SOURCES OF

FINANCING
◦ Objective
◦ Introduction
◦ Estimating Financial Requirements
◦ Sources of Long-Term Financing
◦ Working Capital Financing
◦ Summary
 After reading this lesson you should be able to
◦ Describe the procedure for estimating of requirement of
finance.
◦ Explain the various sources of long-term finance.
◦ Discuss the methods of estimation of working capital
requirements.
◦ Explain the various sources of working capital finance.
 Like many works of art, a business begins on a piece
of paper.
 They would be an entrepreneur may sit down and
design a small electronics plant to meet customer
needs and make a fine product, but without money
the plan may never become a reality.
 This twin problem fascinates entrepreneurs, perhaps
more so than any other part of launching a new
venture.
 This fascination may stem from a romantic view of
how some multimillion-dollar businesses have begun
on shoestrings of just a few thousand dollars.
 Before they can estimate how much money they
need, entrepreneurs must know what they plan to do,
unfortunately, and many entrepreneurs do not, often
because they have failed to work out business plans.

 The center piece of the business plan is the cash

budget, which translates operating plans into dollars.
 The cash budget, for example, helps the banker to
obtain answers to the following questions:
◦ How much money do you need?
◦ How will you spend the money?
◦ How soon will you pay us back?
 The mere language of finance ….sounds so official,
important, and difficult that many businesspersons
automatically assume it is beyond their
understanding.
 They feel that anything so obviously “textbookish” is
better left to the professionals.
 Preparing a Budget
◦ Before beginning to develop a cash budget, an
entrepreneur must first spell out his or her operating
plans, defining production, marketing, staffing,
accounting, and legal goals.
◦ Note that these are all key parts of the business
plan.
 Fixed Assets: Fixed assets are resources whose
use will benefit the entrepreneur for more than
one year.
 Current Assets: In contrast to fixed assets,
current assets are resources whose benefits will
last less than one year. Commonly, current assets
are cash, accounts receivable, and inventories.
 Having estimated how much money is needed
to finance the venture, the entrepreneur must
then decide what fraction of this money should
come from investors as equity capital, and from
creditors as debt capital.
 Having estimated how much money is needed
to finance the venture, the entrepreneur must
then decide what fraction of this money should
come from investors as equity capital, and from
creditors as debt capital.
 Differences arise because bankers in general
are not risk takers.
 Entrepreneurs, on the other hand, are risk
takers.
 Sources of finance equity capital:
◦ One of the most puzzling questions for an
entrepreneur is where best to raise money.
◦ The sources range from private to governmental.
◦ We begin by looking at sources of equity capital
(investor’s money); later we examine sources of debt
capital (creditors’ money).
 Venture Capital firms
◦ A venture capital firm typically receives more than
1,000 requests for money each year, many of which
stand little chance of success.
◦ Out of every 100 requests, 80 are dropped after less
than a day’s study, 10 are dropped after a week’s
study, 8 are dropped after a month’s study, and 2 are
accepted after one or more months of detailed study.
 Among the many types of venture capital firms are the
following:
◦ Traditional partnerships
◦ Professionally managed pools
◦ Insurance companies
◦ Investment banking firms
◦ Small Business Investment companies
◦ Big Business
◦ Other Sources
◦ Sources of Debt Capital
◦ Private Lenders
◦ Short-Term Loans
◦ Long-Term Loans
◦ Supplier Credit
◦ Government Lenders
 Working capital is the lifeblood of a business.
 Its adequate planning and proper management is
necessary for the successful operation and continued
existence of a business.
 Working capital management basically means
management of current assets, current liabilities, and
interrelationship between the two.
 Concept of Working Capital: Working capital is
understood in the following two ways:

◦ Net Working Capital: Net working capital is the excess of

current assets over the current liabilities. In other words, it
may be defined as the provision of long-term (non-current)
funds for current assets.
◦ Gross Working Capital: Gross working capital is
considered to be equal to the total current assets required by
a business firm.
 Components of Gross Working Capital: The
constituent parts of gross working capital, otherwise
called current assets, are:
◦ Advance given for purchases of raw materials and stores,
etc.
◦ Inventories:
 Raw materials, stores and packing material, spare parts, etc.
 Work-in-process.
 Finished goods.
◦ Book debtors or credit to customers.
◦ Marketable investment (securities) on short-term
basis:
 To earn something on temporary surplus cash.
 To meet the requirement of offering security for some
facilities and/ or contract with government or some other
agencies.
◦ Cash and bank balances.
 Estimating Working Capital Requirements
◦ As stated earlier both excess and shortage of working
capital are harmful for the health of an enterprise. It is,
therefore, essential to correctly assess the amount of
working capital for an enterprise.
 The following methods can be used to estimate
the amount of working capital.
◦ Operating Cycle Method
◦ Assets and Liabilities Method
 SOURCES OF FINANCE AND FORMS
OF CREDIT:
◦ After determining the level of working capital, as
illustrated earlier, a firm has to decide how it is to
be financed.
 The sources of finance for working capital
may be said to fall into four categories,
namely,
◦ Trade Credit;
◦ Bank Credit;
◦ Current provisions of non-bank short-term borrowings; and
◦ Long-term sources comprising equity capital and long-term
borrowings.
 Forms of Credit: After getting the overall credit limit
sanctioned by the banker, the borrower draws funds
periodically.
 The following forms of credit are available to him:
◦ Loan Arrangement: Under this arrangement the entire amount of
loan is credited by the bank at the borrower's account. In case the
loan is repaid in installments, interest is payable on actual
balances outstanding.
◦ Overdraft Arrangements: Under this arrangement, certain
facilities are available to the borrowers which are not available
under the loan arrangement.
◦ Cash Credit Arrangement
◦ Bills Purchased and Bills Discounted
◦ Term Loans for Working Capital
◦ Mode of Security Banks provide credit on the basis
of the following modes of security:
 Hypothecation
 Pledge
 Lien
 Mortgage
 Charge
 Accrual Accounts
◦ Merits
 Accrual accounts are a spontaneous source of finance as these
are self- generating.
 Financing through accruals is an interest free method and no
charge is created on the assets.
 As the size of business increases, the amount of accruals also
increase.
◦ Demerits
 An enterprise cannot indefinitely postpone the payment of
wages/salaries and taxes. Therefore, it is not a discretionary
source of finance
 This source should be used only as a matter of last resort.
 Factoring
◦ Merits
 As a result of factoring services, the enterprise can concentrate
on manufacturing and selling.
 The risk of bad debts is eliminated.
 The factoring institution also provides advice on business trends
and other related matters.
◦ Demerits
 A substantial amount of discount or rebate has to be paid to the
factoring concern.
 If he factoring institution uses strong arm tactics to collect
money it will spoil the image and relations of the firm with its
customers.
 Advances from Customers: Manufacturers
and suppliers of goods, which are in short,
supply usually demand advance money from
their customers at the time of accepting their
orders.
 Despite its romantic aspects, financing a new venture
frustrates many entrepreneurs.
 Often they do not know where to begin; if they do
know, they go at it haphazardly.
 The act of preparing a financial plan enables
entrepreneurs to crystallize their thinking on how best
to launch their ventures.
 It forces them to move logically and systematically
from the stage of dreams and ideas to that of concrete
action.
 The centerpiece of the business plan is the cash
budget, which translates operating plans into dollars.
 Without a cash budget, the entrepreneur has no way
of estimating financial needs.
 Before beginning to develop a cash budget, an
entrepreneur must first spell out his or her operating
plans, defining production, marketing, staffing,
accounting, and legal goals.
 Having estimated how much money is needed to
finance the venture, the entrepreneur must then
decide what fraction of this money should come from
investors as equity capital, and from creditors as debt
capital.
 Various sources of raising working capital finance
may include trade credit, bank credit, current
provisions of non-bank short term borrowings and
long term sources.
 Capital: A business's total amount of money and/or
property meant for use in ways or activities that are
intended to produce wealth.
Current Assets: Current assets are those assets which
can be easily converted into cash with a period of one
year or one operating cycle.
 Gross Working Capital: It is considered to be equal
to the total current assets required by a business firm.
 Net Working Capital: Net working capital is the
excess of current assets over current liabilities.
 Lien: It refers tot he right of a party to retain goods
belonging to another party until a debt due to him is
paid.
 As a new entrepreneur, how would you estimate the requirement of
finance? Give detailed account with imaginary figures.
 What do you understand by the term 'working capital"? Distinguish
between Gross working capital and Net working capital.
 Discuss the need for and significance of adequate working capital in the
successful functioning of small-scale enterprises.
 How will you estimate the amount of working capital required for a new
small business firm?
 Discuss the sources of working capital finance for a small firm.
 You are an entrepreneur planning to set up a small-scale unit catering to
everyday provision needs of a large housing complex. How would you
assess your working capital requirements and wherefrom such
requirements be met?
 Explain the main elements of managing effectively the working capital of
small-scale industries.