All businesses in order to exist and develop need a capital, which is provided by financing. Financing is the entity of funds required for business operations. In the theory of financial management, there are two main types of funding: internal and external.
Considering external funds, these sources require inclusion of a person, who is not among directors or managers. On the other hand, internal sources of financing do not require the participation of the other sides. They appear as a result of administrative decisions. Internal sources are a form of traditional investment in any company.
There are two basic interpretations of the nature and classification of internal funding sources. The first approach focuses on the financial results, the second one – on cash flow. The internal sources of finance companies mainly include the following: net income, depreciation and other costs and fees. There is a debatable question about the inclusion of the percents, dividends, proceeds from the sale of non-current assets, financial investments, etc. into the internal sources.
As a part of the internal sources of funds, important place belongs to the profits which remain in the company. It forms the largest part of its own financial resources, provides the growth of the equity capital, as well as the growth of market enterprise value. Depreciation plays an important role in the internal sources, especially in companies with high costs of their fixed assets and intangible assets (National Bureau of Economic Research, 2012). Although, they do not increase the amount of equity, they are important in the reinvestment process. Other internal sources do not play a significant role in forming their own financial resources.
There are two types of external funds, according to the time periods: short and long term. Long term financing includes equity capital and borrowed funds. Short-term funding source is the bank overdrafts, commercial papers, sales of debt obligations and loans against receivables. External sources of funding for small businesses may be commercial banks or non-bank financial institutions; for instance, insurance companies, trust companies, investment funds, investment companies, private firms, government and regional programs, the sale of shares, funds from family and friends and many others. There are also non-bank creditors, family and friends, private and public equity and bank loans. Other external sources of funding can allocate funds from family and friends. It is not the major source of its size and timing. These funds are used for the formation of start-up capital or in extraordinary cases, the operation of the business (Price, 2001).
Banks impose some requirements for small firms. Firstly, the owner of a small firm should invest in the project 25-50% of own funds. Secondly, banks require guarantees as collateral for a loan. Thirdly, some banks often prescribe small firms' interest above the base rate for large corporations. Short term loans can be provided by banks in case of temporary financial difficulty that arises in connection with the costs of production and turnover. Medium term loans may be available to pay for equipment, operating costs and financing investment. Long term loans provide the formation of the core. Credit costs are mostly used for renovation, modernization and expansion of existing major funds for new construction, privatization and so on. Bank gives loans to the entrepreneurs for the debtors by opening margin deposit accounts (Halloran, 1992).
The specific character of internal and external financing impacts the features of financial decisions. For a company, which occupies a strong position in its business and does not intend to significantly expand its involvement with significant resources, decisions on financial matters are automatically close. In this case, monetary policy is to hold the well-defined dividend policy, which establishes, for example, the regular payment of dividends to shareholders in the form of one-third or other parts of the profit. In addition to that, monetary policy affects the maintenance of bank credit line that is ensuring the needs of the corporation established stable credit resources within the limits agreed with the bank. For managers it typically requires less time and effort to make such decisions on internal fixation, than in the case of external financing.
If a corporation attracts funds from external sources, which may be needed for large-scale expansion of its business, managerial decisions are more complex and require more time (Price, 2001). The external investors usually want to see detailed plans for the use of their funds, and also want to make sure that the investment projects of companies provide cash flow sufficient to cover costs and make a profit. They carefully study the plans and corporations about the prospects of success and are more skeptical than their managers.
Thus, the use of external financing puts the company in close dependence on the capital markets, access to which is associated with higher requirements to the investment plans of the corporation, than the use of sources of domestic financing.
Although, the main role in financing the enterprise is having enough money because the use of equity has a number of advantages and it indicates a high level of financial stability of the company. Sixty percent of corporations use external funds as financing sources, while only forty percent of funds are internally raised (National Bureau of Economic Research, 2012). However, all of the above discussed operations depend on the company choices.
In order to determine the best sources of financing, it is necessary to conduct a company analysis. The informed choice of funds increases the successful results of the used load enterprise.