Sources Of Finance: Best Guide 2025

Businesses consistently explore various avenues to secure funding for their expansion. This crucial aspect is often referred to as financing. Sources of finance is a financial provision aimed at fulfilling business operational needs.

It’s common to underestimate the cash required to cover startup costs and sustain initial operations until the Business becomes beneficial and covers expenditures. The size and type of Business will determine the amount of cash needed.

For example, processing businesses are capital-intensive and need large amounts of capital. While Retail companies usually require less capital.

Sources of finance are broadly categorized into internal and external sources of finance. The internal source of finance involves sourcing funds from within the Business. At the same time, external sources of finance involve external entities. This is also referred to as Debt and Equity finance.

Internal sources of finance (detailed)

Internal sources of finance denote the funds generated within the organization. Internal sources generate cash flows without involving external parties.

Internal sources of finance are considered the cheapest sources of finance. This is because it attracts no interest. When going by the internal sources. Funds are generated through retained earnings, sales of assets, owner’s capital, and stock issues.

Examples of internal sources of finance

Below are the examples of internal sources of finance:

Retained Earnings:

This is the profit a business makes and then reinvests into the company for expansion. It is arrived at after the deduction of tax and payment of dividends. This is less expensive for the Business as there is no interest charge. I am making it a highly desirable form of finance.

An Increase in retained earnings increases the credit profile of the entity.

Owners Capital:

This is the money that the owners of a business bring into the Business. At the same time, this form of financing incurs no explicit interest charges. This comes with business risks as the owner expects returns from their investment.

In the context of a corporate entity, this investment aligns with share capital. You are contributing to the overall financial foundation. This distinction makes it an attractive option for companies seeking capital without the burden of ongoing interest obligations.

Issue of Stock:

Here, publicly listed companies issue more stocks to the public. They are issued via a further public offering (F.P.O.) to raise funds for business expansion. The financial cost associated with this financing source is the risk premium requested by the shareholders.

Sale of Assets:

Companies sell old or obsolete assets to acquire new ones to raise money for business expansion. There is no cost of finance attached to this source of finance. The sale of operating assets as a financial source is suitable for an entity on the verge of shutting down its operations.

Debt Collection:

This involves the realization of funds from credit sales. Or from the provision of services offered to a customer on a credit basis. In situations where the entity faces a cash crunch. It tightens the credit period extended to customers.

This source of finance has no capital cost; however, situations with a delay in the customers’ debt payment lead to high financial costs.

Advantages of Internal Sources of Finance

Internal sources of finance offer greater flexibility compared to external sources.
Business owners deal with internal financial risks.
The Business operates on owned funds. I am avoiding reliance on borrowed funds and eliminating third-party dominance.
Internal sources of finance are typically less expensive than external sources, with no interest or other charges.
Internal sources of finance are readily available without the need for lengthy approval processes.
Internal sources of finance allow businesses to keep operations and financial information confidential. They are avoiding public disclosure.
Unlike external financing options, internal sources of finance do not come with the obligation of repayments.
Independence from bank loans and lines of credit results in a higher credit profile. It lowers risk premiums on financial instruments like commercial papers.

Disadvantages of Internal Sources of Finance

Internal sources may tie up funds in long-term investments, impacting liquidity.
Dependency on internal funds limits diversification, increasing financial risk.
Existing financial resources constrain internal sources. Posing challenges for funding large projects.
Relying solely on internal sources may distort a company’s financial statements.
Funds used internally cannot be redirected for new opportunities or shareholder dividends.
Profitability is crucial for internal sources, making fundraising difficult for financially troubled companies.
More than relying on internal funds may lower credit ratings, affecting future external financing prospects.

External Source of Finance (detailed)

External sources of finance refer to obtaining funds from entities outside the Business. These entities include bank loans, bonds, venture capital, and crowdfunding. These funds can originate from individuals or other entities that do not engage in direct transactions with the organization.

External sources of finance provide businesses with the flexibility to access a diverse range of capital options beyond their internal resources. However, external financing often comes with more conditions and obligations.

Examples of External Sources of Finance

The external sources of finance are categorized into three categories—the short-term, middle-term, and long-term sources of finance.

Short-term external sources of finance

This is also referred to as working capital financing. It is usually less than a year. The following are the three sources of short-term external finance:

Trade Credit:

Trade credit is a type of short-term external finance where a business purchases goods or services on credit to pay a supplier on a scheduled date. This enables the purchasing firm to keep cash during this credit period. The firm may sell the acquired items before fulfilling the payment obligation.

Bank Overdraft:

A bank overdraft represents a form of financial assistance. That allows customers to withdraw more than what is in their bank account for a fee. It is considered a current liability. It is flexible because businesses can pay back whenever they wish. Bank overdraft attracts higher interest rates.

Debt Factoring:

Debt factoring is also used for invoice factoring. Debt factoring is the transfer or sale of company receivables to a third party for cash. Companies sell their accounts receivable at a reduced price in exchange for immediate cash. But lose a percentage of the total value of the debts.

Medium-Term External Sources of Finance

Medium-term external sources of finance are finance with a one to five-year repayment period. The medium-term external sources of finance include:

Leasing:

Leasing is a type of financing where the owner of an asset grants another party the right to use the asset. It is usually for a fee.

There exist two categories of leases: finance lease and operating lease. In a finance lease agreement. Ownership transfers to the lessee at the lease term’s conclusion. While in an operating lease agreement. The leasing company retains ownership during and after the lease term.

A finance lease has a flexible payment structure, allowing companies to save money.

Medium-Term Bank Loan:

Medium-term bank loans are loans with a repayable period of two to five years. Repayment of this type of loan may either be made in one sum at an agreed date or in installments over some time.

Long-Term External Sources of Finance

Long-term external sources of finance are those payable within five years and above. These long-term sources of finance include:

Share Capital:

Share capital is a source of financing where owners of a company issue some part of the company’s ownership to the public in exchange for funds. This is only applicable to public companies.

Private companies are restricted and can only raise funds from family and friends. Share capital attracts no interest as shareholders are entitled to dividends.

Long-Term Bank Loan:

A Long-term bank loan is a type of credit with three to thirty years of tenure. The interest can be fixed or variable. Variable interest rates are subject to change due to some factors.

The lending bank also ensures the customer has an account with the bank. The bank uses the customer account history to know the extent of the loan to be issued to the customer. The bank will communicate the repayment terms and interest as well. Banks also request for a collateral against the loan in case of default.

Venture Capital:

Venture capital is financing used to support businesses and startups that are well-doing and have growth potential.

They seek businesses with a competitive advantage and often emphasize short-term gains. Venture capitalists usually adopt an active role. Securing representation on the board of directors and sometimes influencing managerial appointments. This form of financing is crucial for ventures deemed too risky by traditional banks.

Additionally, business angels, wealthy individuals investing in startups, may form syndicates. They are acquiring a minority shareholding in exchange for their financial support.

Business Angels:

Business angels are individual investors who invest privately in businesses with potential in exchange for equity stakes. They also bring valuable skills, extensive experience, and a robust network for growing the startups.

An example in Nigeria is the Tony Elumelu Entrepreneurship Programme (T.E.E.P.).

Government Grants:

Government grants are financing issued by the government to fund startups and businesses.

These grants act as a valuable asset for financing advantageous projects.

The government gives grants without the obligation of repayment. The federal government of Nigeria offers various grants; some of these grants include:

1. Survival Fund Grant.

2. FG Grant for Agriculture.

3. Youth Investment Fund.

Advantages of External Sources of Finance

It facilitates business growth by funding projects beyond the Business’s independent financial capacity.
External financing can be cost-effective. We feature lower interest rates and fees than equity financing options.
External financiers often provide valuable guidance and expertise. They are acting as valuable partners in the Business’s journey.
External financing allows businesses to use funds as needed. They are eliminating the need for a permanent commitment of resources.
External sources contribute to diversifying a company’s funding mix, reducing reliance on internal funds, and minimizing financial risk.
External financing enables businesses to conserve internal resources, redirecting them to alternative uses.
Utilizing external financing can enhance a company’s credit profile. Augmenting its ability to secure more funding in the future.
·External financing preserves the ownership structure of a company. I am avoiding dilution and maintaining control and equity for existing owners.

Disadvantages of External Sources of Finance

Interest charges add to the cost of external financing, potentially exceeding initial projections.
External funding can negatively impact a company’s reputation.
External financing comes with the obligation to repay. Often with interest, straining a company’s financial resources.
Securing external finance may entail a loss of ownership. Specific sources may demand a share in the company.
Utilizing external financing adds to a company’s debt load. Impacting financial stability and credit rating negatively.
External financiers may impose covenants and restrictions. They are limiting a company’s decision-making and opportunity pursuit.
Companies seeking external financing need to meet legal and regulatory obligations, including registration with securities regulators and financial statement filings.

Alternative Sources of Finance

Franchise:

A Franchise is a license or right given to an individual or Business to allow it To market a product or service owned by another company in exchange for compensation.

The entity providing these rights is termed the ‘franchisor.’ And the one receiving the franchise is known as the ‘franchisee.’

Crowdfunding:

Crowdfunding is an online way of raising funds from many people to finance businesses and projects. Crowdfunding is one of the fastest alternative sources of finance. It attracts no upfront fee.

Some of the crowdfunding platforms in Nigeria include MicroVentures, GoFundMe, Indiegogo, and Kickstarter.

There are various types of crowdfunding. These include debt-based, equity-based, cause-based, rewards-based, software value token, litigation, etc.

Microcredit:

Microcredit is a small loan issued to small business owners without an appropriate collateral guarantee. N.G.O.s and micro banks mainly provide this type of loan.

Peer-to-Peer Lending:

Peer-to-peer lending is how individuals borrow money from each other without going through the necessary procedure. This is done through an online financial platform.

Peer-to-peer lending offers both secured and unsecured loans. However, most of the loans are unsecured personal loans.

Distinctions Among Internal and External Sources of Finance

Internal sources have no obligation to repay and no loss of ownership. While External sources require repayments, securing external finance may entail a loss of ownership.
Internal sources have no legal or regulatory obligations. At the same time, External sources may meet legal and regulatory requirements, including registration and financial statement filings.
There are no interest charges for Internal sources of finance. At the same time, External sources of finance have Interest charges. The interest charges are added to the cost.
Internal funding options offer greater flexibility than external ones because of some restrictions the external sources face.
Internal sources of finance face the risk of credit rating. At the same time, external sources of finance may enhance credit rating.
Internal sources of finance limit diversification when there is over-dependence. At the same time, external sources of finance contribute to diversifying a company’s funds.
Internal sources of finance are Less likely to impact a company’s reputation. At the same time, external sources of finance May impact a company’s reputation. Especially if viewed as a sign of financial difficulty or weakness.

Similarities Between Internal and External Sources of Finance

Internal and external sources aim to facilitate business growth by providing funds for various projects and initiatives.
Internal and external sources support a company’s operations and finance its ongoing activities.
Both allow businesses to conserve resources, whether internal or external. I am redirecting them to alternative uses.
Internal and external sources, such as registration and financial filings, may involve compliance requirements.
Both internal and external may have long-term or short-term effects on the company.

Factor Considerations when Choosing a Source of Finance

Finance:

Amount of funds needed.

Cost:

The administrative or interest fees.

Duration:

The timeframe for which financing is needed.

Objective:

Short-term finance covers revenue expenses. At the same time, long-term finance is used for capital expenditures.

Scale and Standing:

Smaller enterprises face limitations due to the need for more security.

Financial Status:

Companies facing liquidity issues may encounter challenges. And a higher cost of borrowing.

Conclusion

In conclusion, the article emphasizes understanding financing options for business growth. It highlights internal sources like retained earnings and owner’s capital for flexibility. And cost-effectiveness, contrasting them with external sources like bank loans and government grants. This enables expansive projects but involves conditions.

They are emphasizing factors like flexibility, costs, and independence. Differences between these sources, such as repayments and legal obligations, and their shared role in supporting operations and growth are noted.

Critical considerations for selecting a finance source. T include amount, cost, duration, objective, scale, standing, and financial status.

Alternative finance avenues, like franchising and crowdfunding, are introduced. They are providing businesses with innovative options beyond traditional sources. These alternatives range from licensing to online, offering more pathways for securing necessary funds.