Finance is important to any business as it serves different functions which allow the business to run effectively. A company may need additional funds to expand its business operations or running expenses (Wright 2007). Expanding a business may include entering new markets, introducing new products and increasing annual output. New businesses struggle with cash flow problems as they try to establish a steady customer base. External sources are vital for the survival of these businesses. Financial sources offer funding to firms and individuals in return for interest or a stake in the business. Sources of funding include financial institutions, non-governmental organisations, governments, private institutions and individuals (Kidwell 2011). A firm needs to take into consideration the amount of funding it requires, the amount of time it will take to repay the funds, and the amount of interest it has to pay when choosing an external source of funding. Managers have to provide financial sources with an accurate financial status of the business that is supposed to receive funds.
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Financial institutions provide financial services to the public and are regulated by the government (Sanders 2011). Commercial banks, investment bank, credit unions and mortgage loan companies are all financial institutions. The amount of money and interest rates charged by financial institutions are set and controlled by the government. The main advantage of receiving funding from financial institutions is that government regulations protect borrowers. Interest rates are fixed and as such, a firm can compare different rates of various financial institutions and choose the most favourable. Convenience is another advantage of financial institutions as they provide instant funding.
Financial institutions have the capacity to provide large sums of money to borrowers, and their flexibility means that they can secure secondary loans to businesses. The main disadvantage of borrowing from financial institutions is that firms may find it difficult to pay the interest charged. Financial institutions also require extensive documentation before funds are released; this can be problematic for businesses that don’t have the required paperwork and businesses operating in the informal sector. Firms that default on their loans face having their assets auctioned off and may possibly lose their business.
Individuals and Private Firms
Private firms and individuals are a source of funding that is bound by a contract or informal agreement between parties (Tvede 2009). Funding from this source is not regulated by the government and any conflicts that may arise between parties are referred to civil courts. The main advantage of receiving funding from private parties is flexibility and borrowers can negotiate a favourable funding agreement. Private firms may also provide information and technical support in addition to funding. Firms with inadequate funds can offer a percentage of their company in exchange for funding and this means the lender will have a vested interest in the success of the firm (Bodie, Kane & Marcus 2013). The main disadvantage of borrowing from private parties is that there is a limit to the amount and frequency with which an individual can borrow. Conflicts are common between lenders and borrowers and this can impact negatively on the business especially if the private party is the only source of external funding for the business. A firm that is unable to repay the funds it has borrowed can be sued by the lender and if the lawsuit is successful the firm may lose its assets to the lender.
Non-governmental organizations are institutions that are independent from the government and are non-profit making (Tvede 2009). The main objective of non-governmental organisations is promoting community development. One way of doing this is through the promotion of local economies by providing funding to companies (Wright 2007, p. 129). The main advantage of this funding is the low-interest rate and the long grace period borrowers have before paying loans. Loan defaulters also do not face the risk of losing assets instead non-governmental organisations try to help these firms to become more profitable. The main disadvantage of funding from non-governmental organisations is that the amount offered to borrowers is too low. Borrowers also have to wait for long periods before they receive funding and in many cases borrowers only receive a portion of the funding they requested.
Government funding is financial assistance provided to firms by the government (Wright 2007). Businesses have to apply and provide relevant documentation to the government in order to receive funding. The main advantage of government funding is the low-interest rates borrowers pay. The problem with government funding is that the firms seeking financing from the state have to wait for a long time before they receive the funds. The government has limited funds and some firms apply for this funding and wait for a long period of time and they still do not receive funding. Government funding targets small firms therefore large firms do not benefit from this government project.
Comparing and Contrasting Various Sources of Finance
Different sources of funding have advantages and disadvantages. The least attractive source of financing is government funding due to its unpredictability. The lack of communication during the long waiting period after application makes it difficult for the borrower to know whether their loan application is successful or not. In contrast, non-governmental organisations offer the same funding and at low-interest rates while offering an open platform where borrowers can get information on their application process and money management. Private entities and financial institutions offer a relatively large source of funding. However, the risk and cost of this financing are relatively high.
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The Business Life Cycle
The business life cycle is the path that a firm follows from conception to profitability. Four phases encompass the business life cycle namely establishment, growth, maturity and postmaturity (Tvede 2009). The establishment is when capital is invested and the business is formed. Growth is the phase where there is an increase in the customer base, sales, number of employees and profits. This is also the phase where the firm has to start planning for expansions as it seeks to satisfy its customer base. Maturity is the phase where the company experiences high profits and seeks to maintain this position. Postmaturity is the final stage of the business life cycle where firms maintain a steady state, expand and continue growing or decline. The decline of a firm may be due to its products becoming obsolete or as a result of poor management.
Changing Sources of Finance as the Business Life Cycle Changes
A firm needs different sources of funding to successfully navigate the business life cycle (Tvede 2009). In the establishment phase a firm would need government or non-governmental organisations funding. This funding will provide low interest and low liability financing at a time when a firm is vulnerable to financial downturns. In the growth phase, private entities will provide the best funding. Such funding will give the firm not only funding but technical support that will help it grow. In the maturity and postmaturity phase, the firm should seek funding from financial institutions as the business will require a substantial amount of funding.
The main conclusion one draw is that the different sources of funding have their advantages and disadvantages but are all vital during the business life cycle of a firm. A firm has to consider its current financial position and its future plans before seeking external funding.
In the light of the conclusion, any organisation seeking funding should consider the advantages and disadvantages of each source of funding before making a final decision.
Bodie, Z, Kane, A & Marcus, A. J 2013, Essentials of investments, McGraw-Hill-Irvin, New York, NY.
Kidwell, D. S 2011, Study guide: financial institutions, markets, and money, John Wiley & Sons, Hoboken, NJ.
Tvede, L 2009, Business cycles: history, theory and investment reality, John Wiley & Sons, Chichester.
Wright, T. C 2007, Solving the capital equation: financing solutions for small businesses, Toca Family Publishing, Atlanta, ATL.
Sanders, A 2011, Financial Institutions Management: A risk Management Approach, McGraw-Hill, New York, NY.