where to go for finance as there are a number of factors to consider.