They are three broad ways of classifying finance. These classifications are:
1. With respect to the propriety interest or otherwise of the providers of the funds.
2. With respect to whether the fund is raised from sources within or outside the business and.
3. With respect to the length of time the money will be used in the business.
Finance can be classified with respect to the proprietary interest of the providers of the funds. If the provider of fund wishes to be an owner or part owner of the business, the finance is classified as equity. But if on the other hand the provider of the funds wishes to remain a lender to the business, the funds so provided is referred to as dept finance. Thus under this method of classification, we have (i) debt finance and (ii) equity finance. In giving examples of these types of finance we shall distinguish between the unincorporated business (Sole Proprietorship and Partnership) and the incorporated (Limited Liability) business.
(a) For the sole proprietorship/partnership types of business units, equity finance will comprise the following:
(i) Cash introduce from previous savings.
(ii) Retained profits.
(b) For the limited liability company equity finance will include the following:
(i) The issued ordinary share capital.
(ii) The founders share capital (if any).
(iii) The preference share capital.
(iv) Retained profits and reserves.
Providers of equity finance are the ultimate risk bearers in the business. This is because they receive their own share of the income (profit) after all prior claims have been settled. In event of liquidation, they also stand at the end of the queue for capital repayment.
Debt finance as we said earlier are provided by those who have only creditor interest in the business. The owners of these funds are considered first in both interest and capital repayment. In most cases, interest is payable on such capital irrespective of the fortunes of the company i.e whether the firm makes profits or not.
(a) Debt finance for limited liability companies will include;
(i) Secured debenture stock with maturity date.
(ii) Naked debenture stock with maturity date.
(iii) Bank loans/overdrafts.
(iv) Directors loans/overdrafts.
(v) Amount due to trade creditors.
For the sole proprietorship/partnership, debt finance include the following:
(i) Montage loans.
(ii) Bank loans/overdrafts.
(iii) Capital introductions by the sole proprietor/partner
(iv) Amount due to trade creditors.
It is possible for one person to have both ownership and creditor interest in the same business i.e he can be a provider of equity finance as well as a provider of debt finance at the same time. An example is where a director of a company who is a part owner thereof lands money to the same company under the heading “Director’s Loan”. The point being made here is that the distinction between debt and equity finance may be made at the level of intentions of their providers..whether to acquire creditor or ownership interest.
The classification of finance according to whether the fund is raised from sources within or outside the business/firm leads to the grouping of finance into:
(i) Internal finance. (ii) external finance
Internal finance refers to funds used in the business which are provided from internal sources.. i.e. sources within the business organization. Internal sources constitute a major source of fund for expansion. This explains why managers of firms look within before they look beyond the firm for necessary funds. Internal sources of fund include the following:
These are profits otherwise available for distribution to shareholders as dividends but which are put back into the business. In periods of high and stable profits retained earnings may constitute a very good source of funds for expansion and growth. This, of course depends on the dividend policy of the firm.
ADVANTAGES OF RETAINED EARNINGS
(i) it enables the firm to expand its operations free from any “conditionalities ” dictated by external bodies.
(ii) The fact that a firm is able to successfully finance its expansion from profits is an indication of financial stability. It thus, strengthens the firms’ credit rating.
(iii) It is a cost-free source of fund.
DISADVANTAGES OF RETAINED EARNINGS
(i) It decreases the investors’ purchasing power through the reduction or complete absence of dividend payment. This implies that this policy may not be adopted by a firm with a large number of shareholders who look forward to substantial regular dividends i.e people who depend on the dividend income for current living if on the other hand the shareholders are few and have a preference for capital growth, retained earnings can be a major source of finance.
(ii) It reduces the demand in the money market and in consequence tends to reduce the number of investment outlets for individual savings.
PROVISION FOR TAX
Corporation tax is usually not paid to the board on Inland Revenue until about one year after the provision was made. This implies that the money meant for the payment of tax would still be used in the firm for as long as it is not paid. Though the profit and loss account has been debited no outward payment has been made. And for as long as the money has not been paid out, the firm uses it.
PROVISION FOR DEPRESSION
Another internal source of fund is the provision for depreciation. Depreciation is only a charge on the profit and loss account and does not imply an actual outflow of cash from the firm. It’s effect is therefore like that of retained earnings in the business. Perhaps, this may be made clearer when we understand that depreciation is simply the accountants way of apportioning the cost of an asset over its useful life. Thus the depreciated amount each year is not paid out to any person/organization.
The financial requirements of modern firms are so large that they can hardly be met from internal sources alone. Hence the need to look beyond internal sources for necessary funds both for starting the business for eventual expansion. Sources of external finance include:
(i) Trade creditors
(ii) Bank overdrafts
(iv) Bank loans
(vi) Hire purchase
(viii) Preference and ordinary shares
External finance therefore refers to all funds raised from sources outside the firm.