Sources Of Business Finance PDF

Chapter 8 Sources of Business Finance LEARNING OBJECTIVES After studying this chapter, you should be able to: state the meaning, nature and importance of business finance;...

Chapter 8 Sources of Business Finance LEARNING OBJECTIVES After studying this chapter, you should be able to: state the meaning, nature and importance of business finance; classify the various sources of business finance; evaluate merits and limitations of various sources of finance; identify the international sources of finance; and examine the factors that affect the choice of an appropriate source of finance. 2024-25 Chapter 8.indd 172 9/2/2022 2:14:08 PM  SOURCES OF BUSINESS FINANCE 173 Mr. Anil Singh has been running a restaurant for the last two years. The excellent quality of food has made the restaurant popular in no time. Motivated by the success of his business, Mr. Singh is now contemplating the idea of opening a chain of similar restaurants at different places. However, the money available with him from his personal sources is not sufficient to meet the expansion requirements of his business. His father told him that he can enter into a partnership with the owner of another restaurant, who will bring in more funds but it would also require sharing of profits and control of business. He is also thinking of getting a bank loan. He is worried and confused, as he has no idea as to how and from where he should obtain additional funds. He discusses the problem with his friend Ramesh, who tells him about some other methods like issue of shares and debentures, which are available only to a company form of organisation. He further cautions him that each method has its own advantages and limitations and his final choice should be based on factors like the purpose and period for which funds are required. He wants to learn about these methods. 8.1 Introduction needs of society. For carrying out various activities, business requires This chapter provides an overview of money. Finance, therefore, is called the the various sources from where funds life blood of any business. The can be procured for starting as also for requirements of funds by business to running a business. It also discusses carry out its various activities is called the advantages and limitations of business finance. various sources and points out the A business cannot function unless factors that determine the choice of a adequate funds are made available to suitable source of business finance. it. The initial capital contributed by the It is important for any person who entrepreneur is not always sufficient to wants to start a business to know take care of all financial requirements about the different sources from of the business. A business person, where money can be raised. It is also therefore, has to look for different other important to know the relative merits sources from where the need for funds and demerits of different sources so can be met. A clear assessment of the that choice of an appropriate source financial needs and the identification can be made. of various sources of finance, therefore, is a significant aspect of running a 8.2 Meaning, Nature and Significance business organisation. of Business Finance The need for funds arises from the Business is concerned with the stage when an entrepreneur makes production and distribution of goods a decision to start a business. Some and services for the satisfaction of funds are needed immediately say for 2024-25 Chapter 8.indd 173 9/2/2022 2:14:08 PM  174 BUSINESS  STUDIES the purchase of plant and machinery, stock of material, bills receivables furniture, and other fixed assets. and for meeting current expenses Similarly, some funds are required like salaries, wages, taxes, and for day-to-day operations, say to rent. purchase raw materials, pay salaries to The amount of working capital employees, etc. Also when the business required varies from one business expands, it needs funds. concern to another depending on The financial needs of a business various factors. A business unit selling can be categorised as follows: goods on credit, or having a slow sales (a) Fixed capital requirements: In turnover, for example, would require order to start business, funds more working capital as compared to a are required to purchase fixed concern selling its goods and services assets like land and building, plant on cash basis or having a speedier and machinery, and furniture turnover. and fixtures. This is known as The requirement for fixed and fixed capital requirements of the working capital increases with the enterprise. The funds required in growth and expansion of business. At fixed assets remain invested in times additional funds are required for the business for a long period of upgrading the technology employed time. Different business units need so that the cost of production or varying amount of fixed capital operations can be reduced. Similarly, depending on various factors such larger funds may be required for as the nature of business, etc. A building higher inventories for the trading concern for example, may festive season or to meet current debts or expand the business or to shift to a require small amount of fixed capital new location. It is, therefore, important as compared to a manufacturing to evaluate the different sources from concern. Likewise, the need for where funds can be raised. fixed capital investment would be greater for a large enterprise, 8.3 Classification of Sources of as compared to that of a small enterprise. Funds (b) Working capital requirements: In case of proprietary and partnership The financial requirements of concerns, the funds may be raised either an enterprise do not end with from personal sources or borrowings the procurement of fixed assets. from banks, friends etc. In case of No matter how small or large a company form of organisation, the business is, it needs funds for different sources of business finance its day-to-day operations. This which are available may be categorised is known as working capital of as given in Table 8.1 an enterprise, which is used for As shown in the table, the sources holding current assets such as of funds can be categorised using 2024-25 Chapter 8.indd 174 9/2/2022 2:14:08 PM  SOURCES OF BUSINESS FINANCE 175 Classification of Sources of Funds Table 8.1 2024-25 Chapter 8.indd 175 9/2/2022 2:14:08 PM  176 BUSINESS  STUDIES different basis viz., on the basis of often need short-term financing for the period, source of generation and the interim period between seasons. the ownership. A brief explanation of Wholesalers and manufacturers with these classifications and the sources a major portion of their assets tied is provided as follows: up in inventories or receivables also require large amount of funds for a 8.3.1 Period Basis short period. On the basis of period, the different sources of funds can be categorised 8.3.2 Ownership Basis into three parts. These are long-term On the basis of ownership, the sources sources, medium-term sources and can be classified into ‘owner’s funds’ short-term sources. and ‘borrowed funds’. Owner’s funds The long-term sources fulfil the means funds that are provided by the financial requirements of an enterprise owners of an enterprise, which may for a period exceeding 5 years and be a sole trader or partners or include sources such as shares and shareholders of a company. Apart debentures, long-term borrowings and from capital, it also includes profits loans from financial institutions. Such reinvested in the business. The financing is generally required for the owner’s capital remains invested in acquisition of fixed assets such as the business for a longer duration equipment, plant, etc. and is not required to be refunded Where the funds are required for a period of more than one year but less during the life period of the business. than five years, medium-term sources Such capital forms the basis on which of finance are used. These sources owners acquire their right of control of include borrowings from commercial management. Issue of equity shares banks, public deposits, lease financing and retained earnings are the two and loans from financial institutions. important sources from where owner’s Short-term funds are those which funds can be obtained. are required for a period not exceeding ‘Borrowed funds’ on the other one year. Trade credit, loans from hand, refer to the funds raised through commercial banks and commercial loans or borrowings. The sources papers are some of the examples of the for raising borrowed funds include sources that provide funds for short loans from commercial banks, loans duration. from financial institutions, issue of Short-term financing is most debentures, public deposits and trade common for financing of current credit. Such sources provide funds for assets such as accounts receivable a specified period, on certain terms and inventories. Seasonal businesses and conditions and have to be repaid that must build inventories in after the expiry of that period. A fixed anticipation of selling requirements rate of interest is paid by the borrowers 2024-25 Chapter 8.indd 176 9/2/2022 2:14:08 PM  SOURCES OF BUSINESS FINANCE 177 on such funds. At times it puts a lot 8.4 Sources of Finance of burden on the business as payment A business can raise funds from of interest is to be made even when various sources. Each of the source has the earnings are low or when loss is unique characteristics, which must be incurred. Generally, borrowed funds properly understood so that the best are provided on the security of some available source of raising funds can fixed assets. be identified. There is not a single best source of funds for all organisations. 8.3.3 Source of Generation Basis Depending on the situation, purpose, Another basis of categorising the cost and associated risk, a choice may sources of funds can be whether the be made about the source to be used. funds are generated from within the For example, if a business wants to organisation or from external sources. raise funds for meeting fixed capital Internal sources of funds are those requirements, long term funds may that are generated from within the be required which can be raised in business. A business, for example, the form of owned funds or borrowed can generate funds internally by funds. Similarly, if the purpose is to accelerating collection of receivables, meet the day-to-day requirements of disposing of surplus inventories and business, the short term sources may ploughing back its profit. The internal be tapped. A brief description of various sources of funds can fulfill only limited sources, along with their advantages needs of the business. and limitations is given below. External sources of funds include 8.4.1 Retained Earnings those sources that lie outside an organisation, such as suppliers, A company generally does not lenders, and investors. When large distribute all its earnings amongst the amount of money is required to be shareholders as dividends. A portion raised, it is generally done through of the net earnings may be retained the use of external sources. External in the business for use in the future. funds may be costly as compared to This is known as retained earnings. It those raised through internal sources. is a source of internal financing or self- In some cases, business is required to financing or ‘ploughing back of profits’. mortgage its assets as security while The profit available for ploughing back obtaining funds from external sources. in an organisation depends on many Issue of debentures, borrowing from factors like net profits, dividend policy commercial banks and financial and age of the organisation. institutions and accepting public Merits deposits are some of the examples of external sources of funds commonly The merits of retained earning as a used by business organisations. source of finance are as follows: 2024-25 Chapter 8.indd 177 9/2/2022 2:14:09 PM  178 BUSINESS  STUDIES (i) Retained earnings is a permanent creditors’ or ‘accounts payable’. Trade source of funds available to an credit is commonly used by business organisation; organisations as a source of short- (ii) It does not involve any explicit cost term financing. It is granted to those in the form of interest, dividend or customers who have reasonable floatation cost; amount of financial standing and (iii) As the funds are generated goodwill. The volume and period of internally, there is a greater credit extended depends on factors degree of operational freedom and flexibility; such as reputation of the purchasing (iv) It enhances the capacity of the firm, financial position of the seller, business to absorb unexpected volume of purchases, past record of losses; payment and degree of competition in (v) It may lead to increase in the the market. Terms of trade credit may market price of the equity shares vary from one industry to another and of a company. from one person to another. A firm may also offer different credit terms to Limitations different customers. Retained earning as a source of funds has the following limitations: Merits (i) Excessive ploughing back may The important merits of trade credit cause dissatisfaction amongst the are as follows: shareholders as they would get (i) Trade credit is a convenient and lower dividends; continuous source of funds; (ii) It is an uncertain source of funds (ii) Trade credit may be readily as the profits of business are available in case the credit fluctuating; (iii) The opportunity cost associated worthiness of the customers is with these funds is not recognised known to the seller; by many firms. This may lead to (iii) Trade credit needs to promote the sub-optimal use of the funds. sales of an organisation; (iv) If an organisation wants to 8.4.2 Trade Credit increase its inventory level in Trade credit is the credit extended order to meet expected rise in the by one trader to another for the sales volume in the near future, purchase of goods and services. Trade it may use trade credit to, finance credit facilitates the purchase of the same; supplies without immediate payment. (v) It does not create any charge Such credit appears in the records on the assets of the firm while of the buyer of goods as ‘sundry providing funds. 2024-25 Chapter 8.indd 178 9/2/2022 2:14:09 PM  SOURCES OF BUSINESS FINANCE 179 Limitations (b) Providing information about credit worthiness of prospective client’s Trade credit as a source of funds has etc., Factors hold large amounts certain limitations, which are given of information about the trading as follows: histories of the firms. This can (i) Availability of easy and flexible be valuable to those who are trade credit facilities may induce using factoring services and can a firm to indulge in overtrading, thereby avoid doing business with which may add to the risks of the customers having poor payment firm; record. Factors may also offer (ii) Only limited amount of funds can relevant consultancy services in the be generated through trade credit; areas of finance, marketing, etc. (iii) It is generally a costly source of The factor charges fees for funds as compared to most other the services rendered. Factoring sources of raising money. appeared on the Indian financial scene only in the early nineties 8.4.3 Factoring as a result of RBI initiatives. The Factoring is a financial service under organisations that provides such which the ‘factor’ renders various services include SBI Factors and services which includes: Commercial Services Ltd., Canbank (a) Discounting of bills (with or without Factors Ltd., Foremost Factors Ltd., recourse) and collection of the State Bank of India, Canara Bank, client’s debts. Under this, the Punjab National Bank, Allahabad receivables on account of sale of Bank. In addition, many non- goods or services are sold to the banking finance companies and factor at a certain discount. The other agencies provide factoring factor becomes responsible for all service. credit control and debt collection from the buyer and provides Merits protection against any bad debt The merits of factoring as a source of losses to the firm. There are two finance are as follows: methods of factoring — recourse (i) Obtaining funds through factoring and non-recourse. Under recourse is cheaper than financing through factoring, the client is not protected other means such as bank credit; against the risk of bad debts. On (ii) With cash flow accelerated by the other hand, the factor assumes factoring, the client is able to meet the entire credit risk under non- his/her liabilities promptly as and recourse factoring i.e., full amount when these arise; of invoice is paid to the client in the (iii) Factoring as a source of funds event of the debt becoming bad. is flexible and ensures a definite 2024-25 Chapter 8.indd 179 9/2/2022 2:14:09 PM  180 BUSINESS  STUDIES pattern of cash inflows from credit arrangements are given in the lease sales. It provides security for a contract. At the end of the lease period, debt that a firm might otherwise the asset goes back to the lessor. Lease be unable to obtain; finance provides an important means (iv) It does not create any charge on of modernisation and diversification to the assets of the firm; the firm. Such type of financing is more (v) The client can concentrate on prevalent in the acquisition of such other functional areas of business assets as computers and electronic as the responsibility of credit equipment which become obsolete control is shouldered by the quicker because of the fast changing factor. technological developments. While making the leasing decision, the cost Limitations of leasing an asset must be compared with the cost of owning the same. The limitations of factoring as a source of finance are as follows: Merits (i) This source is expensive when the invoices are numerous and The important merits of lease financing smaller in amount; are as follows: (ii) The advance finance provided (i) It enables the lessee to acquire the by the factor firm is generally asset with a lower investment; available at a higher interest cost (ii) Simple documentation makes it than the usual rate of interest; easier to finance assets; (iii) Lease rentals paid by the lessee (iii) The factor is a third party to are deductible for computing the customer who may not feel taxable profits; comfortable while dealing with it. (iv) It provides finance without diluting the ownership or control 8.4.4 Lease Financing of business; A lease is a contractual agreement (v) The lease agreement does not whereby one party i.e., the owner of an affect the debt raising capacity of asset grants the other party the right an enterprise; to use the asset in return for a periodic (vi) The risk of obsolescence is borne payment. In other words it is a renting by the lesser. This allows greater flexibility to the lessee to replace of an asset for some specified period. the asset. The owner of the assets is called the ‘lessor’ while the party that uses the Limitations assets is known as the ‘lessee’ (see Box A). The lessee pays a fixed periodic The limitations of lease financing are amount called lease rental to the lessor given as below: for the use of the asset. The terms (i) A lease arrangement may impose and conditions regulating the lease certain restrictions on the use 2024-25 Chapter 8.indd 180 9/2/2022 2:14:09 PM  SOURCES OF BUSINESS FINANCE 181 of assets. For example, it may (iii) It may result in higher payout not allow the lessee to make any obligation in case the equipment alteration or modification in the is not found useful and the lessee opts for premature termination of asset; the lease agreement; and (ii) The normal business operations (iv) The lessee never becomes the may be affected in case the lease owner of the asset. It deprives him is not renewed; of the residual value of the asset. Box A The Lessors 1. Specialised leasing companies: There are about 400-odd large companies which have an organisational focus on leasing, and hence, are known as leasing companies. 2. Banks and bank-subsidiaries: In February 1994, the RBI allowed banks to directly enter leasing. Till then, only bank subsidiaries were allowed to engage in leasing operations, which was regarded by the RBI as a non-banking activity. 3. Specialised financial institutions: A number of financial institutions, at the Central as well as the State level in India, use the lease instrument along with traditional financing instruments. Significantly, the ICICI is one of the pioneers in Indian leasing. 4. Manufacturer-lessors: As competition forces the manufacturer to add value to his sales, he finds the best way to sell the product on lease. Vendor leasing is gaining increasing importance. Presently, vendors of automobiles, consumer durables, etc., have alliances or joint ventures with leasing companies to offer lease finance against their products. The Lessees 1. Public sector undertakings: This market has witnessed a good rate of growth in the past. There is an increasing number of both centrally as well as State- owned entities which have resorted to lease financing. 2. Mid-market companies: The mid-market companies (i.e., companies with reasonably good creditworthiness but with lower public profile) have resorted to lease financing basically as an alternative to bank/institutional financing. 3. Consumers: Recent bad experience with corporate financing has focussed attention towards retail funding of consumer durables. For instance, car leasing is a big market in India today. 4. Government deptts. and authorities: One of the latest entrants in leasing markets is the government itself. Recently the Department of Telecommunications of the central government took the lead by floating tenders for lease finance worth about ` 1000 crores. 2024-25 Chapter 8.indd 181 9/2/2022 2:14:09 PM  182 BUSINESS  STUDIES 8.4.5 Public Deposits (iv) As the depositors do not have The deposits that are raised by voting rights, the control of the organisations directly from the public company is not diluted. are known as public deposits. Rates of interest offered on public deposits Limitations are usually higher than that offered The major limitation of public deposits on bank deposits. Any person who is are as follows: interested in depositing money in an (i) New companies generally find it organisation can do so by filling up difficult to raise funds through a prescribed form. The organisation public deposits; in return issues a deposit receipt as (ii) It is an unreliable source of finance acknowledgment of the debt. Public as the public may not respond deposits can take care of both medium when the company needs money; and short-term financial requirements (iii) Collection of public deposits may of a business. The deposits are prove difficult, particularly when beneficial to both the depositor as the size of deposits required is well as to the organisation. While the large. depositors get higher interest rate than that offered by banks, the cost of 8.4.6 Commercial Paper deposits to the company is less than the cost of borrowings from banks. Commercial Paper (CP) is an unsecured Companies generally invite public money market instrument issued in deposits for a period upto three years. the form of a promissory note. It was The acceptance of public deposits is introduced in India in 1990 for enabling regulated by the Reserve Bank of India. highly rated corporate borrowers to diversify their sources of short-term Merits borrowings and to provide an additional instrument to investors. Subsequently, The merits of public deposits are: primary dealers and all-India financial (i) The procedure of obtaining institutions were also permitted to deposits is simple and does not issue CP to enable them to meet their contain restrictive conditions short-term funding requirements for as are generally there in a loan agreement; their operations. Individuals, banking (ii) C o s t o f p u b l i c d e p o s i t s i s companies, other corporate bodies generally lower than the cost (registered or incorporated in India) of borrowings from banks and and unincorporated bodies, Non- financial institutions; Resident Indians (NRIs) and Foreign (iii) Public deposits do not usually Institutional Investors (FIIs) etc. can create any charge on the assets of invest in CPs. CP can be issued for the company. The assets can be maturities between a minimum of 7 used as security for raising loans days and a maximum of up to one year from other sources; from the date of issue in denominations 2024-25 Chapter 8.indd 182 9/2/2022 2:14:09 PM  SOURCES OF BUSINESS FINANCE 183 of Rs.5 lakh or multiples thereof. (iii) C o m m e r c i a l p a p e r i s a n However, the maturity date of the CP impersonal method of financing. should not go beyond the date up to As such if a firm is not in a which the credit rating of the issuer position to redeem its paper is valid. due to financial difficulties, extending the maturity of a CP is Merits not possible. (i) A commercial paper is sold on 8.4.7 Issue of Shares an unsecured basis and does not contain any restrictive conditions; The capital obtained by issue of shares (ii) As it is a freely transferable is known as share capital. The capital instrument, it has high liquidity; of a company is divided into small (iii) It provides more funds compared units called shares. Each share has to other sources. Generally, the its nominal value. For example, a cost of CP to the issuing firm is company can issue 1,00,000 shares lower than the cost of commercial of Rs. 10 each for a total value of bank loans; Rs. 10,00,000. The person holding (iv) A commercial paper provides a the share is known as shareholder. continuous source of funds. This There are two types of shares normally is because their maturity can be issued by a company. These are tailored to suit the requirements equity shares and preference shares. of the issuing firm. Further, The money raised by issue of equity maturing commercial paper shares is called equity share capital, can be repaid by selling new while the money raised by issue of commercial paper; preference shares is called preference (v) Companies can park their excess share capital. funds in commercial paper (a) Equity Shares thereby earning some good return E q u i t y s h a r e s i s t h e m o s t on the same. important source of raising long term capital by a company. Equity Limitations shares represent the ownership of (i) Only financially sound and highly a company and thus the capital rated firms can raise money raised by issue of such shares through commercial papers. New is known as ownership capital and moderately rated firms are or owner’s funds. Equity share not in a position to raise funds by capital is a prerequisite to the this method; creation of a company. Equity (ii) The size of money that can be shareholders do not get a fixed raised through commercial paper dividend but are paid on the is limited to the excess liquidity basis of earnings by the company. available with the suppliers of They are referred to as ‘residual funds at a particular time; owners’ since they receive what 2024-25 Chapter 8.indd 183 9/2/2022 2:14:09 PM  184 BUSINESS  STUDIES is left after all other claims on (vi) D e m o c r a t i c c o n t r o l o v e r the company’s income and assets management of the company is have been settled. They enjoy assured due to voting rights of the reward as well as bear the equity shareholders. risk of ownership. Their liability, however, is limited to the extent of Limitations capital contributed by them in the The major limitations of raising funds company. Further, through their through issue of equity shares are as right to vote, these shareholders have a right to participate in the follows: management of the company. (i) Investors who want steady income may not prefer equity shares Merits as equity shares get fluctuating The important merits of raising funds returns; through issuing equity shares are (ii) The cost of equity shares is given as below: generally more as compared to (i) Equity shares are suitable for the cost of raising funds through investors who are willing to other sources; assume risk for higher returns; (iii) Issue of additional equity shares (ii) Payment of dividend to the equity dilutes the voting power, and shareholders is not compulsory. earnings of existing equity Therefore, there is no burden on shareholders; the company in this respect; (iv) More formalities and procedural (iii) Equity capital serves as permanent delays are involved while raising capital as it is to be repaid only funds through issue of equity at the time of liquidation of a share. company. As it stands last in (b) Preference Shares the list of claims, it provides a The capital raised by issue cushion for creditors, in the event of preference shares is called of winding up of a company; preference share capital. The (iv) Equity capital provides credit preference shareholders enjoy worthiness to the company and a preferential position over confidence to prospective loan equity shareholders in two ways: providers; (i) receiving a fixed rate of dividend, (v) Funds can be raised through out of the net profits of the equity issue without creating company, before any dividend is any charge on the assets of declared for equity shareholders; the company. The assets of a and (ii) receiving their capital company are, therefore, free to after the claims of the company’s be mortgaged for the purpose of creditors have been settled, at borrowings, if the need be; the time of liquidation. In other 2024-25 Chapter 8.indd 184 9/2/2022 2:14:09 PM  SOURCES OF BUSINESS FINANCE 185 words, as compared to the equity (v) Preference shareholders have a shareholders, the preference preferential right of repayment shareholders have a preferential over equity shareholders in the claim over dividend and repayment event of liquidation of a company; of capital. Preference shares (vi) Preference capital does not create resemble debentures as they any sort of charge against the bear fixed rate of return. Also assets of a company. as the dividend is payable only at the discretion of the directors Limitations and only out of profit after tax, to The major limitations of preference that extent, these resemble equity shares as source of business finance shares. Thus, preference shares are as follows: have some characteristics of both (i) Preference shares are not suitable equity shares and debentures. for those investors who are willing Preference shareholders generally to take risk and are interested in do not enjoy any voting rights. A higher returns; company can issue different types (ii) Preference capital dilutes the of preference shares (see Box B). claims of equity shareholders over assets of the company; Merits (iii) The rate of dividend on preference shares is generally higher than The merits of preference shares are the rate of interest on debentures; given as follows: (iv) As the dividend on these shares is (i) P r e f e r e n c e s h a r e s p r o v i d e to be paid only when the company reasonably steady income in the earns profit, there is no assured form of fixed rate of return and return for the investors. Thus, safety of investment; these shares may not be very (ii) Preference shares are useful for attractive to the investors; those investors who want fixed (v) The dividend paid is not deductible rate of return with comparatively from profits as expense. Thus, low risk; there is no tax saving as in the (iii) It does not affect the control case of interest on loans. of equity shareholders over the management as preference 8.4.8 Debentures shareholders don’t have voting Debentures are an important rights; instrument for raising long term debt (iv) Payment of fixed rate of dividend capital. A company can raise funds to preference shares may enable through issue of debentures, which a company to declare higher bear a fixed rate of interest. The rates of dividend for the equity debenture issued by a company is an shareholders in good times; acknowledgment that the company 2024-25 Chapter 8.indd 185 9/2/2022 2:14:09 PM  186 BUSINESS  STUDIES has borrowed a certain amount of Merits money, which it promises to repay at The merits of raising funds through a future date. Debenture holders are, therefore, termed as creditors of the debentures are given as follows: company. Debenture holders are paid (i) It is preferred by investors who a fixed stated amount of interest at want fixed income at lesser risk; specified intervals say six months or (ii) Debentures are fixed charge funds one year. Public issue of debentures and do not participate in profits requires that the issue be rated by a of the company; credit rating agency like CRISIL (Credit (iii) The issue of debentures is suitable Rating and Information Services of in the situation when the sales India Ltd.) on aspects like track record and earnings are relatively stable; of the company, its profitability, debt (iv) As debentures do not carry servicing capacity, credit worthiness voting rights, financing through and the perceived risk of lending. A debentures does not dilute company can issue different types of control of equity shareholders on debentures (see Box C and D). Issue of Zero Interest Debentures (ZID) which management; do not carry any explicit rate of interest (v) Financing through debentures is has also become popular in recent less costly as compared to cost of years. The difference between the face preference or equity capital as the value of the debenture and its purchase interest payment on debentures is price is the return to the investor. tax deductible. Box B 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. 2024-25 Chapter 8.indd 186 9/2/2022 2:14:09 PM  SOURCES OF BUSINESS FINANCE 187 Limitations 8.4.9 Commercial Banks Debentures as source of funds has Commercial banks occupy a vital certain limitations. These are given position as they provide funds for as follows: different purposes as well as for (i) As fixed charge instruments, different time periods. Banks extend debentures put a permanent loans to firms of all sizes and in many burden on the earnings of a ways, like, cash credits, overdrafts, term company. There is a greater risk loans, purchase/discounting of bills, when earnings of the company and issue of letter of credit. The rate fluctuate; of interest charged by banks depends (ii) In case of redeemable debentures, on various factors such as the the company has to make provisions for repayment on characteristics of the firm and the the specified date, even during level of interest rates in the economy. periods of financial difficulty; The loan is repaid either in lump sum (iii) E a c h c o m p a n y h a s c e r t a i n or in installments. borrowing capacity. With the Bank credit is not a permanent issue of debentures, the capacity source of funds. Though banks have of a company to further borrow started extending loans for longer funds reduces. periods, generally such loans are Box C 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. 2024-25 Chapter 8.indd 187 9/2/2022 2:14:09 PM  188 BUSINESS  STUDIES used for medium to short periods. of obtaining funds slightly The borrower is required to provide difficult; some security or create a charge on (iii) In some cases, difficult terms and the assets of the firm before a loan is conditions are imposed by banks. sanctioned by a commercial bank. for the grant of loan. For example, restrictions may be imposed on Merits the sale of mortgaged goods, thus The merits of raising funds from a making normal business working commercial bank are as follows: difficult. (i) Banks provide timely assistance to business by providing funds as 8.4.10 Financial Institutions and when needed by it. The government has established (ii) Secrecy of business can be a number of financial institutions maintained as the information all over the country to provide supplied to the bank by the finance to business organisations borrowers is kept confidential; (see Box E). These institutions are (iii) Formalities such as issue of established by the central as well as prospectus and underwriting are state governments. They provide both not required for raising loans owned capital and loan capital for long from a bank. This, therefore, is and medium term requirements and an easier source of funds; supplement the traditional financial (iv) Loan from a bank is a flexible agencies like commercial banks. As source of finance as the loan these institutions aim at promoting the amount can be increased according to business needs and industrial development of a country, can be repaid in advance when these are also called ‘development funds are not needed. banks’. In addition to providing financial assistance, these institutions Limitations also conduct market surveys and provide technical assistance and The major limitations of commercial managerial services to people who banks as a source of finance are as run the enterprises. This source of follows: financing is considered suitable when (i) Funds are generally available for large funds for longer duration are short periods and its extension or required for expansion, reorganisation renewal is uncertain and difficult; and modernisation of an enterprise. (ii) Banks make detailed investigation of the company’s affairs, financial Merits structure etc., and may also ask for security of assets and personal The merits of raising funds through sureties. This makes the procedure financial institutions are as follows: 2024-25 Chapter 8.indd 188 9/2/2022 2:14:09 PM  SOURCES OF BUSINESS FINANCE 189 BOX D Inter Corporate Deposits (ICD) Inter Corporate Deposits are unsecured short-term deposits made by a company with another company. ICD market is used for short-term cash management of a large corporate. As per the RBI guidelines, the minimum period of ICDs is 7 days which can be extended to one year. The three types of Inter Corporate Deposits are: (i) Three months deposits; (ii) Six months deposits; (iii) Call deposits. Interest rate on ICDs may remain fixed or may be floating. The rate of interest on these deposits is higher than that of banks. These deposits are usually considered by the borrower company to solve problems of short-term funds insufficiency. (i) Financial institutions provide (i) Financial institutions follow long-term finance, which are not rigid criteria for grant of loans. provided by commercial banks; Too many formalities make the (ii) Besides providing funds, many procedure time consuming and of these institutions provide expensive; financial, managerial and technical advice and consultancy (ii) Certain restrictions such as to business firms; restriction on dividend payment (iii) Obtaining loan from financial are imposed on the powers of institutions increases the goodwill the borrowing company by the of the borrowing company in the financial institutions; capital market. Consequently, (iii) Financial institutions may have such a company can raise funds their nominees on the Board easily from other sources as well; of Directors of the borrowing (iv) As repayment of loan can be made company thereby restricting the in easy instalments, it does not prove to be much of a burden on powers of the company. the business; (v) The funds are made available 8.5 International Financing even during periods of depression, In addition to the sources discussed when other sources of finance are above, there are various avenues not available. for organisations to raise funds internationally. With the opening up Limitations of an economy and the operations of The major limitations of raising funds the business organisations becoming from financial institutions are as given global, Indian companies have an below: access to funds in global capital 2024-25 Chapter 8.indd 189 9/2/2022 2:14:09 PM  190 BUSINESS  STUDIES market. Various international sources of a company are delivered to the from where funds may be generated depository bank. The depository include: bank issues depository receipts (i)  Commercial Banks: Commercial against these shares. Such banks all over the world extend foreign depository receipts denominated currency loans for business purposes. in US dollars are known as Global They are an important source of Depository Receipts (GDR). GDR is financing non-trade international a negotiable instrument and can be operations. The types of loans and traded freely like any other security. services provided by banks vary from In the Indian context, a GDR is an country to country. For example, instrument issued abroad by an Standard Chartered emerged as a Indian company to raise funds major source of foreign currency loans in some foreign currency and is to the Indian industry. listed and traded on a foreign stock exchange. A holder of GDR (ii) International Agencies and can at any time convert it into the Development Banks: A number number of shares it represents. The of international agencies and holders of GDRs do not carry any development banks have emerged over voting rights but only dividends the years to finance international trade and capital appreciation. Many and business. These bodies provide Indian companies such as Infosys, long and medium term loans and Reliance, Wipro and ICICI have grants to promote the development of raised money through issue of economically backward areas in the GDRs (see Box F). world. These bodies were set up by the (b) American Depository Receipts Governments of developed countries (ADRs): The depository receipts of the world at national, regional and issued by a company in the USA international levels for funding various are known as American Depository projects. The more notable among Receipts. ADRs are bought and sold them include International Finance in American markets, like regular Corporation (IFC), EXIM Bank and stocks. It is similar to a GDR Asian Development Bank. except that it can be issued only to (iii) International Capital Markets: American citizens and can be listed Modern organisations including and traded on a stock exchange multinational companies depend of USA. upon sizeable borrowings in rupees as (c) Indian Depository Receipt (IDRs): well as in foreign currency. Prominent An Indian Depository Receipt is a financial instruments used for this financial instrument denominated purpose are: in Indian Rupees in the form of a (a) Global Depository Receipts Depository Receipt. It is created (GDR’s): The local currency shares by an Indian Depository to enable 2024-25 Chapter 8.indd 190 9/2/2022 2:14:09 PM  SOURCES OF BUSINESS FINANCE 191 Box E Companies rush to float GDR issues It’s not the IPO (initial public offer) market alone which is humming with activity. Companies — mostly small and medium-sized — are rushing to the overseas market to raise funds through Global Depository Receipts (GDRs). Five firms have already raised $464 million (around ` 2,040 crore) from the international markets through GDR offerings this year. This is almost double of $228.6 mn raised by nine companies in 2004 and $63.09 mn mobilised by four companies in 2003. Nearly 20 companies are waiting in the wings to launch GDR issues worth over $1 bn in the coming months. On the other hand, though the number of companies going for FCCB (Foreign Currency Convertible Bonds) issues has come down, several companies are still in the FCCB race, thanks to lax rules and disclosure norms. For example, Aarti Drugs Ltd. has decided to raise $12 mn by issuing FCCBs. Significantly, small and medium companies are now taking the GDR route to raise funds this time even for a small amount. For example, Opto Circuits has decided to go for a GDR issue of $20 mn with a green-shoe option of $5 mn. The share price of this company shot up by 370 per cent from ` 34 on May 17, 2004 to around ` 160 on the BSE recently. Videocon Industries, Lyka Labs, Indian Overseas Bank, Jubilant Organosys, Maharashtra Seamless, Moschip Semiconductors, and Crew BOS are planning GDR issues. Two banks — UTI Bank ($240 million) and Centurion Bank ($70 million) — raised funds from the GDR market recently. Companies now prefer GDR over FCCB issues in view of the rise in interest rates abroad. a foreign company to raise funds issued. The issuer company makes from the Indian securities market. a public offer in India, and residents The IDR is a specific Indian version can bid in exactly the same format and of the similar global depository method as they bid for Indian shares. receipts. ‘Standard Chartered PLC’ was The foreign company issuing the first company that issued Indian IDR deposits shares to an Indian Depository Receipt in Indian securities Depository (custodian of securities market in June 2010. registered with the Securities and (d) Foreign Currency Convertible Exchange Board of India). In turn, the Bonds (FCCBs): Foreign currency depository issues receipts to investors convertible bonds are equity linked in India against these shares. The debt securities that are to be benefits of the underlying shares (like converted into equity or depository bonus, dividends, etc.) accrue to the receipts after a specific period. IDR holders in India. Thus, a holder of FCCB has the According to SEBI guidelines, option of either converting them into IDRs are issued to Indian residents in equity shares at a predetermined the same way as domestic shares are price or exchange rate, or retaining 2024-25 Chapter 8.indd 191 9/2/2022 2:14:09 PM  192 BUSINESS  STUDIES the bonds. The FCCB’s are issued (ii) Financial strength and stability in a foreign currency and carry a of operations: The financial fixed interest rate which is lower strength of a business is also a than the rate of any other similar key determinant. In the choice of non-convertible debt instrument. source of funds business should FCCB’s are listed and traded in be in a sound financial position foreign stock exchanges. FCCB’s so as to be able to repay the are very similar to the convertible principal amount and interest on debentures issued in India. the borrowed amount. When the earnings of the organisation are 8.6 Factors Affecting the Choice not stable, fixed charged funds like of the Source of Funds preference shares and debentures should be carefully selected as Financial needs of a business are of these add to the financial burden different types — long term, short of the organisation. term, fixed and fluctuating. Therefore, (iii) Form of organisation and legal business firms resort to different types status: The form of business of sources for raising funds. Short- organisation and status influences term borrowings offer the benefit of the choice of a source for raising reduced cost due to reduction of idle money. A partnership firm, for capital, but long – term borrowings example, cannot raise money by are considered a necessity on many issue of equity shares as these grounds. Similarly equity capital has can be issued only by a joint stock a role to play in the scheme for raising company. funds in the corporate sector. (iv) P u r po s e a n d t i m e pe r i o d: As no source of funds is devoid Business should plan according of limitations, it is advisable to use to the time period for which the a combination of sources, instead funds are required. A short-term of relying only on a single source. A need for example can be met number of factors affect the choice through borrowing funds at low of this combination, making it a very rate of interest through trade complex decision for the business. The credit, commercial paper, etc. For factors that affect the choice of source long term finance, sources such of finance are briefly discussed below: as issue of shares and debentures (i) Cost: There are two types of cost are more appropriate. Similarly, viz., the cost of procurement of the purpose for which funds are funds and cost of utilising the required need to be considered so funds. Both these costs should be that the source is matched with taken into account while deciding the use. For example, a long- about the source of funds that will term business expansion plan be used by an organisation. should not be financed by a bank 2024-25 Chapter 8.indd 192 9/2/2022 2:14:09 PM  SOURCES OF BUSINESS FINANCE 193 overdraft which will be required to (vii) Effect on credit worthiness: be repaid in the short term. The dependence of business on (v) Risk profile: Business should certain sources may affect its evaluate each of the source credit worthiness in the market. of finance in terms of the risk For example, issue of secured involved. For example, there is a debentures may affect the interest least risk in equity as the share of unsecured creditors of the capital has to be repaid only at the company and may adversely time of winding up and dividends affect their willingness to extend need not be paid if no profits are further loans as credit to the available. A loan on the other company. hand, has a repayment schedule (viii) Flexibility and ease: Another for both the principal and the aspect affecting the choice of a interest. The interest is required source of finance is the flexibility to be paid irrespective of the firm and ease of obtaining funds. earning a profit or incurring a Restrictive provisions, detailed loss. investigation and documentation in case of borrowings from banks (vi) Control: A particular source and financial institutions for of fund may affect the control example may be the reason that and power of the owners on the a business organisations may management of a firm. Issue of not prefer it, if other options are equity shares may mean dilution readily available. of the control. For example, as (ix) Tax benefits: Various sources equity share holders enjoy voting may also be weighed in terms of rights, financial institutions may their tax benefits. For example, take control of the assets or while the dividend on preference impose conditions as part of the shares is not tax deductible, loan agreement. Thus, business interest paid on debentures firm should choose a source and loan is tax deductible and keeping in mind the extent to may, therefore, be preferred which they are willing to share by organisations seeking tax their control over business. advantage. 2024-25 Chapter 8.indd 193 9/2/2022 2:14:09 PM  194 BUSINESS  STUDIES Key Terms Finance Owned capital Fixed capital Working capital Borrowed capital Short term sources Restrictive conditions Long term sources Charge on assets Voting power Fixed charge funds Accounts receivable Bill discounting Factoring GDRs FCCBs ADRs 1CD 1DR SUMMARY Meaning and significance of business finance: Finance required by business to establish and run its operations is known as business finance. No business can function without adequate amount of funds for undertaking various activities. The funds are required for purchasing fixed assets (fixed capital requirement), for running day-to-day operations (working capital requirement), and for undertaking growth and expansion plans in a business organisation. Classification of sources of funds: Various sources of funds available to a business can be classified according to three major basis, which are (i) time period (long, medium and short term), (ii) ownership (owner’s funds and borrowed funds), and (iii) source of generation (internal sources and external sources). Long, medium and short-term sources of funds: The sources that provide funds for a period exceeding 5 years are called long-term sources. The sources that fulfill the financial requirements for the period of more than one year but not exceeding 5 years are called medium term sources and the sources that provide funds for a period not exceeding one year are termed as short term sources. Owner’s funds and borrowed funds: Owner’s funds refer to the funds that are provided by the owners of an enterprise. Borrowed capital, on the other hand, refers to the funds that are generated through loans or borrowings from other individuals or institutions. Internal and external sources: Internal sources of capital are those sources that are generated within the business say through ploughing back of profits. External sources of capital, on the other hand are those that are outside the business such as finance provided by suppliers, lenders, and investors. 2024-25 Chapter 8.indd 194 9/2/2022 2:14:09 PM  SOURCES OF BUSINESS FINANCE 195 Sources of business finance: The sources of funds available to a business include retained earnings, trade credit, factoring, lease financing, public deposits, commercial paper, issue of shares and debentures, loans from commercial banks, financial institutions and international sources of finance. Retained earnings: The portion of the net earnings of the company that is not distributed as dividends is known as retained earnings. The amount of retained earnings available depends on the dividend policy of the company. It is generally used for growth and expansion of the company. Trade credit: The credit extended by one trader to another for purchasing goods or services is known as trade credit. Trade credit facilitates the purchase of supplies on credit. The terms of trade credit vary from one industry to another and are specified on the invoice. Small and new firms are usually more dependent on trade credit, as they find it relatively difficult to obtain funds from other sources. Factoring: Factoring has emerged as a popular source of short-term funds in recent years. It is a financial service whereby the factor is responsible for all credit control and debt collection from the buyer and provides protection against any bad-debt losses to the firm. There are two methods of factoring — recourse and non-recourse factoring. Lease financing: A lease is a contractual agreement whereby the owner of an asset (lessor) grants the right to use the asset to the other party (lessee). The lessor charges a periodic payment for renting of an asset for some specified period called lease rent. Public deposits: A company can raise funds by inviting the public to deposit their savings with their company. Pubic deposits may take care of both long and short-term financial requirements of business. Rate of interest on deposits is usually higher than that offered by banks and other financial institutions. Commercial paper (CP): It is an unsecured promissory note issued by a firm to raise funds for a short period The maturity period of commercial paper usually ranges from 90 days to 364 days. Being unsecured, only firms having good credit rating can issue the CP and its regulation comes under the purview of the Reserve Bank of India. Issue of equity shares: Equity shares represents the ownership capital of a company. Due to their fluctuating earnings, equity shareholders are called risk bearers of the company. These shareholders enjoy higher returns during prosperity and have a say in the management of a company, through exercising their voting rights. Issue of preference shares: These shares provide a preferential right to the shareholders with respect to payment of earnings and the repayment of 2024-25 Chapter 8.indd 195 9/2/2022 2:14:09 PM  196 BUSINESS  STUDIES capital. Investors who prefer steady income without undertaking higher risks prefer these shares. A company can issue different types of preference shares. Issue of debentures: Debenture represents the loan capital of a company and the holders of debentures are the creditors. These are the fixed charged funds that carry a fixed rate of interest. The issue of debentures is suitable in the situation when the sales and earnings of the company are relatively stable. Commercial banks: Banks provide short and medium-term loans to firms of all sizes. The loan is repaid either in lump sum or in instalments. The rate of interest charged by a bank depends upon factors including the characteristics of the borrowing firm and the level of interest rates in the economy. 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. EXERCISES Short Answer Questions 1. What is business finance? Why do businesses need funds? Explain. 2. List sources of raising long-term and short-term finance. 3. What is the difference between internal and external sources of raising funds? Explain. 4. What preferential rights are enjoyed by preference shareholders. Explain. 5. Name any three special financial institutions and state their objectives. 6. What is the difference between GDR and ADR? Explain. Long Answer Questions 1. Explain trade credit and bank credit as sources of short-term finance for business enterprises. 2. Discuss the sources from which a large industrial enterprise can raise capital for financing modernisation and expansion. 3. What advantages does issue of debentures provide over the issue of equity shares? 4. State the merits and demerits of public deposits and retained earnings as methods of business finance. 2024-25 Chapter 8.indd 196 9/2/2022 2:14:09 PM  SOURCES OF BUSINESS FINANCE 197 Projects/Assignment 1. Collect information about the companies that have issued debentures in recent years. Give suggestions to make debentures more popular. 2. Institutional financing has gained importance in recent years. In a scrapbook paste detailed information about various financial institutions that provide financial assistance to Indian companies. 3. On the basis of the sources discussed in the chapter, suggest suitable options to solve the financial problem of the restaurant owner. 4. Prepare a comparative chart of all the sources of finance. 2024-25 Chapter 8.indd 197 9/2/2022 2:14:09 PM