Sources of finance

Starting up - New businesses starting up need money to invest in long-term assets such as buildings and equipment. They also need cash to purchase materials, pay wages and to pay day-to-day bills such as water and electricity. 

Growing - Once the business is established there will be income from sales. If this is greater than the operating costs, the business will be making a profit. This should be kept in the business and used to help finance growth. Later on, the owners can draw money out, but at this stage as much as possible should be left in. Even so, there may not be enough to allow the business to grow as fast as it would like to. It may need to find additional finance and this will probably be from external sources such as bank loans.

Other situations - Businesses may need finance in other circumstances, such as cash flow problem. A major customer may refuse to pay for the goods, causing a huge gap in cash inflows. Or there may ne a large order, requiring the purchase of additional raw materials. In all thee cases businesses will need to find additional funding. 

Internal finance comes from within the business and the resources. The most important is profit, that is a surplus of revenue over costs. That surplus will start by accumulating in the company bank account, and then will typically be spent, perhaps on buying new machinery, new vehicles or on a new launch. Nothing soothes a difficult cash situation better than profit. It is also the best way to finance investment into a firm's future. Research shows that over 60% of business investment comes from reinvested profit.

Another internal source of finance is from within the company's working capital, that is the cash spent on building inventory and in credit provided to customers. If that investment can be cut, cash will be generated. 

Loan capital 

The most unusual way is through borrowing from a bank. This may be in the form of a bank loan or an overdraft. A loan is usually for a set period of time. It may be short-term - one or two years; medium term - three to five years; or long term - more than five years. The loan can either be repaid in instalments over time or at the end of the loan period. The bank will charge interest on the loan. This can be fixed or variable. The bank will demand collateral to provide security in case the loan cannot be repaid. 

An overdraft is a very short-term loan. This is a facility that allows the business to be 'overdrawn'. This means that the account is allowed to go 'into the red'. The length of time that this runs for will have to be negotiatied. The interest charges on overdrafts are usually much higher than on loans. Fortunately the interest charges only apply to actual debts instead of the facility itself. For firms that use the overdraft as a way of soothing short-term cash variations, the interest payments can be quite small.

Share Capital

As an alternative to debt, if the business is a limited company it may look for additional share capital. This could come from private investors or venture capital funds. Venture capital providers are interested in investing in businesses with dynamic growth prospects. They are willing to take a risk on a business that may fail, or may do spectacularly well. They believe that if they make ten investments, five can flop. 

Once it has become a public limited company (plc), the firm may consider floating on the stock exchange. For smaller UK businesses this will usually be on the Alternative Investment Market (AIM).

Internal sources 

Retained (reinvested) profit. From any profits generated by the business most companies pay out about half as an annual dividend to the shareholders, ploughing the other half back into the business to grow. The advantage of reinvested profit is that it does not have an associated cost. Unlike loans it does not have to be repaid and there are no interest charges. The disadvantage is that there may be too little profit to allow the business to grow to its full capability. 

Cash squeezed out of day-to-day finance. By cutting stocks, chasing up customers or delaying payments to suppliers, cash can be generated. This has the advantage of reducing the amount that needs to be borrowed. However, this is a very short-term solution and if the cash is taken from day-to-day capital for a purpose such as buying long-term assets, the firm may find itself short of cash flow. 

Debt factoring. A way to squeeze capital from day-to-day finances is by the use of debt factoring. A company that sells goods on credit can arrange that a bank or debt factoring firm to buy the remaining debt. 

External sources

Bank overdrafts. Most common form of borrowing. The bank allows the firm to overdraw up to an agreed level. This has the advantages that the firm on ehas to borrow whne and as much as it needs. It is however an expensive way of borrowing. 

Trade credit. Simplest form of external financing. The business obtains goods or services from another business but does not pay for these immediately. The average credit period is two months. It is a goos way of boosting day-to-day finance. A disadvantage could be that other businesses may be reluctant to trade with the business if they do not get paid in good time. 

Bank loan. Usually for a period of 2-5 years (medium term). It is an excellent form of finance for a new, growing business because there is no need to repay any capital until the capital says so - usually at the end of the period. 

External

Venture capital

This is a way of getting outside capital for businesses that are unable to raise finance through the stock markets or loans. Venture capitalists invest in smaller, riskier companies. To compensate for the risks, venture capital providers usually require a substantial part of the ownership of the company. They are also likely to want to contribute to the running of the business. This dialutes the owner's control but brings in new experience and knowledge. 

A modern form of venture capital is 'crowdfunding'; its a way of getting small incestors to put money into a new business - often with an incentive such as to get a sample product or service in return for their investment. It works via the internet and works most effectively when the sponsors use social media to promote their business. 

Businesses need sufficient access to finance to meet current and future needs. This is a major issue for new firms and for those that are expanding rapidly. When a businesses expands without sufficient finance it is known as 'overtrading'.

The key is to match the type of finance to its use. A distinction is made in company financing between short and long-term finance. 

Short term finance should not be used to finance long-term projects. Using short-term finance such as overdrafts puts continual pressure on the company's cash position. An overdraft should only be used to cope with ups and downs in cash flow. By its very nature, growth is a long-term activity, so appropriate long-term finance should be sought to fund it.

Another key aspect of appropriate finance is that busiensses should find the right balance between 'equity' and debt. Equity means share capital, which is safe and stable, as shareholders need not be paid a dividend if times are tough. Debt-based finance such as an overdraft or loan is more risky. Even when business is poor the bank still expects to be paid interest on the loan, plus - with an overdraft - the bank may demand that the overdraft is repaid immediately.