External Sources of Finance

External Sources of Finance

External Fund means external sources from which funds can be collected such as funds collected by taking a loan from a bank. It is a popular source of finance. Bank loan has some features.

First: A Bank loan has a fixed term, within this term loan is to be utilized and the the principal amount with interest has to be paid back to the bank.

Second: The rate of interest remains the same, for the long period of its term no change is made. 

Third: Repayment of interest and installment of loan regularly and repaying the principal amount within the term is compulsory for the business. These dues have to be repaid even though selling debentures or bonds to the bank. The selling of preference shares is another source of external financing.

External sources of financing are very popular. Two reasons for these are identifiable:

1. If a business is financed through a loan, tax is imposed on the profit left after deducting the interest of the loan from gross profit. As a result, the amount of tax payable becomes less.

2. In the case of small businesses, sometimes internal financing becomes comparatively less in amount; as a result, external sources act as the main sources of finance.

But one problem with external funds is the compulsory payment of interest. It was previously said that whether profit is earned or not, the business is bound to pay the imposed interest as per schedule. This problem doesn't create if internal sources are used. Based on terms, external sources can be divided into three types:

a) Short term

b) Mid-term and 

c) Long term.

Now we will get ideas from these three types of sources.

a) Short Term Source of External Finance

Short-term means one year or less than one year. Most of the finances of an organization are usually collected from short-term sources which are required within a year. In the case of short-term financing, an organization enjoys some benefits. For example:

First: The cost of capital from the short-term sources may be comparatively both the highest and the lowest. For example, a loan collected from a commercial bank is requested to pay a high rate of interest in the short term. Again, with different interest-free sources like purchases on credit or wages kept due, a business organization can create funds for the short term, which has no cost of capital. 

Second: The process of short-term capital exchanges is the fastest and simplest process. On the other hand, the exchange of mid-term and long-term financing requires expanding huge time and following a long process.

Three: The business institutions whose product demand changes very swiftly within one year cannot make long-term plans for production and financing. For example, due to the rapid change of demand for the fashion house's products, these types of businesses make plans for short-term production and thus require a small amount of money at a time. Short-term sources of financing are suitable for these types of businesses.

Now we will discuss the short-term sources of finance. The sources of finance of this term can be divided into two types. We will discuss below first the institutional sources of short-term finance and then non-institutional sources of short-term finance.

1. Institutional Sources of Short Term Financing

A. Discounting Bills Receivable

When products are purchased on credit, the buying firm promises to the selling firm by signing a document to pay a specified amount of money after the expiry of a certain period (usually 3 months). This type of document is called the Bill of Exchange. This bill is receivable for the selling firm. So, a selling firm can collect cash by exchanging or discounting this bill in a commercial bank. Let us assume, on 1 January, a buyer purchases goods for 500 takas on credit and agrees through signing the Bill of Exchange that he would be bound to pay 500 takas to the selling firm to the bearer of the document on March 30. In this condition, if the seller needs money before March 30, he can sell this bill to a bank before the expiry of the period but he has to receive less than 500 taka, for example, with a discount rate of 8% per annum, after discounting he will receive 490 taka.

B. Bills Payable

In the above example, a Bill of Exchange is a bill receivable from the perspective of the seller, which is a bill payable to the buyers and is one of the sources of short-term finance. When a business institution purchases raw materials, production materials, etc. on credit, finance inflows for a short time in the business. If a business couldn't get the opportunity of credit purchasing, finance would be required to buy on cash payment; hence if the loan was collected from the bank, interest would have to be paid.

C. Short-Term Bank Loan

In the case of short-term finance, an unsecured bank loan is the main source. This kind of bank loan, usually interest with principal amount has to be repaid at a time after a specified period. Many times, the bank tries to collect the full portion or part of the sanctioned loan before the specified period and for this purpose, the bank gives a discount on the total amount receivable as an incentive for earlier payment. For example, if a bank allows a 2% discount on the total amount to repay before the expiry of the term to the borrower of Tk 6,000 payable after 6 months then the borrower will pay Tk 5,880 to the bank.

Besides, if the creditor agrees to repay on demand instead of agreeing on a fixed term, this type of loan is called a "Demand Loan". The institutions that have alternative sources of finance can use this source at a low cost of capital.

D. Bank Overdraft

Bank Overdraft is another type of short-term finance. Every institution usually realizes its receivables and repays its payables through a current account. This type of bank account mainly allows its account holders to withdraw more than the amount of savings in the account; however, the bank restricts the maximum amount of overdraft. Generally, finance collection from this type of source is a well-known system for those institutions where sales decrease for some time of the year. For example, it could be mentioned that an ice cream factory spends money throughout the year for production, warehousing, management, etc. but the maximum amount of ice cream is sold in the Summer season; so for the purpose of financing in other times of the year, this type of source can be used. Generally, in the case of other types of loans, interest has to be paid till the full repayment of the loan, but interest for such types of loans has to be paid only when this loan is being used. However, the rate of interest of this type of loan is higher than the other types of loan and it is repayable on demand.

E. Small Credit

This type of loan is generally provided to meet the demand for current assets for agriculture-based and small & cottage industries, such as management of a small industry, purchasing of agriculture-based materials, management of a firm, etc. Grameen Bank, Youth Development Bank, and Co-operative Banks are used to provide such kinds of loans. This kind of loan is given step by step on the achievement of the goal.

2. Non-Institutional Sources of Short Term Financing

A. Commercial Papers

Some business organization sells Commercial Paper by promising to pay back the principal amount with interest after the expiry of a certain period. At that time the company's goodwill acts as a security to the purchaser. Usually, those persons who have some excess money left as unutilized for the time being, purchase commercial papers as an alalternative ofnvestment in shares. Generally, a well-known person, commercial bank, insurance company, etc. can arrange finance for a short time by selling commercial papers.

B. Advance from Purchaser

In many cases, trustful and permanent customers pay as advance to the producing or selling firm the full amount or part of their total purchase, and as a result, this acts as a source of finance to the seller for the time being.

C. Inventory Mortgaging

For the purpose of short-term financing, warehouse assets can be used. If any business firm uses its inventory as security of loan received from a well-known person or organization, it is called inventory financing. In this type of financing, the lender's control and right on inventories are kept until the loan with interest is refunded.

D. Village Moneylenders

Since long days ago, rich people in the villages have been providing short-term loans to the poor people. In this case, the debtor has to pay a high rate of interest. If the person fails to pay back the loan with interest within a specified period, the moneylenders the possession of his (debtor's) tangible and intangible property. Village moneylenders impose interest on this loan daily, weekly basis, or monthly basis.

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