Chapter 8 – Sources Of Business Finance

Meaning: Requiring funds or capital to run various business activities.

Financing: process of raising money

A clear assessment or analysis of financial needs and identification of

financial sources for funds are crucial in running a business. Reason: The
money provided by the entrepreneur may not be adequate to run the
business.

Financial needs of a business can be categorized based on time and

requirement such as:

Fixed Capital Requirements:

 The money is invested in the business for a long period of time.

 The money is used for purchases of fixed assets, ex: land, machines
etc.
 Fixed capital requirements vary based on the different nature of
business, such as a trading company may require less FCR compared
to a manufacturing company.

Working Capital Requirements:

 It is the funds required for day-to-day operations in a business. Ex:

current assets such as salaries, bills receivable, rent, wages, stock etc.
 Capital requirements vary based on nature, such as businesses that
sell on credit may require more capital than businesses that sell on
immediate cash.

Classification on sources of funds:

Time period basis:

Long term –

 Long term financing means, sources of funds that help business

fulfil their requirments for a time period that lasts for 5 years or
above. This includes shares, debunteres and loans from banks, this
type of financing is usually used to buy machinery, land, plant etc.

Medium term-

 Medium term financing means when the business requires money

for more than a year but less that 5 years, and these include loans
from banks or financial institutions, lease financing, accepting public
deposits.

Short term-

 Short term financing is often reciprocated when business require

funds for less than a year, this mostly includes trade credit, loans
from commercial banks etc.
 This type of financing is the most common when dealing with
current assets like inventories, and receivables.
 Two types of businesses that require this type of financing are
(1)season businesses. Reason: due to their fluctuating profits.
(2)Manufactors/wholesalers. Reason: due to most of their assets
being tied to receivables and inventories, requires large sum of
money – short period.

Ownership Basis:

Owner’s fund:- Refers to the funds aqquired through the owner’s money.
These people can be parternes of a business, shareholders, or sole trader.
Apart from the money invested(capital) it also includes profits(money that is
owed to the owner) that is reinvested in the business. The money invested in
the business stays for a longer period of time as in the owner may not take it
all back at once while the business is still running(refunding). There are two
ways to aqquire this form of finance:

(1)Equity shares.
 (2)Retained earnings.

Borrowed funds:- This refers to the funds that is aqquired through loans or
borrowings. This type of financing is often used for a specefic period of time
and on certain terms and conditions, the firm has to pay back the owed
money by the expiry date. A fixed rate of interest is paid by the borrowers,
this casts a huge burden on the borrowers in case the pay is low, fixed assets
are often used as security when providin borrowed funds.

Ways to aqquire this form of funds:

(1)Loans from c.bank & f.bank.

(2)Debentures
(3)Trade credit
(4)Shareholders
(5)Public deposits

Generation of funds basis:

Internal sources:-

 Funds generated within the business.

 Only fullfils limited needs of the business.
 Can initiate the funds through: reinvesitng profits, selling out the
inventories, collection of recievables.

External source:-

 Funds are generated from sources – outside the business, such as

money lenders, investors, supliers.
 This type of funds are used when large sum of money is required.
 this method is more costly as of comapred to ‘internal sources’
 issue of debentures, shareholders, public deposits, loans from c.bank
and f.I.

Sources of finance:
1.1 Retained earnings: When a business firm earns money(profits) not
all the earned income is distributed amoung shareholders/investors, some
amount is retained for future uses. This amount is called retained
earnings.

Merits:

 This type of finacing is permenant.

  There is a greator degree of freedom and flexibilty – income is
generate internally
 Does not require to pay off any explicit costs.
 Market price may rise for equity shares.
 Helps covering unexpected loss, low profits.

Limits:

 The shareholders may not be satisfied with holding part of the

earnings as their dividends becomes less.
 It is uncertain form of funds, as profits earned is not a constant
factor.
 If the opporutinty cost is not recognised it weel lead to optimal use of
the funds.

1.2 Trade credit:- Trade credit means immediate payment is not required
at the time of sales and is noted down as sundry creditors or accounts
payable in accounts record. This type of payment is only provided to
companies that has a goodwill

Merit:-

 Trade credit is a continues and convinent from of fund.

 It does not create any charge on the funds of the business.
 Trade credit can be easily acsessible if the credit worthiness is
known.
 Trade credit helps in the promotion of sales of the business.

Limits:

 Only satisfies limited needs of the business

 It is generally costly.
 Due to the nature of trade credit, overtrading may end up bringing a
lot of risks.

1.3 Public Deposits:- Is the process of inquiring money by an

oragnisation directly from the public the rates of interest here are higher
than that of a bank interest. This type of financing facilietes in
accomplishing short termed and medium termed needs of a commpany.
This extends to up about 3 years of time period, and the acceptance of
deposits is regulated by the RBI of india.

Merits:
  The cost of public deposits are lower than borrowings.
 The process is simple making it easy to aqquire funds faster.
 This does not cause any charges on business assets.
 The depostiers only pools cash into the business and has no power to
control it.

Limits:

 New companies may find it hard to convince the public to deposit.

 This is an unreliable source, as when the company requires large
money there may not be adequete deposits
 Collection of public deposts may be challenging due to large
population.

1.4 Issue Of Shares:- In this process the company divides its capital into
dividends called shares to raise money, the money raised through this
process is called share capital. This process is usually adopted when the
business require huge investments. There are further two types of shares:
(1)Equity shares: They are the most important when it comes to raising
long term capital. People who own these shares become the fraction
owners of the firm. They bear the risks and enjoy their income earned
based on the earning of the company, though their liability is limited to
the amount invested. Further these shareholders have the right to vote
which gives them the power to be part of the company’s management.

Merits:

 It is suitable for investors who is ready to take greater risks for

better profits.
 The democratic control of the managament is given through voting
rights.
 There is no burden to the company as paing the dividend is not
cumplosary
 It is a permentant source of financing as repayment is only needed
at the time of liquidation.
 Equity share does not create any charges on the businesses assets.

Limits:

 Complicated process and requires time to raise funds.

 Cost of rasing equity shares is high compared to other types of
financing.
  Investors who want steady income may not prefer equity shares due
to its fluctuating profits.
 Issue of addition equity shares, dilutes the voting power.

(2)Prefferend shares: The capital raised through selling prefferend shares

are called prefferend share capital. The shareholds prefer this type of
shares over quity shares is due to 2 reasons which are:
I. They receive a fixed rate of dividend before any dividends for
equity share is announced.
II. Their claim for receiving capital is settled at the time of
liquidation(shutting down) the creditors of the company’s money
is settled.

Merits:

 This type of shares bears less risk towards the investors.

 Provides steady income in form of fixed shares
 This does not create any charges against the assets of the business
 They have preferential rights over equity shareholders.

Limits:

 This is not suitable for investions willing to take risks for high
returns.
 The rate of dividends are higher than the rate of interest on
debentures.
 As the investors earn income only when the company earns profits it
may not look attractive to investors.

Types of prefferend shares:

Cummilative and non cumilative: cummilative refers to the scenario where a

business could not pay a dividend to its shareholder in a year it gets added
to the next year’s dividend. But in non cumilative if the shareholder looses
his dividend the particualr year, it does not get added up, and the payment
is skipped to the next.

Participating and non participating: Participating refers to the scenario where

after the company pays off all its usual dividends and the participating
sharholders receive their fixed deposits, if the company still has some extra
profits(surplus) this money is given to the participating prefference
shareholders as bonus. While in non participating they only receive theyre
fixed dividends.
Convertible and non convertible: Convertible refers to the scenario where the
shares of the holder can be swaped or changed to equity shares within a
specefic period of time and conditions. While in the non convertible you
cannot change from preference to equity.

1.5 Debentures:- refers to the intrument used to raise long term debt
capital, through the issue of debentures it is the company akwloedging
that they will pay back the money, debenture holders are payed a fixed
amount of interest at specif time.

Merits:

 This is mostly prefered by investors who want a fixed income with

less risks.
 this is much less costlier than preferrend or equity shareholders.
 the issue of debentures is only possible when the company is stable
in its earnings.
 Debentures does not hold voting rights hence it does not dilute the
voting power of equity shareholders.

Limits:

 These put a huge burden on the businesses

 The company has to make provision for the reepayment of the
debentures which put a lot fo pressure
 Debenture holder do not get voting rights
 Raising finance from this form of financing reduces the ability to
borrow from other sources.

Types of debentures:

Secured and unsecured: Secured refers to the debenture creating charges

on the company’s assets, in case of failure of the repayment the holder
will sell the asset and earn the owed money (mortgaging). While in
unsecured it doesn’t create any charges on the assets

Registeres and uregistered: Registered refers to the debenteres that are

officially recorded and mainatined by the company, to transfer these
debentures the owner must go throught the regular intrument of transfer.
While in Unregistered debenetures can be transferred easily.
 Convertible and non-convertible: Convertible refers to debentures than
can be converted to equity shares after a specefic period of time, while in
non convertible this process is not applicable.

First and second: first debenture refers to the scenario where they are
paid first before any other debenture holders are paid. While the second
states they are paid after the first is paid.

1.6 comercial banks: They provide funds to all for different purposes and
time period they also extend their loans to all sizes of businesses through
many ways like, cash, credit, overdraft, purcahde discounts etc. Banks
charge a interest on a firm based on various factors.

Merits:

 This is a reliable source as the bank is ready to provide loans

whenever the company requires funds.
 C.B provides security, by keeping the borrowers information
confidential.
 Loan from the bank is flexible as the amount can be increased if the
company requires, and pas back when fund is not required.
 Does not require compliacted formalitires like prosespectous or
underwritting.

Limits:

 These banks create charges on the assets of the company,

mortgaging them for security purposes.
 Funds are ready and available for a shorter period of time and is
difficult to renew them.
 Some of the terms and conditions created by the bank are quite
difficult.

1.7 Financial institutions: Both central and state governments have

established a number of financial institutions all over the country to
provide industrial finance to companies engaged in business. They are
also called development banks. This source of financing is considered
suitable when large funds are required for expansion, reorganisation and
modernisation of the enterprise.

Merits:
  Provides long term financing unlike comercial banks.
 They also provide financial and manegerial cunsultancy and
advises to the firm.
 Borrowing from these increases the goodwill of a company.
 The money can be easy repayed in installments reducing the
burden.
 The funds are made available even during deppresion.

Limits:

 A rigid criteria and formality is followed when sanction loans which

can be time consuming.
 Restriction of the payment of dividends are imposed on the power of
borrowing of the company.
 F.I appoints its nominees to the board of directors of the company to
keep a close eye which restricts the companies powers.