Chapter 8

Sources of Business Finance

For carrying out various activities, business requires money. Finance, therefore, is called the
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life blood of any business. The requirements of funds by business to carry out its various
activities is called business finance.

Nature/Features of Business Finance

. A business cannot function unless adequate funds are made available to it. For
carrying out various activities, business requires money.
. The initial capital contributed by the entrepreneur is not always sufficient to take care
of all financial requirements of the business. A business person, therefore, has to look
for different other sources from where the need for funds can be met.

Importance/Significance of Business Finance

Finance is needed for the following reasons:

. Fixed capital requirements

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● In order to start business, funds are required to purchase fixed assets. This is known
as fixed capital requirements of the enterprise.
● The funds required in fixed assets remain invested in the business for a long period of
time.
● Different business units need varying amount of fixed capital depending on various
factors such as the nature of business, scale of operations, growth and expansion of
business, etc.

–
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Nature of business: A trading concern for example, may require small amount of fixed
capital as compared to a manufacturing concern.
–
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Scale of operations: The need for fixed capital investment would be greater for a large
enterprise, as compared to that of a small enterprise.
– Growth and expansion of business: The requirement for working capital increases
with the growth and expansion of business.

. Working Capital requirements

● The financial requirements of an enterprise do not end with the procurement of fixed
assets. A 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 and for meeting current expense.
● The amount of working capital required varies from one business concern to another
depending on various factors such as basis of sales, sales turnover, growth and
expansion of business, technology upgradation, seasonal factors, etc.

– A business unit selling goods on credit, or having a slow sales turnover would require
more working capital as compared to a concern selling its goods and services on cash
basis or having a speedier turnover.
– The requirement for working capital increases with the growth and expansion of
business.
– At times additional funds are required for upgrading the technology employed so that
the cost of production or operations can be reduced.
– Similarly, larger funds may be required for building higher inventories for the festive
season or to meet current debts or expand the business or to shift to a new location.

Classification of Sources of Funds

. Period Basis

● The long-term sources fulfil the financial requirements of an enterprise for a period
exceeding 5 years. Such financing is generally required for the acquisition of fixed
assets such as equipment, plant, etc.
● Where the funds are required for a period of more than one year but less than five
years, medium-term sources of finance are used.
● Short-term funds are those which are required for a period not exceeding one year.
● Short-term financing is most common for financing of current assets such as accounts
receivable and inventories. Seasonal businesses that must build inventories in
anticipation of selling requirements often need short-term financing for the interim
period between seasons.
● Wholesalers and manufacturers with a major portion of their assets tied up in
inventories or receivables also require large amount of funds for a short period.

. Ownership Basis
 . Source of Generation Basis

● Internal sources of funds are those that are generated from within the business. A
business, for example, can generate funds internally by accelerating collection of
receivables, disposing of surplus inventories and ploughing back its profit. The internal
sources of funds can fulfill only limited needs of the business.
● External sources of funds include those sources that lie outside an organisation, such
as suppliers, lenders, and investors. When large amount of money is required to be
raised, it is generally done through the use of external sources. External funds may be
costly as compared to those raised through internal sources.
● In some cases, business is required to mortgage its assets as security while obtaining
funds from external sources.

Retained Earnings

● A company generally does not distribute all its earnings amongst the shareholders as
dividends. A portion of the net earnings may be retained in the business for use in the
future. This is known as retained earnings.
● It is a source of internal financing or self-financing or 'ploughing back of profits’.

Features/ Merits

. Retained earnings is a permanent source of funds available to an organisation.

. It does not involve any explicit cost in the form of interest, dividend or floatation cost.
. As the funds are generated internally, there is a greater degree of operational
freedom and flexibility.
. It enhances the capacity of the business to absorb unexpected losses.
. It may lead to increase in the market price of the equity shares of a company.

Limitations

. Excessive ploughing back may cause dissatisfaction amongst the shareholders as they
would get lower dividends.
. It is an uncertain source of funds as the profits of business are fluctuating.
. The opportunity cost associated with these funds is not recognized by many firms.
This may lead to sub-optimal use of the funds.

Trade Credit (Bills of Exchange) (Purchasers POV)

Trade credit is the credit extended by one trader to another for the purchase of goods and
services.

● Trade credit facilitates the purchase of supplies without immediate payment. The
borrower does not receive any cash, but gets its supplies on credit.
● Trade credit is commonly used by business organisations as a source of short-term
financing.
● It is granted to those customers who have reasonable amount of financial standing and
goodwill.
● The volume and period of credit extended depends on factors such as reputation of the
purchasing firm, financial position of the seller, volume of purchases, past record of
payment and degree of competition in the market.
● Terms of trade credit may vary from one industry to another and from one person to
another. A firm may also offer different credit terms to different customers.

Features/Merits

. Trade credit is a convenient and continuous source of funds.

. Trade credit may be readily available in case the credit worthiness of the customers
is known to the seller.
. Trade credit needs to promote the sales of an organisation.
. If an organisation wants to increase its inventory level in order to meet expected rise in
the sales volume in the near future, it may use trade credit to, finance the same.
. It does not create any charge on the assets of the firm while providing funds.

Limitations

. Availability of easy and flexible trade credit facilities may induce a firm to indulge in
overtrading, which may add to the risks of the firm;
. Only limited amount of funds can be generated through trade credit;
. It is generally a costly source of funds as compared to most other sources of raising
money.

Public Deposits

The deposits that are raised by organisations directly from the public are known as public
deposits.

● Companies generally invite public deposits for a period up to three years.

● Rates of interest offered on public deposits are usually higher than that offered on
bank deposits.
● The acceptance of public deposits is regulated by the Reserve Bank of India.
 ● Any person who is interested in depositing money in an organisation can do so by
filling up a prescribed form. The organisation in return issues a deposit receipt as
acknowledgment of the debt.
● Public deposits can take care of both medium and short-term financial requirements of
a business.
● Public deposits are beneficial to both the depositor as well as to the organisation.
While the depositors get higher interest rate than that offered by banks, the cost of
deposits to the company is less than the cost of borrowings from banks.

Features/Merits

. The procedure of obtaining deposits is simple ana does not contain restrictive
conditions as are generally there in a loan agreement.
. Cost of public deposits is generally lower than the cost of borrowings from banks and
financial institutions.
. Public deposits do not usually create any charge on the assets of the company. The
assets can be used as security for raising loans from other sources.
. As the depositors do not have voting rights, the control of the company is not diluted.

Limitations

. New companies generally find it difficult to raise funds through public deposits;
. It is an unreliable source of finance as the public may not respond when the company
needs money;
. Collection of public deposits may prove difficult, particularly when the size of deposits
required is large.

Issue of Shares

– The capital obtained by issue of shares is known as share capital.

– The capital of a company is divided into small units called shares. Each share has its
nominal value. The person holding the share is known as shareholder.

. Equity Shares

Equity shares is the most important source of raising long term capital by a company. Equity
shares represent the ownership of a company and thus the capital raised by issue of such
shares is known as ownership capital or owner's funds.

● Equity share capital is a pre-requisite to the creation of a company.

 ● Equity shareholders do not get a fixed dividend but are paid on the basis of earnings
by the company.
● 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.
● They enjoy the reward as well as bear the risk of ownership. Their liability, is limited to
the extent of capital contributed by them in the company.
● Through their right to vote, equity shareholders have a right to participate in the
management of the company.

Features/Merits

. Equity shares are suitable for investors who are willing to assume risk for higher
returns;
. Payment of dividend to the equity shareholders is not compulsory. Therefore, there is
no burden on the company in this respect.
. Equity capital serves as permanent capital as it is to be repaid only at the time of
liquidation of a company. As it stands last in the list of claims, it provides a cushion for
creditors, in the event of winding up of a company.
. Equity capital provides credit worthiness to the company and confidence to
prospective loan providers;
. Funds can be raised through equity issue without creating any charge on the assets of
the company. The assets of a company are, therefore, free to be mortgaged for the
purpose of borrowings, if the need be.
. Democratic control over management of the company is assured due to voting rights of
equity shareholders.

Limitations

. Investors who want steady income may not prefer equity shares as equity shares get
fluctuating returns;
. The cost of equity shares is generally more as compared to the cost of raising funds
through other sources;
. Issue of additional equity shares dilutes the voting power, and earnings of existing
equity shareholders;
. More formalities and procedural delays are involved while raising funds through issue
of equity share.

. Preference Shares

The capital raised by issue of preference shares is called preference share capital.
The preference shareholders enjoy a preferential position over equity shareholders in two
ways:

● Receiving a fixed rate of dividend, out of the net profits of the company, before any
dividend is declared for equity shareholders; and
● Receiving their capital after the claims of the company's creditors have been settled,
at the time of liquidation.
● Preference shareholders generally do not enjoy any voting rights.

Preference shares resemble debentures as they bear fixed rate of return. Also as the
dividend is payable only at the discretion of the directors and only out of profit after tax, to
that extent, these resemble equity shares. Thus, preference shares have some
characteristics of both equity shares and debentures.

Features/Merits

. Preference shares provide reasonably steady income in the form of fixed rate of return.
Thus, preference shares are useful for those investors who want fixed rate of return.
. It does not affect the control of equity shareholders over the management as
preference shareholders don't have voting rights.
. Payment of fixed rate of dividend to preference shares may enable a company to
declare higher rates of dividend for the equity shareholders in good times.
. Preference shareholders have a preferential right of repayment over equity
shareholders in the event of liquidation of a company.
. Preference capital does not create any sort of charge against the assets of a
company.

Limitations

. Preference shares are not suitable for those investors who are willing to take risk and
are interested in higher returns;
. Preference capital dilutes the claims of equity shareholders over assets of the
company;
. The rate of dividend on preference shares is generally higher than the rate of interest
on debentures;
. As the dividend on these shares is to be paid only when the company earns profit,
there is no assured return for the investors. Thus, these shares may not be very
attractive to the investors;
. The dividend paid is not deductible from profits as expense. Thus, there is no tax
saving as in the case of interest on loans.
Debentures

Debentures are an important instrument for raising long-term debt capital. A company can
raise funds through issue of debentures, which bear a fixed rate of interest.

● The debenture issued by a company is an acknowledgment that the company has

borrowed a certain amount of money, which it promises to repay at a future date.
● Debenture holders are, therefore, termed as creditors of the company. Debenture
holders are paid a fixed stated amount of interest at specified intervals.
● 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.
● Issue of Zero Interest Debentures (ZID) which do not carry any explicit rate of interest
has also become popular in recent years. The difference between the face value of the
debenture and its purchase price is the return to the investor.

Features/Merits

. It is preferred by investors who want fixed income at lesser risk.

. Debentures are fixed charge funds and do not participate in profits of the company.
. The issue of debentures is suitable in the situation when the sales and earnings are
relatively stable.
. As debentures do not carry voting rights, financing through debentures does not
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dilute control of equity shareholders on management.
. Financing through debentures is less costly as compared to cost of preference or
equity capital as the interest payment on debentures is tax deductible.

Limitations

. As fixed charge instruments, debentures put a permanent burden on the earnings of a

company. There is a greater risk when earnings of the company fluctuate;
. In case of redeemable debentures, the company has to make provisions for repayment
on the specified date, even during periods of financial difficulty;
. Each company has certain borrowing capacity. With the issue of debentures, the
capacity of a company to further borrow funds reduces.

Commercial Banks

Commercial banks occupy a vital position as they provide funds for different purposes as
well as for different time periods.

Banks extend loans to firms of all sizes and in many ways:

(i) Cash credits
(ii) Bank overdrafts
(iii) Term loans
(iv) Purchase/discounting of bills
(v) Issue of letter of credit

● The rate of interest charged by banks depends on various factors such as the
characteristics of the firm and the level of interest rates in the economy.
● The loan is repaid either in lump sum or in installments.
● Bank credit is not a permanent source of funds. Though banks have started extending
loans for longer periods, generally such loans are used for medium to short periods.
● 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.

Features/ Merits

. Banks provide timely assistance to business by providing funds as and when needed
by it.
. Secrecy of business can be maintained as the information supplied to the bank by the
borrowers is kept confidential.
. Formalities such as issue of prospectus and underwriting are not required for raising
loans from a bank. This, therefore, is an easier source of funds.
. Loan from a bank is a flexible source of finance as the loan amount can be increased
according to business needs and can be repaid in advance when funds are not needed.

Limitations

. Funds are generally available for short periods and its extension or renewal is uncertain
and difficult;
. Banks make detailed investigation of the company's affairs, financial structure etc.,
and may also ask for security of assets and personal sureties. This makes the
procedure of obtaining funds slightly difficult;
. In some cases, difficult terms and conditions are imposed by banks. for the grant of
loan. For example, restrictions may be imposed on the sale of mortgaged goods, thus
making normal business working difficult.

Financial Institutions

The government has established a number of financial institutions all over the country to
provide finance to business organisations.
 ● These institutions are established by the central as well as state governments.
● They provide loan capital for long and medium term requirements.
● This source of financing is considered suitable when large funds for longer duration
are required for expansion, reorganisation and modernisation of an enterprise.

As financial institutions aim at promoting the industrial development of a country, these are
also called 'development banks'.

Features/Merits

. Financial institutions provide long-term finance, which are not provided by

commercial banks.
. Besides providing funds, many of these institutions provide financial, managerial and
technical advice and consultancy to business firms;
. Obtaining loan from financial institutions increases the goodwill of the borrowing
company in the capital market. Consequently, such a company can raise funds easily
from other sources as well.
. As repayment of loan can be made in easy instalments, it does not prove to be much of
a burden on the business;
. The funds are made available even during periods of depression, when other sources
of finance are not available.

Limitations

. Financial institutions follow rigid criteria for grant of loans. Too many formalities make
the procedure time consuming and expensive;
. Certain restrictions such as restriction on dividend payment are imposed on the
powers of the borrowing company by the financial institutions;
. Financial institutions may have their nominees on the Board of Directors of the
borrowing company thereby restricting the powers of the company.
Call Deposits- Hourly Basis