Finance is significant for business because it cannot carry out its operations even for a single day without finance. It is therefore important to search the sources from where funds can be collected. The selection of source depends upon the amount of funds required, nature of business, repayment period, debt-equity mix, etc. The selection of source also depends upon the purposes for which funds are needed.
Funds required for acquiring machine, land & building, etc., should be procured from such sources, the tenure of which must be between 5 and 10 years. Funds required for more than 1 year but less than 5 years should be financed from medium-term sources. Funds required for meeting day-to-day expenses should be acquired from short-term sources.
A firm can obtain funds from a variety of sources (see Figure 3.1), which may be classified as follows:
1. Long-term Sources:
A firm needs funds to purchase fixed assets such as land, plant & machinery, furniture, etc. These assets should be purchased from those funds which have a longer maturity repayment period. The capital required for purchasing these assets is known as fixed capital. So funds required for fixed capital must be financed using long-term sources of finance.
2. Medium-term Sources:
Funds required for say, a heavy advertisement campaign, the benefit of which lasts for more than one accounting period, should be financed through medium-term sources of finance. In other words expenditure that results in deferred revenue should be financed through medium-term sources.
3. Short-term Sources:
Funds required for meeting day-to-day expenses, i.e. revenue expenditure or working capital should be financed from short-term sources whose maturity period is one year or less.
4. Owned Capital:
Owned capital represents equity capital, retained earnings and preference capital. Equity share has a perpetual life and are entitled to the residual income of the firm but the equity shareholders have the right to control the affairs of the business because they enjoy the voting rights.
5. Borrowed Capital:
Borrowed capital represents debentures, term loans, public deposits, borrowings from bank, etc. These are contractual in nature. They are entitled to get a fixed rate of interest irrespective of profit and are to be repaid on a fixed date.
6. Internal Sources:
If the funds are created internally, i.e. without using debt, such sources can be termed as internal sources. Examples of such could be: Ploughing back of profits, provision for depreciation, etc.
7. External Sources:
If funds are re-used through the sources which create some obligation to the firm, such sources can be termed as external sources, e.g. lease financing, hire purchase, etc..