Ch 7

Sources of business finance

Meaning of Business finance

1. The requirement of funds by business to carry out its various activities is called business
finance.
2. It also refers to the management of cash and credit in the organization not only to meet the day
to day expenses of the organization but also for its growth expansion and diversification.

Need/ Importance of business finance

1. Establishment Expenses: Preliminary expenses, promotion expenses, fees paid to specialist for
setting up of the business etc.
2. Cost of Procuring Finance: Underwriting commission, brokerage, issue of prospectus, commission
etc.
3. for procuring fixed assets: Like land, building, plant and machinery etc.
4. for procuring current assets: Like cash, raw material, payment of expenses etc.
5. for procuring intangible assets: Like patents, goodwill, copyright, trademark etc.
6. Procuring funds for growth, expansion and diversification.

Financial needs are categorized in two categories

1. Fixed Capital Requirement 2. Working Capital Requirement

1. The capital required for buying fixed 1. The funds required for holding the
assets of the business is known as current assets such as stock of
fixed capital requirement because material, debtors, cash bills
the funds required for fixed assets receivables and for day-to-day
remain invested in the business for expenses like salaries, rent, wages
a long period of time. etc. are called as working capital of
2. Fixed assets means those assets the business.
which will remain in the business 2. Depends on various factors such as
for a long period such as land, basis of sales, sales turnover,
building, Machinery, Furniture etc. technology up gradation, seasonal
3. Depends on factors like nature of factors etc.
business, scale of operations and
growth of business.
 Sources of finance on the basis of ownership

1. Owners’ funds 2. Borrowed funds

1. Owner‘s funds means funds that are 1. Borrowed funds refer to the funds
provided by the owners of an raised through loans or borrowings.
enterprise, Apart from capital, 2. The sources for raising borrowed
2. It also includes profits reinvested in funds include loans from
the business. commercial banks, loans from
3. Issue of equity shares and retained financial institutions, issue of
earnings are the two important debentures, public deposits and
sources from where owner‘s funds trade credit.
can be obtained.

Difference between owners’ funds and borrowed funds

 Types of owners’ funds
1. Retained Earnings/Ploughing back of Profit
a. The part of profits which is invested in business rather than distributing it as dividend to the
shareholders is known as retained earnings. It is a source of internal financing or self-
financing or ‘ploughing back of profits‘.
b. The profit available for ploughing back in an organisation depends on many factors like net
profits, dividend policy and age of the organisation.
c. A permanent source of funds
d. Does not involve any explicit cost like interest, dividend etc.
e. As it is a source of internal financing, there is a greater degree of operational
freedom.
f. Business is able to absorb unexpected losses better.
g. Sometimes, excessive ploughing causes dissatisfaction amongst the shareholders.

2. Shares
a. The capital of the company is divided into small indivisible unit known as share.
b. Each share has its nominal value. For example, a company can issue 1, 00, 000 shares of ₹ 10
each for a total value of ₹ 10, 00, 000.
c. Company issues shares to raise the funds as capital.
d. The persons who subscribe the shares are called shareholders.
e. They are the owners of company and receive share of the profits every year which is known as
dividend.

Types of Shares
There are two types of shares:
1. Equity Shares
2. Preference Shares

Equity Shares
a. This capital is a pre-requisite to the creation of a company.
b. These are those shares which do not impose any obligation on the company to pay fixed rate of
dividend to their holders.
c. Equity shares carry voting rights in the company.
d. It means equity shareholders have right to participate in the management of the company.
e. They are referred to as ‘residual owners’ since they receive what is left after all other claims on
the company’s income and assets have been settled.
f. They enjoy the reward as well as bear the risk of ownership.
g. They have limited liability.

Preference Shares
a. These are those shares which carry following two preferential rights over equity shares:
i. At the time of distribution of dividend, preference shareholders get dividend at fixed
rate before any dividend paid to equity shareholders; and
 ii. At the time of liquidation of the company, preference shareholder is repaid before
equity shareholders.
b. They do not carry any voting rights.
c. They carry characteristics of both debentures and equity shares.
i. Resemble debentures – carry fixed rate of return
ii. Resemble equity shares – dividend is payable on discretion of directors and paid from
profit after tax.

Example: 10% preference shares of ₹1200 each.

Assumption: co. has only 1 pref. sh. And 1 eq. sh.

Types of borrowed funds

1. Debentures
a. Debenture is an acknowledgement of the debt taken by a company which is to be repaid after a
specified period along with interest.
b. The people who buy debentures of a company are called debentureholders and they are the
creditors of the company.
c. Public issue of debentures requires that the issue be rated by a credit rating agency like CRISIL
(Credit Rating and Information Services of India Ltd.) on aspects like track record of the
company, its profitability, debt servicing capacity, credit worthiness and the perceived risk of
lending.
 d. They receive fixed rate of interest at specified intervals.
e. For example: if X ltd. has 1 debentures of ₹1 then annual interest on debentures
1 of ₹1 ₹1
f. Investors who prefer less risk opt for debentures.
g. They do not carry any voting rights.
h. Financing is less costly as interest payment on debentures is tax deductible.
i. Bonds: These are also debt instruments that do not carry a specific rate of interest, but issued
at a heavy discount. The difference between nominal value and issue price is treated as the
amount of interest related to the duration of bonds.

2. Commercial Banks
a. Commercial banks extend loans to firms of all sizes and in many ways, like, cash credits,
overdrafts, term loans, purchase/discounting of bills, and issue of letter of credit.
b. The loan is repaid either in lump sum or in installments.
c. Though banks have started extending loans for longer periods, generally such loans are used for
medium to short periods.
d. The borrower is required to provide some security or create a charge on the assets of the firm
before a loan is sanctioned by a commercial bank.
e. The secrecy of the business remains intact as information of the borrower is kept confidential.
f. Easier source of finance as formalities like issue of prospectus and underwriting is not required.

3. Financial Institutions
a. These institutes are established by the central and state government.
b. Financial institutions provide both owned capital and loan capital for long and medium term
requirements.
 c. Suitable for large funds for longer duration, which are required for modernization, expansion
and diversification.
d. They supplement the traditional financial agencies like commercial banks.
e. As these institutions aim at promoting the industrial development of a country, these are also
called ‘development banks’.
f. In addition to providing financial assistance, these institutions also conduct market surveys and
provide technical assistance and managerial services to people who run the enterprises.
g. They are also available during the time of depression.
h. Raising funds from financial institutions increases the goodwill of the company.
i. Ex: IDBI (Industrial development bank of India) and SFC (State Financial corporation of India)

4. Trade Credit
a. It refers to the credit period offered by the supplier of the goods to the buyer of the goods.
b. The trade credit normally ranges from 30 days to 90 days.
c. Trade credit facilitates the purchase of supplies without immediate payment; they can make
payment on some future date.
d. It is recorded as ‘sundry creditors’ or ‘bills payable’
e. It is a source of short-term financing.
f. It is granted to those customers who have reasonable goodwill and financial position.
g. Credit extended depends on factors like reputation of business firms, volume of purchases, past
record of payment, and degree of competition.

5. Public Deposits
a. The deposits that are raised by organisations directly from the public are known as public
deposits.
b. Rates of interest offered on public deposits are usually higher than that offered on bank
deposits.
c. This source of finance fulfills the short term and medium term capital requirements of the
company.
d. Companies generally invite public deposits for a period upto three years.
e. The acceptance of public deposits is regulated by the Reserve Bank of India.
f. Any person can do so by filling up the prescribed form of the organisation. In turn, company
issues a deposit receipt as acknowledgement of debt.
g. Beneficial to both investor and company, as depositors get higher rate of interest than that
offered by banks, the cost of deposits of the company is less than the cost of borrowings from
the company.

6. Inter corporate Deposits

a. These are unsecured short-term deposits made by a company with another company.
b. It is used for short-term funds insufficiency of a large company.
c. The min. period is 7 days and maximum period can be 1 year.
d. There are three types of Inter corporate deposits:
i. Three month deposits
 ii. Six months deposits
iii. Call deposits
e. Interest can be fixed or floating.
f. Interest rate is usually higher than that of banks.
g. The deal takes place through commission agents.

NOTE: These notes are not exhaustive. Kindly refer to the Business Studies (Subhash Dey) for detailed
explanation.

Sources
KVS Study material
NCERT
Subhash Dey