Types and Sources of Financing for Businesses

Nowadays, businesses may receive funding from a variety of sources, which have their own advantages and disadvantages. Basically, selection of a particular source of finance depends on several factors, such as the time scale involved, size and type of business organization and purpose of finance. For example, small businesses to support a constant flow of working capital can use their own finance, while big companies should seek alternative financing sources.

For a better understanding, I will consider different sources of finance in detail. In general, sources of finance can be classified in three ways. First of all, there are two types of finance, namely equity-finance and debt-finance. The distinction between them is that debt financing involves borrowing a fixed sum from a lender, which is then paid back with interest, while equity financing is the sale of a percentage of the business to an investor, in exchange for capital. Some business owners who do not want to lose some part of ownership, may not consider equity-finance. However, there is no interest to repay unlike debt-finance, which is a great advantage.

Secondly, when companies’ borrowing debts they receive money from outsiders, this is called external financing. While, equity-finance is internal financing, since is provided by the company itself. Usually, internal financing is available for already established companies, which generate positive cash flow.

Thirdly, sources of finance classified by its duration, such as long-term, medium-term and short-term. Long-term fulfil the financial requirements of a business for a period more than five years. There are several sources of long-term debt, including debentures and long-term bank loans. In order to borrow the money for a long period of time, the company must ensure it can cover the interest, since the bank most likely will not provide long-term loans for small businesses which do not have an adequate level of liquidity.

Next part is medium-term sources, where the funds are required for a period between one to five years. It includes bank loans, hire purchase and leasing. Hire purchase, which is most commonly used, defined as a type of asset finance that allows firms or individuals to possess and control an asset during an agreed term, while paying rent or instalments covering depreciation of the asset, and interest to cover capital cost.

This option can be very convenient for businesses which are unable to pay full value immediately while purchasing assets, so they can make initial deposits and later pay instalments over a period of time. Advantage of Hire purchase is that unlike leasing, at the end of repayment hirer can become the legal owner of the asset. Medium-term loans are more flexible then long-term, because it is possible to repay them faster.

Finally, short-term sources of finance, where funds are required for a period not exceeding one year. In fact, short-term financing has a strategic role in many businesses today, which use them to finance everything from emergencies to inventory. Examples of short-term finance are line of credit, trade credit and commercial paper. By definition, commercial paper involves unsecured money market instruments issued in the form of a promissory note. By issuing this type of security, firms can access financing from institutional investors such as insurance companies or pension funds.

Another form of short-term finance is trade credit. This basically means delayed payment for materials, and usually provided by suppliers. In other words, when a business establishes a good relationship with suppliers, they can purchase goods now and pay later. Last source of finance under this category is line of credit, which is defined as an amount of money, extended to the company by a financial institution, such as a bank, that company can draw from when it's needed. This is a very convenient option, because a company can draw a required amount of money anytime, and once it paid back with the interest, the funds again will be available for drawing.

By Adil Maidanov | 10 November 2020

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