SOURCES OF BUSINESS FINANCE
Concept Of Business Finance
The term finance means money or fund. The requirements of funds by business to carry out its various activities is called
business finance. Finance is needed at every stage in the life of a business. A business cannot function unless adequate funds
are made available to it.
Need Of Business Finance
1. Fixed Capital Requirement: In order to start a business, funds are needed to purchase fixed assets like land and building,
plant and machinery. The funds required in fixed assets remain invested in the business for a long period of time.
2. Working Capital Requirement: A business needs funds for its day to day operation. This is known as working Capital
requirements. Working capital is required for purchase of raw materials, to pay salaries, wages, rent and taxes.
3. Diversification: A company needs more funds to diversify its operation to become a multi-product company e.g. ITC.
4. Technology upgradation: Finance is needed to adopt modern technology for example uses of computers in business.
5. Growth and expansion: Higher growth of a business enterprise requires higher investment in fixed assets. So finance is
needed for growth and expansion.
Classification of Sources of Fund:
On the basis of period, the different sources of funds can be categorised into three parts. These are long-term sources,
medium-term sources and short-term sources.
1. The long-term sources fulfil the financial requirements of an enterprise for a period exceeding 5 years and include sources
such as shares and debentures, long-term borrowings and loans from financial institutions. Such financing is generally required
for the acquisition of fixed assets such as equipment, plant, etc.
2. 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. These sources include borrowings from commercial banks, public deposits, lease financing and loans from financial institutions.
3. Short-term funds are those which are required for a period not exceeding one year. Trade credit, loans from commercial banks and
commercial papers are some of the examples of the sources that provide funds for short duration.
Ownership Basis of Business Finance:
Depending upon the types of fund a business gets, the funds can be classified into two sets- ‘owner’s funds’ and ‘borrowed funds’.
1) Owner Funds: If the funds are provided by the business or shareholders or partners’ creator, then it is the Owner’s funds.
Profits used to invest again in the business also fall under this. Owner funds usually do not need to be refunded and remain
invested in the business’s life period. Two important sources of owner funds include Equity shares and Retained earnings.
This type of investment grants controls over the enterprise. It carries risk with the investment as the principal amount and
returns are not guaranteed.
2) Borrowed Funds: If the investment source comes from outside the business, it is called Borrowed funds. It cannot be a permanent
source of capital because it has to be returned. Even though it carries less risk because the principal and returns are guaranteed, it
does not grant control. A fixed interest rate is also levied on borrowed funds, and it can put a lot of burden to payback when the
company/business is not raising enough funds.
On the basis of source of generation:
1) Internal Sources: Funds generated from within the organization are known as internal sources. Though only short term or limited
needs could be fulfilled by this source. For example: Ploughing back profit, Disposing surplus inventory, etc.
2) External Sources: Large amounts of money requirements are fulfilled through external sources. These are more expensive sources
than internal sources of financing. These are done through: Borrowings from commercial banks Acceptance of Public deposits, Raising
debentures etc.
Sources of Finance
Retained Earnings
Out of the company’s total earnings, a certain section of the total profits can be saved for the future. This part is not divided among
shareholders and is a source of self-financing. It depends heavily on the net profits and age of the organization.
Merits
(i) Retained earnings is a permanent source of funds available to an organisation.
(ii) It does not involve any explicit cost in the form of interest, dividend or floatation cost.
(iii) As the funds are generated internally, there is a greater degree of operational freedom and flexibility.
(iv) 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
(i) Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividends.
(ii) It is an uncertain source of funds as the profits of business are fluctuating.
(iii) The opportunity cost associated with these funds is not recognised by many firms. This may lead to sub-optimal use of the funds.
Trade Credits
Trade credits refer to sources of short term finances where a business extends credit for purchasing goods and services to the other.
According to class 11 sources of business finance chapter, it appears as a record for an account payable and isn’t taken immediately.
It is based on goodwill and a decent financial situation.
Merits
(i) Trade credit is a convenient and continuous source of funds.
(ii) Trade credit may be readily available in case the credit worthiness of the customers is known to the seller.
(iii) Trade credit needs to promote the sales of an organisation.
(iv) 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
(v) It does not create any charge on the assets of the firm while providing funds.
Limitations
(i) 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.
(ii) Only limited amount of funds can be generated through trade credit
(iii) It is generally a costly source of funds as compared to most other sources of raising money.
Factoring
It is referred as a financial service within which the ‘ factor’ provides various services like-
1) Discounting the bill as well as collecting clients’ debt through which the receivables on the account of sales of goods or services will be
sold to the factor at a variable discount.
2) It also provides information about the creditworthiness of the prospective clients, etc. along with very factors that possess information
regarding the trading history of the firm.
Merits
(1) Obtaining funds through factoring is cheaper than financing through other means such as bank credit.
(2) With cash flow accelerated by factoring, the client is able to meet his/her liabilities promptly as and when these arise.
(3) Factoring as a source of funds is flexible and ensures a definite pattern of cash inflows from credit sales. It provides security for a
debt that a firm might otherwise be unable to obtain.
(4) It does not create any charge on the assets of the firm.
(5) The client can concentrate on other functional areas of business as the responsibility of credit control is shouldered by the factor.
Limitations
(1) This source is expensive when the invoices are numerous and smaller in amount.
(2) The advance finance provided by the factor firm is generally available at a higher interest cost than the usual rate of interest.
(3) The factor is a third party to the customer who may not feel comfortable while dealing with it.
Lease Financing
A periodic payment is set up between two parties allowing the temporary use of an asset owned by another company. This also
allows the renting of assets. A fixed periodic amount is called lease rental. The asset is returned after the contract time.
Merits
1) It enables the lessee to acquire the asset with a lower investment.
2) Simple documentation makes it easier to finance assets.
3) Lease rentals paid by the lessee are deductible for computing taxable profits.
4) It provides finance without diluting the ownership or control of business.
5) The lease agreement does not affect the debt raising capacity of an enterprise.
6) The risk of obsolescence is borne by the lesser. This allows greater flexibility to the lessee to replace the asset.
Limitations
1. A lease arrangement may impose certain restrictions on the use of assets. For example, it may not allow the lessee to make any
alteration or modification in the asset.
2. The normal business operations may be affected in case the lease is not renewed,
3. It may result in higher payout obligation in case the equipment is not found useful and the lessee opts for premature termination
of the lease agreement.
4. The lessee never becomes the owner of the asset. It deprives him of the residual value of the asset.
Public Deposits
When an organisation raises certain deposits directly from the public, it is known as public deposits. Usually, the rate of interest
offered on public deposits is higher than that offered on the bank deposits. Those who are interested in investing in an organisation,
they can do so by filling the designated form.
Merits The merits of public deposits are:
(i) The procedure of obtaining deposits is simple and does not contain restrictive conditions as are generally there in a loan agreement;
(ii) Cost of public deposits is generally lower than the cost of borrowings from banks and financial institutions;
(iii) 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;
(iv) As the depositors do not have voting rights, the control of the company is not diluted. Limitations The major limitation of public
deposits are as follows: (i) New companies generally find it difficult to raise funds through public deposits; (ii) It is an unreliable source
of finance as the public may not respond when the company needs money; (iii) Collection of public deposits may prove difficult, particularly
when the size of deposits required is large.
Issue of Share
Also known as share capital, where capital is divided into small marketable units known as shares. Each share gets a variant value fixed
at one point. According to sources of business finance chapter class 11, there are two types of share, i.e., Equity Share and Preference Shares.
Let us take a detailed look at the key features of Equity Shares and Preference Shares.
(a)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 prerequisite 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, however, is limited to the extent of capital
contributed by them in the company. Further, through their right to vote, these shareholders have a right to participate in the management of
the company.
Merits
(1) Equity shares are suitable for investors who are willing to assume risk for higher returns.
(2) Payment of dividend to the equity shareholders is not compulsory. Therefore, there is no burden on the company in this respect.
(3) 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.
(4) Equity capital provides credit worthiness to the company and confidence to prospective loan providers.
(5) 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.
(6) Democratic control over management of the company is assured due to voting rights of equity shareholders.
Limitations
1) Investors who want steady income may not prefer equity shares as equity shares get fluctuating returns.
2) The cost of equity shares is generally more as compared to the cost of raising funds through other sources.
3) Issue of additional equity shares dilutes the voting power, and earnings of existing equity shareholders.
4) More formalities and procedural delays are involved while raising funds through issue of equity share.
b. Preference Share: Preferential Position receives a fixed cut in dividends out of the profit. At the time of liquidation, they enjoy
a later claim to capital. They get the first preference in repayment and dividend. They have a fixed rate of return, like debentures
Merits
(1) Preference shares provide reasonably steady income in the form of fixed rate of return and safety of investment.
(2) Preference shares are useful for those investors who want fixed rate of return with comparatively low risk.
(3) It does not affect the control of equity shareholders over the management as preference shareholders don’t have voting rights.
(4) 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.
(5) Preference shareholders have a preferential right of repayment over equity shareholders in the event of liquidation of a company.
(6) Preference capital does not create any sort of charge against the assets of a company.
Limitations
1) Preference shares are not suitable for those investors who are willing to take risk and are interested in higher returns.
2) Preference capital dilutes the claims of equity shareholders over assets of the company.
3) The rate of dividend on preference shares is generally higher than the rate of interest on debentures.
4) 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.
5) 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 say six months or one year.
Merits
1) It is preferred by investors who want fixed income at lesser risk.
2) Debentures are fixed charge funds and do not participate in profits of the company.
3) The issue of debentures is suitable in the situation when the sales and earnings are relatively stable.
4) As debentures do not carry voting rights, financing through debentures does not dilute control of equity shareholders on management.
5) 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
1) 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.
2) In case of redeemable debentures, the company has to make provisions for repayment on the specified date, even during periods of financial difficulty.
3) Each company has certain borrowing capacity. With the issue of debentures, the capacity of a company to further borrow funds reduces.
Commercial Paper
Commercial paper is an unsecured, short period debt tool issued by a company, usually for the finance and inventories and temporary
liabilities. The maturities in this paper do not last longer than 270 days. These papers are like a promissory note allotted at a huge cost
and exchangeable between the All-India Financial Institutions (FIs) and Primary Dealers (PDs).
Most of the commercial paper investors are from the banking sector, individuals, corporate and incorporated companies, Non-Resident
Indians (NRIs) and Foreign Institutional Investors (FIIs), etc. However, FII can only invest according to the limit outlined by the Securities
and Exchange Board of India (SEBI)
In India, commercial paper is a short-term unsecured promissory note issued by the Primary Dealers (PDs) and the All-India Financial
Institutions (FIs) for a short period of 90 days to 364 days.
Merits
1) A commercial paper is sold on an unsecured basis and does not contain any restrictive conditions
2) As it is a freely transferable instrument, it has high liquidity
3) It provides more funds compared to other sources. Generally, the cost of CP to the issuing firm is lower than the cost of commercial bank loans
4) A commercial paper provides a continuous source of funds. This is because their maturity can be tailored to suit the requirements of the
issuing firm. Further, maturing commercial paper can be repaid by selling new commercial paper
5) Companies can park their excess funds in commercial paper thereby earning some good return on the same.
Limitations
1) Only financially sound and highly rated firms can raise money through commercial papers. New and moderately rated firms are not in a
position to raise funds by this method
2) The size of money that can be raised through commercial paper is limited to the excess liquidity available with the suppliers of funds at a
particular time
3) Commercial paper is an impersonal method of financing. As such if a firm is not in a position to redeem its paper due to financial difficulties,
extending the maturity of a CP is not possible.
Commercial Bank
A commercial bank is a kind of financial institution that carries all the operations related to deposit and withdrawal of money for the general
public, providing loans for investment, and other such activities. These banks are profit-making institutions and do business only to make a profit.
The two primary characteristics of a commercial bank are lending and borrowing. The bank receives the deposits and gives money to various
projects to earn interest (profit). The rate of interest that a bank offers to the depositors is known as the borrowing rate, while the rate at which
a bank lends money is known as the lending rate.
Merits
1) Banks provide timely assistance to business by providing funds as and when needed by it.
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 for raising loans from a bank. This, therefore, is an easier source
of funds
4) 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
1) Funds are generally available for short periods and its extension or renewal is uncertain and difficult
2) Banks make detailed investigation of the company’s affairs, financial structure etc., and may also ask for security of assets and personal
sureties. Thismakes the procedure of obtaining funds slightly difficult
3) 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.
Factors Affecting the Choice of the Source of Funds
1) Cost: It refers to the cost incurred in obtaining the fund and the cost of using the funds. So, while deciding about the source of funds
both the costs should be taken into consideration.
2) Flexibility and ease: Borrowings from banks and financial institutions involve many restrictions, detailed investigation and documentation.
Therefore, business firms may not prefer them in case other sources are easily available.
3) Effect on creditworthiness: The creditworthiness of business is affected by the use of certain sources. For example, the issue of secured
debentures by a company may lead to the withdrawal of loans by unsecured creditors. It might become difficult for the company to raise
further unsecured loans.
4) The form of organisation and legal status: The form of the legal status of business firms also affect the choice of the source of finance.
For example, a sole proprietor or a partnership firm cannot obtain funds by issue of equity shares as these can be issued only by joint
stock companies.
5) Purpose and time period: The time period for which the funds are required also affects the selection of the source of funds. For example,
if the funds are required for a short period, sources such as trade credit, commercial papers, etc. can be used. For the long term, sources
such as the issue of shares, debentures, etc. are preferred. Therefore, the purpose of the business should also be considered while choosing
the source of finance.
6) Tax benefits: Certain sources of funds like debentures and loans provide tax benefits. The interest payable on them is tax deductible. Hence,
the organisations seeking tax advantage prefer to raise fundsthrough debentures or loans.