Although there are a variety of financial resources that are available to business organisations, there is not one source of finance that is better than another. The decision about the best financing option ultimately rests on a variety of considerations, such as the business ownership structure, its stage of development and its future goals.
It is quite intuitive to see how the financing needs of newly established businesses could differ significantly from those of a well-established company. For example, for a business in its early stages, common financing options could be funds from the owner’s family, friends or their own savings. These types of funding will not be appropriate to sustain the complex business plans of established companies. Understanding the basic sources of finance and their features is essential for successful financial decision making and business success, since identifying the best and most appropriate available sources is a vital step in reaching the goals set.
Before going into the details of the various sources of finance, it is useful to look at the overall picture. Broadly speaking, sources of finance can be categorised according to two main features:
- whether the finance is generated internally or externally
- whether the duration of the financing is long- or short-term.
The space dimension: internal and external sources of finance
Sources of finance can be either generated internally or raised externally. Internal sources of finance refer to resources that are generated from within, through the business’ activities. External sources are retrieved from third parties. Amongst external sources of finance, it is possible to distinguish between equity financing (i.e. obtaining funds for the company by issuing shares) and debt financing (i.e. obtaining borrowed funds, for example, in the form of bank loans or, in the case of Plc's, by issuing bonds).
Debt finance, which you will look at more closely in Section 1.2, only implies the payment of interests on the total amount raised. It does not mean sharing any part of the business’ decision-making process or legal ownership with the lender. By way of contrast, equity finance presumes that part of the business’ ownership and control over decisions is shared with investors.
The time dimension: short- and long-term finance
Financial sources can also be classified according to the time period over which they are made available to the organisation. Accordingly, it is possible to distinguish between short-term and long-term finance.
Short-term finance typically refers to any financing that will be paid back within a year, while long-term finance refers to any financing that will be repaid over several years. Short-term financing is typically used to finance temporary deficiencies in funds, such as those arising from a delay in the payments from customers. In contrast, long-term financing is better suited to finance the acquisition of long-term assets such as plant and equipment. In general, bank overdrafts are considered an example of short-term finance, while bank loans are generally categorised as long-term finance.
When choosing between short-term versus long-term borrowing, the following elements should be considered:
What type of asset will the funds be raised for?
Long-term borrowings might be more appropriate for financing non-current assets such as property, plant, equipment, or intellectual property (e.g. patents). Current assets (e.g. raw materials), which are held for a short period, would be more efficiently financed by more flexible short-term borrowings.
What is the cost of short-term v. long-term finance?
Interest payments on long-term borrowing tend to be higher relative to those for short-term borrowing. This is because the lender requires higher returns to cover the longer period over which funds are loaned, as well as the higher risk associated with long-term borrowing. Despite this, since short-term borrowing must be renewed frequently, it could carry higher indirect costs, such as arrangement fees.
Table1, below, summarises the different sources of finance that will be discussed in Section 1.2 and 1.3, according to the categorisation described above.
Table1Sources of finance | Internal | External |
|---|
| | Debt | Equity |
|---|
| Short-term | - Debt factoring
- Invoice discounting
- Working capital management
| - Bank overdrafts
- Bank loans
- Crowdfunding
- Peer-to-peer lending
| |
|---|
| Long-term | | - Bank loans
- Financial lease
- Hire purchase agreements
- Bond issuance
| - Business angels and venture capital
- Stock issuance
|
|---|
FAQs
Within a firm, the financial system encompasses all aspects of finances, including accounting measures, revenue and expense schedules, wages, and balance sheet verification. On a regional scale, the financial system is the system that enables lenders and borrowers to exchange funds.
What is the role of the financial system? ›
The five key functions of a financial system are: (i) producing information ex ante about possible investments and allocate capital; (ii) monitoring investments and exerting corporate governance after providing finance; (iii) facilitating the trading, diversification, and management of risk; (iv) mobilizing and pooling ...
What is the structure of the financial system? ›
What is the structure of the financial system? The structure of the financial system includes financial institutions such as banks, insurance companies, and mutual funds, financial markets such as stock exchanges and bond markets, and regulatory bodies such as the Reserve Bank of India.
How does the global financial system work? ›
The Global Financial System helps to regulate and facilitate global transactions, allocate resources by channeling funds from those with surplus capital to those in need, and manage risks associated with cross-border financial activities.
How does financial works in an organization? ›
A crucial role of financial management is the planning of financial activities and resources in the organization. To this end, they use available data to understand the needs and priorities of the establishment as well as the overall economic situation and make plans and budgets for the same.
What are the four 4 functions of the financial system? ›
It plays a crucial role in economic development by channeling funds efficiently. The 4 functions of the financial system are accumulation of funds, transformation into investments, risk management, and information function, contributing to economic well-being and efficiency.
What roles does a financial management system play in an organization? ›
In short, a financial management system is a way to keep track of financial transactions. Organizations can then use that data for tasks such as: Analyzing performance. Preparing budgets.
Who benefits from the financial system? ›
Financial markets create securities products that provide a return for those with excess funds (investors/lenders) and make these funds available to those needing additional money (borrowers).
What are the two major components of the financial system? ›
What are the three components of financial system? The three components of the financial system include financial institutions, financial services, and financial markets.
What is the financial structure of an organization? ›
Financial structure refers to the mix of debt and equity that a company uses to finance its operations. It can also be known as capital structure. Private and public companies use the same framework for developing their financial structure but there are several differences between the two.
So what are the four basic financial statements you need? Typically, you'll need all four: the income statement, the balance sheet, the statement of cash flow, and the statement of owner equity.
What are the 6 elements of financial system? ›
This course serves as an introduction to the financial system. It breaks down the financial system into its six elements: lenders & borrowers, financial intermediaries, financial instruments, financial markets, money creation and price discovery.
Who controls the financial system? ›
There are numerous agencies assigned to regulate and oversee financial institutions and financial markets in the United States, including the Federal Reserve Board (FRB), the Federal Deposit Insurance Corp. (FDIC), and the Securities and Exchange Commission (SEC).
Who controls money? ›
The U.S. central banking system—the Federal Reserve, or the Fed—is the most powerful economic institution in the United States, perhaps the world. Its core responsibilities include setting interest rates, managing the money supply, and regulating financial markets.
What is a financial system example? ›
A financial system is a collection of institutions which allow the exchange of funds, such as banks, insurance companies, and stock exchanges. The financial system exists in the corporate, national, and global level.
What is the definition of a financial system? ›
A financial system is a system that allows the exchange of funds between financial market participants such as lenders, investors, and borrowers. Financial systems operate at national and global levels.
