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Questions and Answers
What is a primary function of business finance?
What is a primary function of business finance?
Which of the following statements accurately describes working capital?
Which of the following statements accurately describes working capital?
How do sufficient funds benefit a business during economic downturns?
How do sufficient funds benefit a business during economic downturns?
Which source of business finance does not require repayment?
Which source of business finance does not require repayment?
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What is a characteristic of owner's funds in a business?
What is a characteristic of owner's funds in a business?
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What can businesses with adequate funds do effectively?
What can businesses with adequate funds do effectively?
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In terms of business finance, which of the following is NOT considered a liability?
In terms of business finance, which of the following is NOT considered a liability?
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Why is working capital particularly important for businesses with lengthy production processes?
Why is working capital particularly important for businesses with lengthy production processes?
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What is the primary risk associated with equity shareholders?
What is the primary risk associated with equity shareholders?
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Which of the following statements about borrowed funds is correct?
Which of the following statements about borrowed funds is correct?
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Preference shareholders are primarily concerned with:
Preference shareholders are primarily concerned with:
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In the event of company liquidation, who is paid first?
In the event of company liquidation, who is paid first?
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Which of the following represents the true ownership of a company?
Which of the following represents the true ownership of a company?
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What must a company do at the end of the fixed period concerning preference shares?
What must a company do at the end of the fixed period concerning preference shares?
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Which of the following is a feature of borrowed funds?
Which of the following is a feature of borrowed funds?
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How does the risk for equity shareholders compare to that of preference shareholders?
How does the risk for equity shareholders compare to that of preference shareholders?
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In comparison to equity shares, preference shares typically have:
In comparison to equity shares, preference shares typically have:
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Which type of fund does not require security or collateral?
Which type of fund does not require security or collateral?
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Equity shareholders receive dividends based on:
Equity shareholders receive dividends based on:
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What characterizes retained earnings as a source of owners' funds?
What characterizes retained earnings as a source of owners' funds?
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What risk do preference shareholders face compared to equity shareholders?
What risk do preference shareholders face compared to equity shareholders?
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What happens to equity shareholders' investments if the company encounters continuous losses?
What happens to equity shareholders' investments if the company encounters continuous losses?
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What is a primary characteristic of preference shares?
What is a primary characteristic of preference shares?
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What distinguishes retained earnings as a source of finance?
What distinguishes retained earnings as a source of finance?
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What do companies typically use public deposits for?
What do companies typically use public deposits for?
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What is one of the risks associated with trade credit?
What is one of the risks associated with trade credit?
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Which of the following statements about capitalizing profits is true?
Which of the following statements about capitalizing profits is true?
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What is NOT a feature of preference shares?
What is NOT a feature of preference shares?
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How can retained earnings benefit a company during financial hardships?
How can retained earnings benefit a company during financial hardships?
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What characterizes hybrid securities?
What characterizes hybrid securities?
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One advantage of preference shares for investors is:
One advantage of preference shares for investors is:
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Why are retained earnings considered a dependable source of finance?
Why are retained earnings considered a dependable source of finance?
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What is a common duration for trade credit?
What is a common duration for trade credit?
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What is a significant disadvantage of public deposits?
What is a significant disadvantage of public deposits?
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Which statement best explains voting rights in relation to equity shareholders?
Which statement best explains voting rights in relation to equity shareholders?
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Study Notes
Business Finance
- Business Finance refers to the capital funds or credit funds invested in a business.
- Financing refers to making money accessible when needed.
- Financing is an essential element for starting and growing a business.
Importance of Business Finance
- Business finance is crucial for acquiring fixed assets and meeting day-to-day expenses.
- Fixed assets include machinery, land, and buildings.
- Daily expenses include salaries, electricity, and other operational costs.
- A sufficient working capital is required when the production process is lengthy.
- The longer the time to recoup investments, the greater the working capital required.
- Working capital covers day-to-day operational expenses.
- Additional fixed capital is needed when a business expands its operations.
Benefits of Adequate Funds
- A sufficient amount of funds allows a business to meet its liabilities on time, including interest payments, EMIs, creditor payments, and loan repayments.
- This enhances the business's credibility and creditworthiness.
- Businesses with adequate funds can operate smoothly as they can make timely payments, procure raw materials, and pay salaries.
- Businesses with ample funds can adopt the latest technology and innovative methods to improve production efficiency.
- These funds empower businesses to seize emerging market opportunities.
- Sufficient funding enables businesses to handle competitive pressures, such as price wars, effectively.
- Adequate funds allow businesses to replace assets and machinery as needed without facing financial strain.
- These funds help shield businesses from the adverse effects of economic downturns, such as recessions and depressions.
- In times of economic hardship, businesses with sufficient reserves can maintain operations, sustain employment levels, and avoid significant losses.
Sources of Business Finance
- There are two main sources of business finance: owner's funds and borrowed funds.
Owner's Funds
- These funds are contributed by the business owner, including accumulated profits.
- Owner's funds are permanent capital, and the business is not obligated to repay this capital.
- Examples of owner's funds include equity shares and retained earnings.
- Owner's funds are often used to acquire fixed assets.
- Owner's funds are considered "risk capital" as their return depends on the business's profitability.
- Owner's funds are not subject to interest payments or mandatory returns.
Borrowed Funds
- These funds are obtained from external sources, such as banks, financial institutions, or investors.
- Borrowed funds are subject to repayment with interest, making them a temporary source of capital.
- Excessive reliance on borrowed funds can increase the risk of default and financial distress.
- Examples of borrowed funds include loans, debentures, and bonds.
- Borrowed funds are often used for expansion, working capital requirements, or other business objectives.
Owners Fund
- Owners fund is a permanent source of capital for a business.
- Owners fund is a risky capital, because it's subject to the success of business.
- Owners fund doesn't require any security or collateral.
- Sources of owners fund for a company are:
- Equity shares: the real ownership of the company, with voting rights
- Preference shares: fixed return, pre-decided dividend percentage, but no voting rights except when the company defaults on dividend payments
- Retained earnings: company reinvests its profits back into its business.
Borrowed Funds
- Borrowed funds are what a company borrows from lenders.
- Borrowed funds are available for a fixed time period.
- Borrowed funds usually require security or collateral for the loan.
- Interest payments on borrowed funds are compulsory, whether the company is profitable or not.
- Lenders do not have controlling interest in the company.
- Sources of borrowed funds are:
- Debentures: borrow money from public through issuing debt instruments
- Commercial banks: Loans from banks like HDFC, PNB, etc.
- Financial institutions: Loans from lenders that specialize in financing (e.g. HDFC, LIC, etc.)
- Public Deposits: borrow money from public
- Inter-corporate deposits: borrow money from other companies
Equity Shares:
- Represent real ownership in a company.
- Receive dividend based on the company's performance.
- Hold voting rights within the company.
- Generally have a low face value (e.g., ₹1).
Preference Shares:
- Receive a fixed dividend percentage, regardless of the company's performance.
- Do not have voting rights unless dividend payments are not made for two consecutive years.
- Generally have a higher face value (e.g. ₹100.).
Features of Borrowed Funds
- Borrowed funds are raised for a specific period of time.
- Borrowed funds typically require security or collateral (e.g. factory, land)
- Regular interest payments are compulsory, regardless of the company's profitability.
- Lenders do not have the right to control or manage the company.
Equity Shares vs. Preference Shares
- Face Value: Preference shares have a higher face value compared to equity shares.
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Attraction: Equity shareholders are drawn to the opportunity for higher returns but face significant risk.
- Risk: The value of equity shares is directly tied to the company's performance and the market's perception of its future potential.
- Returns: If the company performs well, the value of equity shares can increase substantially. However, if the company experiences losses, equity shareholders bear the brunt of the risk.
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Preference Shareholders are more conservative.
- Risk: Receive a pre-determined percentage of dividend every year, offering a reduced level of risk.
- Returns: They are less susceptible to fluctuations in company performance.
Risk
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Equity Shareholders: They are considered the primary risk bearers as their returns are wholly dependent on the company's profitability.
- If the company doesn't make a profit, there will be no dividend payments, leading to direct losses for Equity Shareholders.
- If the company incurs a loss, the value of their shares will decline.
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Preference Shareholders: They face less risk than equity shareholders.
- Risk: While a company's failing performance may impact the overall investment value, they are guaranteed a pre-determined dividend.
Refund of Capital
- In case of company winding up:
- Outlier liability: External creditors and lenders are paid first.
- Preference Shareholders: are paid before equity shareholders.
- Equity Shareholders: stand a high chance of losing their investment as they are the last to receive their capital if any remains after paying off debts.
- Preference Shareholders: have a priority for capital refund compared to equity shareholders in a winding-up scenario.
Redemption
- Equity Shareholders: Their capital is only returned in the case of company winding up. They are not typically redeemed.
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Preference Shares: have a fixed time period, after which the company must redeem the share capital.
- This offers a pre-determined time frame for capital retrieval, adding to the security of this investment.
Ownership
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Equity Shareholders: represent the true ownership of a company.
- Their voting rights, directly influence company decisions.
- Control: They elect the board of directors and, indirectly, control the management team.
- Preference Shareholders: Have limited voting rights and are primarily concerned with dividend payments.
Features of Equity Shares
- Primary risk bearers: Their investment is directly at risk if the company performs poorly.
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Claim on Residual Income: They receive a share of the company’s income only after all other liabilities and payments (including preference dividends) have been settled.
- They have a claim on the remaining profit, called "Residual Income."
- Profitable Companies: If a company prospers and earns high residual income, equity shareholders benefit greatly, experiencing potentially large returns.
- Unprofitable Companies: Conversely, if the company struggles, they may receive little to no residual income and their investment may even lose value.
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Basis for Loan: Equity shares serve as solid collateral for loans.
- Banks are willing to lend to equity shareholders, as they are the owners of a stake in the company.
- Liquid Asset: In the event of a loan default, banks can recover the loan by selling the shares.
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Voting Rights: They hold significant influence over company decisions through voting rights.
- This right allows them to elect board members and shape the company's direction through shareholder meetings.
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Potential for Higher Profits: Equity Shareholders have the potential to earn disproportionately higher profits compared to Preference Shareholders.
- When a company thrives, equity shareholders have the opportunity for significant capital appreciation.
Features of Preference Shares
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Pre-Determined Dividends: The dividend rate is pre-fixed, ensuring a steady stream of income for investors.
- Stable Returns: They offer predictable returns, making them attractive to risk-averse investors who seek consistent income.
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Limited Voting Rights: They are primarily focused on their dividend income and do not have the same level of influence in company decision making as Equity Shareholders.
- They typically do not have voting rights.
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Hybrid Security: They share characteristics with both equity and debt instruments.
- Debt Feature: They offer a fixed return, similar to bonds, and have priority for capital in a winding-up scenario.
- Equity Feature: They represent a share in the company's ownership, similar to equity shares, but have limited voting rights.
- Risk and Return: The unique mix of features makes them a hybrid option for investors seeking a balance between potential return and risk tolerance.
- Attractive to Investors: Preference shares are attractive to investors who prioritize steady income over a speculative opportunity for higher returns.
- Fundraising Advantage: They help companies raise large capital sums, as they are seen as a secure investment option for conservative investors and financial institutions.
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No Fixed Liability: The company is not obligated to pay dividends if it is not profitable.
- This feature distinguishes them from debt instruments where interest must be paid regardless of the company's profitability.
- No Collateral Needed: Companies do not need to provide any collateral, which is a major advantage in terms of capital raising.
Hybrid Securities
- Combination of Features: They share characteristics of both equity and debt instruments, offering a unique investment proposition to investors.
- Attractive for Raising Funds: The combination of return and risk characteristics makes them a desirable instrument for companies seeking to raise capital from conservative and institutional investors.
- Potential for Large Funds: The preference for stability and predictability makes them attractive to a wider range of investors, allowing companies to raise funds in a structured and controlled way.
Retained Earnings
- Retained earnings represent undistributed profits after paying dividends and taxes.
- Profits are reinvested back into the business, contributing to growth and expansion.
- Considered a vital source of internal financing, reducing reliance on external loans.
- Provide a safety net during financial hardships, allowing companies to weather storms.
- Funds can be allocated for risky ventures like research and development, new projects, or innovative ideas.
- Act as a long-term funding resource, contributing to the company's overall growth.
Capitalization of Profits
- Profits are converted into equity capital through the issuance of bonus shares.
- Bonus shares are given free to existing shareholders, increasing their holdings without additional cost.
- This process is referred to as "capitalization of profits."
Retained Earnings: Advantages
- Most dependable source of finance due to its internal origin.
- Eliminates external pressures and regulatory hurdles associated with other financing methods.
- No need for interest payments or dividends on these funds.
- Offers flexibility for funding new ventures and innovative projects.
- Does not influence the company's ownership structure, as it only increases the number of shares, not shareholders.
Trade Credit
- A short-term loan provided by suppliers to businesses for purchasing raw materials, goods, or services.
- A common practice in manufacturing and trading, typically ranging from 3 to 6 months.
- The duration of trade credit depends on factors like the firm's nature, size, and creditworthiness.
- Easily accessible with minimal paperwork and regulatory compliance.
- Provides flexibility to adjust payment terms based on past business performance.
- Offers a cost-effective alternative to standard loans, avoiding high interest rates and extensive paperwork.
- Risks include possible price increases by suppliers who factor in the cost of extended payment terms.
- Legal action can be taken if a company fails to make timely payments, with documentation like promissory notes providing evidence.
Public Deposits
- A form of medium-term financing where companies invite the public to deposit their surplus funds.
- Unsecured loans, meaning companies do not offer collateral against the deposits.
- Companies typically advertise in newspapers to invite public deposits.
- Offers a simple process for raising funds, with individuals filling out prescribed forms.
- Primarily used for financing working capital needs, such as increasing inventory or extending credit to customers.
- Offers a more cost-effective solution than debt instruments like debentures.
- The company must allocate 10% of the deposited amount for repayment by the end of each financial year.
- Companies pay interest on public deposits, typically lower than what they would pay on debentures or loans.
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Description
This quiz explores the fundamentals of business finance, including the importance of capital funds, fixed assets, and working capital. Understand how adequate financing plays a crucial role in a business's operational efficiency and growth. Test your knowledge on the financial aspects necessary for starting and sustaining a successful business.
