Introduction

To start a business and run daily activities, it is very much essential to make correct decision about
financing. Required fund can be collected from various sources, but at first all available sources to
listed, then appropriate sources to be chosen for raising required fund. Not only to raise fund is
important, but also to use fund properly, effectively and profitably is important for a business.

Sources of Internal Financing

1) Promoters’ initial capital

2) Retained earnings
a) General reserves
b) Dividend equalization fund
c) Sinking fund
d) Workmen‘s compensation and welfare fund
e) Credit balance of profit and loss account
3) Outstanding expenses
4) Provident fund of officers and employees
5) Sales of surplus and over used fixed assets

Sources of External Financing

1) Institutional Source
a) Commercial bank
b) Investment bank
c) Insurance company
d) Development bank
e) Leasing company
f) Capital market

2) Non-institutional Source
a) Trade credit
b) Outstanding Expresses
c) Mortgage
d) Bond and Debenture
e) Friends and Relatives
f) Money Lenders

Sources of Internal Financing

1) Promoters Initial Capital- This is the capital brought by owners when they start a business.
According to the formation and nature of organization the amount of owners’ capital varies.

2) Retained Earnings- It is the amount of net profit after distribution of dividend to the
shareholders. It is an important source of internal capital. It can be in the form of-

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 a) General Reserve- It is the amount of reserve accumulated for general purpose after
distribution of divided from the net profit.

b) Dividend Equalization Fund- Every company’s shareholder expect divided at a particular

rate but due to the instability of earning that is not always possible, so in the years when
more profit is earned a part is kept aside to compensate for the years when the earning is too
low to declare divided. This fund is a source of internal financing.

c) Sinking Fund- Whenever organizations take long term loan or issue bond there is a sinking
fund provision where a fund is kept aside from the net profit. This fund acts as an internal
source until these loans are repaid.

d) Workmen’s Compensation and Welfare Fund- A fund is created to pay compensation to

workers who get injured on duty and until they are paid this is can be used as an internal
source.

e) Credit Balance of Profit and Loss Account- At the time of preparation of P/L account after
declaration of dividend and transference of fund to general reserve the excess from net profit
is an internal source of fund.

3) Outstanding Expenses- nowadays most transactions are conducted on the basis of credit even
bill payments are deferred. Until these payments are made this fund can be used as an internal
source of fund.

4) Provident fund of officers and employees- in order to make sure that the employees do not
suffer from insecurity in their old age a portion of fund in kept aside from their salary. The amount
accumulated in their fund will be paid at the end of their service so in the time being this can be
used for internal financing.

5) Sale of fixed asset and overuse of fixed asset- many a times companies have asset that has been
left unused, overused or does not have any more utility, fund can be accumulated by selling these
assets.

Sources of External Financing

1) Institutional Source

a) Commercial Bank- It is the main source among the institutional sources. It acts as a middle
man by borrowing excess funds from the public at a fixed rate of interest. Usually fund is
provided for establishment of new plant, expansion or modernization of product line etc.
Loans can be in the form of long term secured loan or short term non secured loan.

b) Investment Bank- Investment bank purchases the newly issued share of public limited
companies and sells it in the capital market to expand the base of investment. Beside that it
provides underwriting facility. In Bangladesh, Investment Corporation of Bangladesh acts
as investment bank in the government sector.

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 c) Insurance Company- Insurance companies collect more premiums from the policy holders
in comparison to payment made for fulfilling the claim of the policy holders. As a result a
large amount of capital lay idle for a long period of time from which it provides credit for a
longer period of time. But unlike commercial bank the insurance companies provides loan
for secured big established companies and at a higher rate of interest.

d) Development Financing Institution- To accelerate industrialization these types of

institutions are established. There is Bangladesh Shilpa Rin Sangstha (BSRS) and its main
objective is to provide finance for the establishment and expansion of new plants.
Bangladesh Shilpa Bank (BSB) provides long term loan in local as well as foreign currency
it provides short term bridge financing facility as well.

e) Leasing Companies- Industrial Development Leasing Company(IDLC) and United

Leasing company these two companies provide medium term financing by allowing
companies to use their required asset for few years.

f) Owner’s Capital from Capital Market- the capital initially provided by owners when they
start business. The joint stock companies usually issue share to the public and collect money
for further expansion of their operation.

2) Non Institutional Source

a) Trade Credit- Many times goods are purchased on credit for the purpose of selling and
repaying the money later once it is sold. This short term credit is called trade credit.
However these sorts of credits are given only when the wholesaler purchase goods from the
manufacturer or when the retailer purchase from the wholesaler.

b) Outstanding Expenses- Sometimes bills such as telephone, gas, electricity are deferred.
Until these payments are made, these act as short term external source of financing.

c) Mortgage- Big organization sometimes obtain loan by mortgaging their permanent and
temporary assets. Here the amount of loan along with term and rate of interest is to be
mentioned.

d) Bond and Debenture- Big Blue Chip companies usually raise fund by issuing bonds and
the difference with common share is a fixed rate of interest needs to be paid. Depending on
the terms of repayment, interest rate there may be different types of bonds.

e) Friends and Relatives- Usually in case of sole proprietorship and partnership this is used
as a source and the amount is usually small bearing no interest.

f) Money Lenders- The biggest non institutional source and since there is no regulatory body,
the interest rate is usually higher.

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Equity Capital vs. Debt Capital

Owner’s Capital/Equity Capital- To start any business, the capital initially provided by owners or
later by selling share in the capital market and the retained earning together is identified under this
heading. The owners have legal claim only on the amount left behind after all sorts of claim has
been met from the main capital.

Debt Capital- When the owner’s capital is deduced from the main capital, and then the amount left
is identified as debt capital.

Sources of Owner’s Capital-

1) Common Stock Capital
2) Share Premium
3) Reserve and Retained Earning
i. General Reserve
ii. Retained Earning
iii. Sinking Fund
iv. Dividend Equalization Fund
v. Other Reserve

Sources of Owner’s Capital-

1) Outstanding Expenses
2) Provident Fund
3) Trade Credit/Accounts Payable
4) Commercial Bank
5) Investment Bank
6) Insurance Company
7) Development Bank
8) Leasing Company
9) Specialized Financial Institution
10) Mortgage
11) Bond and Debenture
12) Friends and Relatives
13) Money Lenders

Owners vs. Creditors

1) Position with regard to Income: After meeting all sort of expenses and interest payments the
amount of net profit is available for distribution among the owners. But there is no guarantee that
there will be net profit there might be losses as well. In case of partnership profit is distributed on
the basis of partnership contract whereas in case of public limited company the profit is distributed
on the basis of share holding

Whereas in case of loan creditors are more or less sure about getting their interest and principal
amount according to the terms of contract. But the disadvantage is in the years when the company
is making abnormally high profit creditors cannot claim any extra amount from that.

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2) Position with regard to Risk- The following are the risks incurred by business:

a) Business Risk- The risk that the earning of the firm becomes uncertain due to financial
depression, reduction in demand etc.
b) Financial Risk- The risk that arises due to use of leverage in the capital structure.
c) Risk of Reducing Income- Due to the obligation of payment of interest to creditors at a
fixed rate the earning of the shareholders may reduce.
d) Bankruptcy Risk- It happens when the firms’ income reduces or it suffers from liquidity
crisis and fails to meet the claim of the creditors.

All of the above mentioned risk must be borne by owners; however as for creditors the only risk
they might bear is bankruptcy risk.

3) Position with regard to Control over Management- In case sole proprietorship the owners
have full control and in case of partnership the partners also have controlling power in
proportionate to their shareholding. But the creditors they do not have any power over the decision
making, the only thing they can do is to impose certain terms and conditions when loans are
sanctioned.

Types of Finance Based on Duration

1. Short Term Financing
2. Intermediate Term Financing
3. Long Term Financing

Short Term Financing

Definition: Capital required to buy raw material for production, giving wages and meeting up the
expenses for other administrative and marketing purpose is called short term financing.

Characteristics:
1) Time- Short term capital is usually used for one year or lesser period.
2) Purpose- Short term financing is usually used to meet up the requirement of current capital.
3) Costly and Risky- As the short term capital is given for a short period, the risk factor is more.
That is why the provider of short term capital charges higher interest.
4) Security- Short term financing does not need security as the short term money can be adjusted
by the sale proceeds of the product derived from the businesses’ day to day operation and
current property purchase within a short period of time.
5) Recycling- One advantageous characteristics of short term financing is that, there is always a
scope to collect money at a regular basis from this kind of source.
6) Renewal- If the short term loan which Institutional organization, such as Commercial Banks
and other financial institutions disburse is adjusted as per the terms and conditions of the
sanction advice, it gets easier to get loan again. Even if the loan is not adjusted within the
stipulated time of the sanction advice, it can be renewed.
7) Size and Nature of the Firm- Usually small, medium, big business Firms collect money from
short term financing. But short term loan is required more by the business firms than the
production firms. The medium and small scale firms depends more on short term capital than
the big scale company.

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Intermediate Term Financing
Definition: The interim term financing arrangement between short term and long term financing,
the validity of which is more than one year but less than ten years is called the intermediate term
financing.

Characteristics:
1) Maturity- Intermediate financing is usually done for one year and less than five years. But to
some the validity for this kind of financing could be more than one year but less than ten years.
2) Objective of Credit- In most of the cases the Intermediate term financing is required to meet
up the current capital requirement, to purchase machinery, in special cases to develop and
extend the building and to replace the machinery.
3) Size of Loan- The amount for Intermediate financing is usually less. Because the loan providers
are the commercial banks and insurance companies, and they usually dot not sanction big loans
for expansion of business. There might be deviation depending on individual situations.
4) User of Intermediate Term Financing- Small, medium and big firms can utilize this sort of
loan. But usually small and medium scale firms take the opportunity of financing through
intermediate term financing.
5) Repayment Method- In most of the cases the repayment of the intermediate term loan is done
through installment. Again in some cases it is done through a single payment. That means it
depends on the agreement between the borrower and the loan provider (Bank, NBFI).
6) Security Provision- Maximum of the Intermediate term finance is given against security as this
financing is used to buy fixed asset, such as machinery, building, plan.
7) Renewable- This sort of term finance is renewable. Banks and other NFBI can renew the loan
in favor of the borrowers depending upon their genuine cause.

Long Term Financing

Definition: When loan is taken to fulfill the requirement of permanent property or for the purpose
of long term investment the process is called long term financing.

Characteristics:
1) Duration- The duration of the loan is 7 to 20 years. In certain circumstances it is even longer
than 20 years. The capital of the owners and shareholders are invested for an indefinite period
of time.
2) Use of Fund- It is used for land, machinery, building and furniture.
3) Size of Fund- Since it is used for land purchase, building construction; machinery purchase the
amount is substantial.
4) Nature of Fund- It can be in the local currency as well as foreign currency according to the
need.
5) Repayment Method- It is being repaid according to the agreement between the borrower and
lender, usually repaid in quarterly, half yearly or yearly installments.
6) Security- If long term financing is provided by owners there is no security but if is acquired
through credit adequate security is required.
7) Cost of Fund- Since it is provided for a long term the risk of the fund provider is less providing
less income to them. So the cost of long term financing is less than short or medium term
financing.

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