Critically elucidate the sources of finance. Discuss the advantages and disadvantages of them?
All businesses need finance to fund business activity. This includes Starting up a business, e.g. pay for premises, new equipment; run the business, e.g. having enough cash to pay staff wages and suppliers on time or expand the business, e.g. having funds to pay for a new branch. Whatever the purpose, choosing the right source of financing for each distinctive situation can be puzzling. The source of finance for each business varies according to the type, i.e. external or internal or by the time factor, i.e. short term, medium term and long term.
External sources of ...view middle of the document...
Selling of assets will result in a better use of capital but can may not be available to new businesses.
o Retained Profits
Retained profit is what is left after all cost are cut and has been kept for reinvesting in the business. However the profits of small businesses may be too low.
o Reducing Stock
Stock can be sold to raise additional finance; stock includes the holdings of raw materials, semi-finished and finished products. Cost involved in storage of stocks can be reduced; however it can lead to loss of sales if there is an unexpected rise in demand.
o Deferred Payment
Deferred payment is when payment to creditors are delayed at a later date, this is a form of a very short term source of finance but helps with the liquidity and day to day running of the business.
Advantages of Internal Source of Finance
No interest payment – as the financing comes from within the company, there is no interest to be paid, thus decreasing overhead cost and increasing profit margin as compared to external source of funding.
Credit score - the less debt the business has the more attractive it is to potential investors and creditors. Internal source of finance avoid that the credit score be affected in case of late repayments or failure to repay at all, helping the business to have more credit and at lower interest rate.
Keeping of ownership and control – the more a business depends on internal source of finance the more likely it is to keep ownership and control over decision making and avoiding third party influences. Investors may want a say in decision making.
Internal funding can be quickly available with fewer procedures and less is expensive to acquire.
Disadvantages of Internal Source of Finance
Shrinking of capital - taking money from capital or budget leaves the business with less money to manage the day to day running of the business. This is why internal funding is used for small projects and investments with quick pay back and significant return.
Not tax deductible – internal financing is not tax deductible as compared to external funding where the interest is tax deductible. Thus resulting in the internal funding to be more expensive and may cause the business to incur losses.
Limited and not flexible – internal funding is more limited in volume as compared to external funding
Lack of discipline – the business run the risk of becoming inefficient and complacent if it does not keep a close watch on its investment and budget.
External Source of Finance
External financing can take the shape of two different types of financing:
Debt financing involves borrowing money for example a loan from the bank or other financial institution, but without giving up ownership. The principal plus the interest has to be paid back at specified dates failing to do so may result in severe consequences. Debt can be either short term or long term...