ABU DHABI INDIAN SCHOOL - BRANCH 1, AL WATHBA

Grade 11 Subject: Business Studies

Unit – 8 Chapter: Sources of Business Finance
CONCEPT OF BUSINESS FINANCE:
The term finance means money or fund. The requirement of funds by business to carry out its
various activities is called business finance. For carrying out various activities, business requires
money. Finance, therefore is called the life blood of any business.
1.Why do businesses need funds? Explain.
Answer: The need of fund arises from the stage when an entrepreneur makes a decision to start a
business. The financial need of a business can be categorized in the following ways:

• Fixed Capital Requirements: In order to start business, funds are required to purchase fixed
assets like land and building, plant and machinery, and furniture and fixtures. This is known
as fixed capital requirement of an enterprise.
• Working Capital Requirements: Business needs funds for its day-to-day operations. This is
known as working capital of an enterprise which is used for holding current assets like stock,
bill receivable, current expenses etc.
• Therefore, a business needs funds to meet its fixed as well as working capital requirements.

Question 2. What is the difference between internal and external sources of raising funds?
Explain.
Answer: The differences between internal and external sources of raising funds are summarized in
the table given as follows:

Question 3 : Difference between Owners Fund and Borrowed Fund

 Sources of Raising Fund

On the basis of Ownership

Owner’s Fund Borrowed Fund

Equity Share Debentures

Preference Share Loan from Financial Retained Retained
Earnings Institutions
Loan from Commercial banks
Public deposit
Trade Credit
Inter Corporate Deposit
Sources of Raising Fund

On the basis of Generation

Internal Sources External Sources

• Equity Share Debentures

• Retained Earnings Loan from Financial Institutions
Loan from Commercial banks
Public deposit
Trade Credit
Inter Corporate Deposit

INTERNAL SOURCES OF FINANCE : - Equity Shares , Retained Earnings and Preference Shares

1. Equity Share: It is the most important source of long-term finance. The money raised by issue of
equity shares is known as “equity share capital.” Equity shares represent the ownership of a
company. Equity shareholders do not get a fixed dividend. They receive what is left over after
meeting all other claims. Therefore the equity shareholders are known as “residual owners.”
They have right to vote and right to participate in the management. Equity shareholders are the
primary risk-bearers, but they enjoy high returns in the year of prosperity.
ADVANTAGES/MERITS:
1. It is suitable for investors who are willing to take risk.
2. Payment of dividend to the equity shareholders are not compulsory. Therefore, no burden on
the company.
3. Equity share capital is considered as permanent capital as it is to be repaid only at the time of
liquidation of a company.
4. Equity shareholders provides credit worthiness to the company.
5. Funds can be raised through equity issue without creating any charge on the assets of the
company.
6. Democratic control over management of the company due to voting rights of the equity share
holders.
 LIMITATIONS/DEMERITS :
1. Investors who want steady income may not prefer equity shares.
2. The cost of equity shares is generally more as compared to cost of the raising funds.
3. Issue of additional equity shares dilutes the voting power and earnings of equity
shareholders.
4. More formalities and Procedural delays are involved while issuing equity shares.
2. RETAINED EARNINGS: -
The portion of company’s net profits after tax and preference dividend which is not distributed as
equity dividend but are retained for reinvestment purpose, is called “retained earnings.”
Retained earnings is also called Source of Self-financing or Ploughing back of profits.
Merits
1. It is a permanent source of finance.
2. It does not involve any explicit cost in the form of interest, dividend etc.
3. It enhances the capacity of business.
4. It may lead to increase in the market price of the equity shares.
5. There is greater degree of operational freedom and flexibility.
Demerits:
1. Dissatisfaction among the shareholders as they get lower dividends.
2. It is an uncertain source of fund as profits are fluctuating.
3. The opportunity cost associated with these funds is not recognized by many firms.
3. Preference Share:-
Preference shares are considered safer in investment. (as compared to equity shares) They
receive dividend at a fixed rate. They have no voting right. The preference shareholders enjoy
the following two preferential positions over equity shareholders;
• The rate of dividend payable to them is fixed and is paid before any dividend is declared for
equity shareholders.
• At the time of liquidation of a company their capital is returned before any payment is made
to equity shareholders but after the claims of the company’s creditors have been settled.
MERITS OF PREFERENCE SHARES:
1. Preference shareholders don’t have voting right; they do not affect the control of equity
shareholders over the management of the company.
2. Investors who want fixed rate of return with comparatively low risk prefer to invest in
preference shares.
3. They do not create any charge on the assets of the company.
4. Since the dividend payable to preference shareholders is fixed, therefore a company is in a
position to declare high rates of dividend for equity shareholders during higher profits.
5. They give a preferential right to repayment of capital over equity shareholders at the time of
winding up of the company.
LIMITATIONS /DEMERITS:
1. Costly sources of funds: Rate of preference dividend is greater than rate of interest on
debenture, for a company it is costly source of funds than Debentures.
2. No tax saving: Preference dividend is not deductible from profit for income tax. Therefore,
there is no tax saving.
3. Not suitable for risk takers - Preference shares are not suitable for those who are willing to
take risk for higher return.
4. Burden on the Company: Even in the years of losses, preference dividend has to be paid.
TYPES of Preference Shares

1. Cumulative and Non-Cumulative: The preference shares which enjoy the right to accumulate
unpaid dividends in the future years, in case the same is not paid during a year are known as
cumulative preference shares. On the other hand, on non-cumulative shares, dividend is not
accumulated if it is not paid in a particular year.

2. Participating and Non-Participating: Preference shares which have a right to participate in the
further surplus of a company shares which after dividend at a certain rate has been paid on equity
shares are called participating preference shares. The non-participating preference are such which
do not enjoy such rights of participation in the profits of the company.

3. Convertible and Non-Convertible: Preference shares that can be converted into equity shares
within a specified period of time are known as convertible preference shares. On the other hand,
non-convertible shares are such that cannot be converted into equity shares.

Difference between Equity Shares and Preference Shares

Basis Equity Shares Preference Shares
Face Value The face value of equity shares The face value of preference share is
in generally low. generally high.
Dividend The dividend is paid to equity Preference shareholders get a fixed
shareholders after paying rate of dividend before equity
dividend to all including shareholders.
preference shares.
Voting rights Equity shareholders get all the No voting rights under normal
voting rights in a company. conditions. They get voting right if
the dividend is not paid for two
years.
Attraction The equity shares attract bold The preference shares attract
and adventurous investors. cautious and conservative investors.
Risk The equity shareholders are the The risk involved in preference share
primary risk bearers of the is relatively less.
company.
Refund of At the time of winding up, the At the time of winding up, preference
capital equity shareholders are shares get priority over equity shares
refunded only after preference for refund of capital.
shares are paid.
Redemption The equity shares are never Preference shares may be redeemed
redeemed or paid back during on expiry of a fixed period of time or
the life time of the company. at the option of the company.
BORROWED FUND:
I. Debentures: Debentures are the important debt sources of finance for raising long term
finance. Debenture holders get fixed rate of interest on Debentures. Interest is paid after
every six months or one year. They are like creditors of a company.
MERITS OF DEBENTURES:
1. Investment is Safe: Debentures are preferred by those investors who do not want to take risk
and are interested in fixed income.
2. Control: Debenture holders do not have voting rights so they do not have any control over the
management of the company.
3. Less Costly: Debentures are less costly as compared to cost of preference shares.
4. Tax Saving: Interest on Debentures is a tax deductible expense. Therefore, there is a tax
saving.
LIMITATION OF DEBENTURES:
1. Fixed Obligation: There is a greater risk when there is no earning because interest on
debentures has to be paid even if the company suffers losses.
2. Charge on assets: The Company has to mortgage its assets to issue Secured Debentures.
3. Reduction in Credibility: Each company has a certain borrowing capacity. With the new issue of
debentures, the company’s capability to further borrow funds is reduced.
4. In case of redeemable debentures, the company must make provisions for repayment
after a specified period.
TYPES OF DEBENTURES:
1. Secured and Unsecured: Secured debentures are such which create a charge on the assets of
the company, thereby mortgaging the assets of the company. Unsecured debentures on the other
hand do not carry any charge or security on the assets of the company.
2. Registered and Bearer: Registered debentures are those which are duly recorded in the
register of debenture holders maintained by the company. These can be transferred only through a
regular instrument of transfer. In contrast, the debentures which are transferable by mere delivery
are called bearer debentures.
3. Convertible and Non-Convertible: Convertible debentures are those debentures that can be
converted into equity shares after the expiry of a specified period. On the other hand, non-
convertible debentures are those which cannot be converted into equity shares.
4. First and Second: Debentures that are repaid before other debentures are repaid are known as
first debentures. The second debentures are those which are paid after the first debentures have
been paid back.
2. TRADE CREDIT:
Trade Credit is the credit extended by one trader to another for the purchase of goods and services.
It is commonly used by business organisations as a source of short-term financing. It appears in the
record of the buyer of goods as “sundry creditors or “accounts payable”. It’s a short term finance. It
is granted to those customers who have reasonable amount of financial standing and goodwill.
MERITS:
1. Trade credit facilitates the purchase of goods and services without immediate payment.
2. It is a convenient and continuous source of short-term funds.
3. Trade credit may be readily available if the credit-worthiness of the customer is good.
4. Trade credit does not create any charge on the assets of the firm.
5. It promotes the sale of goods and services.
DEMERITS:
1. Trade credit may result in overtrading which increases the risk of the firm.
2. Only limited amount of funds can be generated through trade credit.
3. Trade credit is a costly source of raising fund as compared to other sources.

3. PUBLIC DEPOSITS:
Public Deposits refer to the unsecured deposits or money invited by companies from the public
mainly to finance their short or long-term working capital needs. The organisation in return
issues a deposit receipt as acknowledgement of the debt. Companies generally invite public
deposits for a period up to three years. The rate of interest offered on public deposits are higher
than the rate of interest on bank deposits. This is regulated by the R.B.I. and cannot exceed 25%
of share capital and reserves.
 Merits:
1. Public deposits are beneficial both to the depositor as well as the organization. While the
depositor gets a higher rate than banks, the cost of public deposits to the company is less
than the cost of borrowings from banks and financial institutions.
2. As the depositors do not have voting rights, the control of the company is not diluted.
3. Public deposits do not usually create any charge on the assets of the company.
4. Interest paid on public deposits is tax deductible: hence, there is tax savings.
5. The procedure for obtaining public deposits is simpler than equity and debenture issues.
Demerits:
1. For Short Term Finance: The maturity period is short. The company cannot depend on
them for long term.
2. Limited fund: The quantum of public deposit is limited because of legal restrictions 25%
of share capital and free reserves.
3. Not Suitable for New Company: New company generally find difficulty to raise funds
through public deposits.
IV. COMMERCIAL BANKS: Commercial Banks give loan and advances to business in the form of
cash credit, overdraft loans, term loans and discounting of Bill. Rate of interest on loan is fixed.
Borrowing from commercial banks are short –term or medium-term finance. The borrower is
required to provide some security or create a charge on the assets of the firm before a loan is
sanctioned by the commercial bank.
Merits :
1. Banks provide timely assistance to business by providing funds as and when required.
2. Secrecy of business can be maintained as the information supplied to the bank by the
borrowers is kept confidential.
3. Formalities such as issue of prospectus and underwriting are not required.
4. Loan from bank is a flexible source of finance as the loan amount can be increased
according to the business needs.
Demerits:
1. Funds are generally available for a short period and its extension or renewal is
uncertain.
2. Banks may make detailed investigations on the company’s affairs.
3. In some cases, difficult terms and conditions are imposed by banks.

V.FINANCIAL INSTITUTION:

The state and central government have established many financial institutions to provide finance
to companies. They provide both owned capital and loan capital for long term and medium-term
requirements. In addition to providing financial assistance, these institutions also conduct
market surveys and provide technical assistance and managerial service to people who run the
enterprise. Such banks are also known as development Banks. These are IFCI, ICICI, IDBI, LIC
and UTI. etc.
Merits :-
1. Financial Institutions provide long term finance, which are not provided by commercial
banks.
2. These financial institutions provide financial, managerial and technical advice and
consultancy to business firms.
3. Loan from financial institutions increases the goodwill of the borrowing company.
4. The funds are made available even during the period of depression.
5. It won’t be a burden on the business, as repayment of loan can be made in easy instalments.
 Demerits:-
1. Financial institutions follow rigid criteria to grant loans.
2. Financial institutions impose certain restrictions on the borrowing company on dividend
payment.
3. Financial institutions may have their nominees on the Board of Directions of the borrowing
Company thereby restricting the powers of the company.
VII. Inter-Corporate Deposits (ICD)
Inter-Corporate Deposits are unsecured short term deposits made by one company with another
company. These deposits are essentially brokered deposits, which led to the involvement of
brokers. The rate of interest on their deposits is higher than that of banks and other markets. The
biggest advantage of ICDs is that the transaction is free from legal hassles.
Type of lCDs

1. Three Months Deposits - These deposits are most popular type of ICDS. These deposits are
generally considered by borrowers to solve problems of short term capital adequacy. The annual
rate of interest for these deposits is around 12%.
2. Six months Deposits - It is usually made first class borrowers. The annual rate of interest for
these deposits is around 15%
3. Call deposits - This deposit can be withdrawn by the lender on a day’s notice. The annual rate of
interest on call deposits is around 10%
Features of ICDs
1. These transactions takes place between two companies.
2. There are short term deposits.
3. These are unsecured deposits.
4. These transactions are generally completed through brokers.
5. These deposits have no organized market.
6. These deposits have no legal formalities.
7. These are risky deposits from the point of view of lenders.
Merits:-
• No much of legal formalities required.
• Good source of working capital.
• Secrecy maintained as deals initiated through brokers.
Demerits:
• Not suitable for long-term finance.
• High rate of interest compared to bank and other lending.
• Risky deposits from lenders perspective.

As a source of finance retained profit is better than other sources. Do you agree with this
view? Give reasons for your answer.
Answer: Yes, we agree. Retained earnings are better than other sources of finance because:

• Retained earnings is a permanent source of funds which an organization can avail of.
• It enhances capacity of the business to absorb unexpected losses.
• It does not involve any explicit cost in the form of interest, dividend or flotation cost.
• It may increase the process of equity shares of a company.
• There is a greater degree of operational freedom and flexibility as the funds are generated
internally.
Differentiate between Equity Shares and Debentures
Basis Equity Shares Debentures
Nature Shares are considered as a part Debentures are part of borrowed fund.
of owner’s fund.
Status Shareholders are known as the Debenture holders are known as
owners of the company. creditors of the company.
Voting rights Shareholders get voting rights. Debenture holders do not get voting
rights.
Control The control of the company lies in Debenture holders have no control over
the hands of equity shareholders. the affairs of the company.

Right to return Equity shareholders have no right Debenture holders have legal right to get
to get regular return in case of loss. regular amount of interest even when
company is not earning profit.
Security No assets of the company are Company has to mortgage some of its
mortgaged as security against the assets as a security against the
issue of shares. debentures.
Redemption Except redeemable preference Debentures are generally redeemed on
shares no shares are redeemable. expiry of a fixed period of time.
They are paid back at the time of
winding up, only after settling the
claim of all the claimants.

Convertibility Shares can’t be converted into Debentures can be converted into shares.
debentures.
Risk Shareholders are the primary risk There is minimum risk in case of
bearers of the company. debentures.