Last updated: May 29, 2020.
Finding the right source of financing that fits with business goals is a continuing challenge for almost every small business. Sources of finances for small and medium enterprise can be categorized into two types;
- Internal sources /equity financing
- External sources/ debt financing
i) Internal Sources of finance
This is the owner’s contribution to a business and is made up of permanently invested capital and reinvested profits. Internal source of finance is also referred to as equity financing which means the money invested in the venture with no legal obligation for an entrepreneur to repay the principal amount or pay interest on it.
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Types of Equity Financing
- Personal savings
- Partners contributions
- Retained earnings
- Corporations( sell of shares)
Advantages of Equity financing
- No repayment in the form of debt
- It is much safer for new ventures than debt financing
- An entrepreneur can enjoy valuable business assistance from the angel investors
Disadvantages of Equity financing
- It requires shared ownership and profits
- limited capital for venture start-ups
- limited development and growth of a venture(shared decision making slow down its growth)
- It can lead to delayed establishment or operation of a venture.
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ii) Debt financing
It refers to the short term and long term borrowings that can be used to finance the enterprise. Short term borrowings can be of one or less than one year, and long term borrowing can be of 1 to 5 years or more.
The most common sources of finance are Bank borrowings. But there are other forms of debt financing which includes;
- Bank borrowings
- Borrowing from friends and relatives
- Leasing loan stock/credit facilities
- Hire purchase
Advantages of Debt financing
- No shared ownership and profits
- Facilitate fast venture growth and development as more borrowing allows for potentially greater profits
- During the period of low-interest rates, the opportunity cost of borrowing is justified since the cost of borrowing is low.
Disadvantages of Debt Financing
- Regular interest payments are required
- Continual cash flow problems can be intensified due to payback responsibility
- Heavy use of debt can inhibit growth and development.
Further read: Differences between Entrepreneur and Business Person