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Classification of Sources of Funds

Last updated date: 25th Feb 2024
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Why are Funds Needed?

The quality of the goods and services offered by the business is greatly affected by the financial situation of the business. The overall picture of the business starting from its market position to providing backup services are all destined by the financial usages that the business has in their capability, hence finance being the lifeblood of the business, is an important factor for the business to run.

Now the question is, how and from where the funds are to be acquired from? 

Funding is the fuel that powers up a business unit. Also, this is to be kept in mind, igniting the power with wrong fuel will hamper the business thus the type of funding is dependent on the business structure. In this case, we should also learn about the types of sources of business funds. 

What is Source of Funds?

For growing their business units, companies seek for sources of funding. Funding, also known as the financing, is an act to contribute the resources to finance the project, or an investment or any cause related to the business. Funding is channelled out for long as well as short term purpose.   

Sources of Funds Can Be Flowed out From –

  • Retained Earnings

  • Debt Capital

  • Equity Capital

We see the main sources of funding are these – retained earnings, debt capital, and equity capital. Companies use retained earnings from business operations to expand their business or to distribute dividends to the shareholders. While businesses may also raise funds by borrowing debt personally from a bank or by issuing debt securities. We will know about the sources in detail while we proceed to the later section. Companies use this equity funding by exchanging the ownership rights for cash which comes from the equity investors. 


Types of Source of Funds

Retained Earnings

Businesses maximise their business profits by selling the product or by rendering the services for a higher cost and to produce the goods and services. Retained earnings are the most primitive way to channelise their funding for any company.  

After the profits being generated, the company needs to decide what to do with the earned capital and how to distribute it efficiently. With the retained earnings at hand, the company can – distribute it to the shareholders as dividends, or reduce the company’s outstanding loans. Yet in another way, the company can invest the money into an entirely new project, like building a new building, factory or a machine. These retained earnings can be used also to create a partnership with another company forming a joint venture

Debt Capital

Debt is often taken as loans from the banks privately. The businesses also can source new funds by issuing the debt to the public. In debt financing, the issuer or the borrower issues debt securities, like the corporate bonds or the promissory notes. These debt issues also include debentures, leases and mortgages.  

Companies who initiate debt issues are the borrowers who exchange securities for cash which they acquire to perform certain business activities. At the time of repaying the loan, the companies will repay this debt (principal and interest) according to the already specified repayment schedule. The drawback of borrowing the money is that the issuer or the borrower needs to make the interest as well as the principal payment on time. Failure in this respect may lead to a penalty. 

Equity Capital 

Companies raise funds from the public in exchange for an ownership stake in the company. This is done in the form of issuing the shares to the investors who are the actual shareholders. After purchasing the share, they become members of the company or business. Alternatively, private equity financing can also be an option which provides entities or individuals to directly invest their money wherever the money is needed for. In comparison to the debt capital source, equity capital funding does not demand any interest or principal payment.

FAQs on Classification of Sources of Funds

1. What is Meant By Long-Term and Short-Term Funding?

Ans. Long-term funding is the funding system by loan or borrowing for a term of more than one year by issuing equity shares, in the form of debt financing. Other long-term loans include leases or bonds that are required to fund big projects. 

Short term funding is the financing of business from short-term sources like taking small loans etc. Short term funding is a period for less than one year and this helps the company in generating cash for the day to day work of the business and for operating expenses. 

2. What Affects the Decision of Channelising the Retained Earnings?

Ans. Utilising retained earnings differs from business to business, a business where the shareholders are prioritised will use the retained earnings in distributing to the shareholders, the business who are in huge debt would like to use these funds in paying the debts. While there are also some businesses, which have greater growth prospects and would like to invest in their business moreover uses the retained earnings in building their venture. 

3. What are Promissory Notes?

Ans. A promissory note is a financial instrument, containing a written promise by one party to pay another party a specific sum of money on demand or at some future date.  

4. What is the Disadvantage Faced By Companies in Equity Funding?

Ans. On a long-term basis, sharing the profits among all the shareholders may dilute the company’s ownership control to other hands. This may lead to takeovers.