NCERT Class 11 Business Studies Chapter 8: Sources of Business Finance PDF

CHAPTER 8 S OURCES 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...

CHAPTER 8 S OURCES 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. 2019-20 186 BUSINESS STUDIES 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 of society. For carrying out various activities, business requires money. This chapter provides an overview of the Finance, therefore, is called the various sources from where funds can life blood of any business. The 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 about take care of all financial requirements the different sources from where money of the business. A business person, can be raised. It is also important to therefore, has to look for different other know the relative merits and demerits sources from where the need for funds of different sources so that choice of an can be met. A clear assessment of the appropriate source can be made. financial needs and the identification of various sources of finance, therefore, 8.2 M E A N I N G , N A T U R E A N D is a significant aspect of running a S IGNIFICANCE OF BUSINESS business organisation. FINANCE The need for funds arises from the Business is concerned with the stage when an entrepreneur makes a production and distribution of goods decision to start a business. Some and services for the satisfaction of needs funds are needed immediately say for 2019-20 SOURCES OF BUSINESS FINANCE 187 the purchase of plant and machinery, The amount of working capital furniture, and other fixed assets. required varies from one business Similarly, some funds are required for concern to another depending on various day-to-day operations, say to purchase factors. A business unit selling goods on raw materials, pay salaries to credit, or having a slow sales turnover, employees, etc. Also when the business for example, would require more expands, it needs funds. working capital as compared to a The financial needs of a business can concern selling its goods and services on be categorised as follows: cash basis or having a speedier turnover. (a) Fixed capital requirements: In The requirement for fixed and order to start business, funds are working capital increases with the required to purchase fixed assets like growth and expansion of business. At land and building, plant and times additional funds are required for machinery, and furniture and upgrading the technology employed so fixtures. This is known as fixed that the cost of production or operations capital requirements of the can be reduced. Similarly, larger funds enterprise. The funds required in may be required for building higher fixed assets remain invested in the inventories for the festive season or to business for a long period of time. meet current debts or expand the Different business units need varying business or to shift to a new location. It amount of fixed capital depending on is, therefore, important to evaluate the various factors such as the nature of different sources from where funds can business, etc. A trading concern for be raised. example, may require small amount of fixed capital as compared to a 8.3 C LASSIFICATION OF SOURCES OF manufacturing concern. Likewise, FUNDS the need for fixed capital investment would be greater for a large In case of proprietary and partnership enterprise, as compared to that of a concerns, the funds may be raised either small enterprise. from personal sources or borrowings (b)Working capital requirements: from banks, friends etc. In case of The financial requirements of an company form of organisation, the enterprise do not end with the different sources of business finance procurement of fixed assets. No which are available may be categorised matter how small or large a business as given in Table 8.1 is, it needs funds for its day-to-day As shown in the table, the sources operations. This is known as working of funds can be categorised using capital of an enterprise, which is used different basis viz., on the basis of the for holding current assets such as period, source of generation and the stock of material, bills receivables and ownership. A brief explanation of these for meeting current expenses like classifications and the sources is salaries, wages, taxes, and rent. provided as follows: 2019-20  188 Table 8.1 Classification of Sources of Funds BUSINESS STUDIES 2019-20 SOURCES OF BUSINESS FINANCE 189 8.3.1 Period Basis 8.3.2 Ownership Basis On the basis of period, the different On the basis of ownership, the sources sources of funds can be categorised can be classified into ‘owner’s funds’ into three parts. These are long-term and ‘borrowed funds’. Owner’s funds sources, medium-term sources and means funds that are provided by the short-term sources. owners of an enterprise, which may The long-term sources fulfil the be a sole trader or partners or financial requirements of an enterprise shareholders of a company. Apart for a period exceeding 5 years and from capital, it also includes profits include sources such as shares and reinvested in the business. The debentures, long-term borrowings and owner’s capital remains invested in the loans from financial institutions. Such business for a longer duration and is financing is generally required for the acquisition of fixed assets such as not required to be refunded during the equipment, plant, etc. life period of the business. Such capital Where the funds are required for a forms the basis on which owners period of more than one year but less acquire their right of control of than five years, medium-term sources management. Issue of equity shares of finance are used. These sources and retained earnings are the two include borrowings from commercial important sources from where owner’s banks, public deposits, lease financing funds can be obtained. and loans from financial institutions. ‘Borrowed funds’ on the other Short-term funds are those which hand, refer to the funds raised through are required for a period not exceeding loans or borrowings. The sources for one year. Trade credit, loans from raising borrowed funds include loans commercial banks and commercial from commercial banks, loans from papers are some of the examples of the financial institutions, issue of sources that provide funds for short debentures, public deposits and trade duration. credit. Such sources provide funds for Short-term financing is most a specified period, on certain terms common for financing of current assets and conditions and have to be repaid such as accounts receivable and after the expiry of that period. A fixed inventories. Seasonal businesses that must build inventories in anticipation rate of interest is paid by the of selling requirements often need short- borrowers on such funds. At times it term financing for the interim period puts a lot of burden on the business between seasons. Wholesalers and as payment of interest is to be made manufacturers with a major portion of even when the earnings are low or their assets tied up in inventories or when loss is incurred. Generally, receivables also require large amount borrowed funds are provided on the of funds for a short period. security of some fixed assets. 2019-20 190 BUSINESS STUDIES 8.3.3 Source of Generation Basis cost and associated risk, a choice may be made about the source to be used. Another basis of categorising the sources For example, if a business wants to of funds can be whether the funds are raise funds for meeting fixed capital generated from within the organisation or requirements, long term funds may be from external sources. Internal sources required which can be raised in the form of funds are those that are generated from of owned funds or borrowed funds. within the business. A business, for Similarly, if the purpose is to meet the example, can generate funds internally by day-to-day requirements of business, accelerating collection of receivables, the short term sources may be tapped. disposing of surplus inventories and A brief description of various sources, ploughing back its profit. The internal along with their advantages and sources of funds can fulfill only limited limitations is given below. needs of the business. 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 distribute lenders, and investors. When large all its earnings amongst the amount of money is required to be shareholders as dividends. A portion of raised, it is generally done through the the net earnings may be retained in the use of external sources. External funds business for use in the future. This is may be costly as compared to those known as retained earnings. It is a raised through internal sources. In source of internal financing or self- 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 deposits are some of the examples of Merits external sources of funds commonly The merits of retained earning as a used by business organisations. source of finance are as follows: (i) Retained earnings is a permanent 8.4 SOURCES OF FINANCE source of funds available to an A business can raise funds from organisation; various sources. Each of the source has (ii) It does not involve any explicit cost unique characteristics, which must be in the form of interest, dividend or properly understood so that the best floatation cost; available source of raising funds can (iii) As the funds are generated be identified. There is not a single best internally, there is a greater degree source of funds for all organisations. of operational freedom and Depending on the situation, purpose, flexibility; 2019-20 SOURCES OF BUSINESS FINANCE 191 (iv) It enhances the capacity of the record of payment and degree of business to absorb unexpected competition in the market. Terms of losses; trade credit may vary from one industry (v) It may lead to increase in the to another and from one person to market price of the equity shares another. A firm may also offer different of a company. credit terms to different customers. Limitations Merits Retained earning as a source of funds The important merits of trade credit are has the following limitations: as follows: (i) Excessive ploughing back may (i) Trade credit is a convenient and cause dissatisfaction amongst the continuous source of funds; shareholders as they would get (ii) T rade credit may be readily lower dividends; available in case the credit (ii) It is an uncertain source of funds worthiness of the customers is as the profits of business are known to the seller; fluctuating; (iii) Trade credit needs to promote the (iii) The opportunity cost associated sales of an organisation; (iv) If an organisation wants to increase with these funds is not recognised its inventory level in order to meet by many firms. This may lead to expected rise in the sales volume sub-optimal use of the funds. in the near future, it may use trade credit to, finance the same; 8.4.2 Trade Credit (v) It does not create any charge on Trade credit is the credit extended by the assets of the firm while one trader to another for the purchase providing funds. of goods and services. Trade credit facilitates the purchase of supplies Limitations without immediate payment. Such Trade credit as a source of funds has credit appears in the records of the certain limitations, which are given as buyer of goods as ‘sundry creditors’ or follows: ‘accounts payable’. Trade credit is (i) Availability of easy and flexible commonly used by business trade credit facilities may induce a organisations as a source of short-term firm to indulge in overtrading, financing. It is granted to those which may add to the risks of the customers who have reasonable amount firm; of financial standing and goodwill. The (ii) Only limited amount of funds can volume and period of credit extended be generated through trade credit; depends on factors such as reputation (iii) It is generally a costly source of of the purchasing firm, financial position funds as compared to most other of the seller, volume of purchases, past sources of raising money. 2019-20 192 BUSINESS STUDIES 8.4.3 Factoring services include SBI Factors and Factoring is a financial service under Commercial Services Ltd., Canbank Factors Ltd., Foremost Factors Ltd., which the ‘factor’ renders various State Bank of India, Canara Bank, services which includes: Punjab National Bank, Allahabad (a) Discounting of bills (with or without Bank. In addition, many non-banking recourse) and collection of the client’s finance companies and other debts. Under this, the receivables on agencies provide factoring service. account of sale of goods or services are sold to the factor at a certain Merits discount. The factor becomes responsible for all credit control and The merits of factoring as a source of finance are as follows: debt collection from the buyer and (i) Obtaining funds through factoring provides protection against any bad is cheaper than financing through debt losses to the firm. There are two other means such as bank credit; methods of factoring — recourse and (ii) With cash flow accelerated by non-recourse. Under recourse factoring, the client is able to meet factoring, the client is not protected his/her liabilities promptly as and against the risk of bad debts. On the when these arise; other hand, the factor assumes the (iii) Factoring as a source of funds is entire credit risk under non-recourse flexible and ensures a definite factoring i.e., full amount of invoice pattern of cash inflows from credit is paid to the client in the event of sales. It provides security for a the debt becoming bad. debt that a firm might otherwise (b) Providing information about credit be unable to obtain; worthiness of prospective client’s etc., (iv) It does not create any charge on Factors hold large amounts of the assets of the firm; information about the trading (v) The client can concentrate on other histories of the firms. This can be functional areas of business as the valuable to those who are using responsibility of credit control is factoring services and can thereby shouldered by the factor. avoid doing business with customers having poor payment record. Factors Limitations may also offer relevant consultancy The limitations of factoring as a source services in the areas of finance, of finance are as follows: marketing, etc. (i) This source is expensive when the The factor charges fees for the invoices are numerous and services rendered. Factoring smaller in amount; appeared on the Indian financial (ii) The advance finance provided by scene only in the early nineties as a the factor firm is generally available result of RBI initiatives. The at a higher interest cost than the organisations that provides such usual rate of interest; 2019-20 SOURCES OF BUSINESS FINANCE 193 (iii) The factor is a third party to the (iii) Lease rentals paid by the lessee are customer who may not feel deductible for computing taxable comfortable while dealing with it. profits; (iv) It provides finance without 8.4.4 Lease Financing diluting the ownership or control of business; A lease is a contractual agreement (v) The lease agreement does not affect whereby one party i.e., the owner of an the debt raising capacity of an asset grants the other party the right 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 of an asset for some specified period. flexibility to the lessee to replace The owner of the assets is called the the asset. ‘lessor’ while the party that uses the assets is known as the ‘lessee’ (see Limitations Box A). The lessee pays a fixed periodic amount called lease rental to the lessor The limitations of lease financing are for the use of the asset. The terms and given as below: conditions regulating the lease (i) A lease arrangement may impose arrangements are given in the lease certain restrictions on the use of contract. At the end of the lease period, assets. For example, it may not the asset goes back to the lessor. Lease allow the lessee to make any finance provides an important means alteration or modification in the of modernisation and diversification to asset; the firm. Such type of financing is more (ii) The normal business operations prevalent in the acquisition of such may be affected in case the lease assets as computers and electronic is not renewed; equipment which become obsolete (iii) It may result in higher payout quicker because of the fast changing obligation in case the equipment technological developments. While is not found useful and the lessee making the leasing decision, the cost opts for premature termination of of leasing an asset must be compared the lease agreement; and with the cost of owning the same. (iv) The lessee never becomes the owner of the asset. It deprives him Merits of the residual value of the asset. The important merits of lease financing 8.4.5 Public Deposits are as follows: (i) It enables the lessee to acquire the The deposits that are raised by asset with a lower investment; organisations directly from the public (ii) Simple documentation makes it are known as public deposits. Rates of easier to finance assets; interest offered on public deposits are 2019-20 194 BUSINESS STUDIES usually higher than that offered on beneficial to both the depositor as well bank deposits. Any person who is as to the organisation. While the interested in depositing money in an depositors get higher interest rate than organisation can do so by filling up a that offered by banks, the cost of prescribed form. The organisation in deposits to the company is less than return issues a deposit receipt as the cost of borrowings from banks. acknowledgment of the debt. Public Companies generally invite public deposits can take care of both medium deposits for a period upto three years. and short-term financial requirements The acceptance of public deposits is of a business. The deposits are regulated by the Reserve Bank of India. 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. 2019-20 SOURCES OF BUSINESS FINANCE 195 Merits business firms, insurance companies, pension funds and banks. The amount The merits of public deposits are: raised by CP is generally very large. As (i) The procedure of obtaining the debt is totally unsecured, the firms deposits is simple and does not having good credit rating can issue the contain restrictive conditions as are CP. Its regulation comes under the generally there in a loan agreement; purview of the Reserve Bank of India. (ii) Cost of public deposits is generally The merits and limitations of a lower than the cost of borrowings Commercial Paper are as follows: from banks and financial institutions; Merits (iii) Public deposits do not usually create any charge on the assets of (i) A commercial paper is sold on an the company. The assets can be unsecured basis and does not used as security for raising loans contain any restrictive conditions; from other sources; (ii) As it is a freely transferable (iv) As the depositors do not have instrument, it has high liquidity; voting rights, the control of the (iii) It provides more funds compared company is not diluted. to other sources. Generally, the cost of CP to the issuing firm is Limitations lower than the cost of commercial bank loans; The major limitation of public deposits (iv) A commercial paper provides a are as follows: continuous source of funds. This (i) New companies generally find it is because their maturity can be difficult to raise funds through tailored to suit the requirements public deposits; of the issuing firm. Further, (ii) It is an unreliable source of finance maturing commercial paper can as the public may not respond be repaid by selling new when the company needs money; commercial paper; (iii) Collection of public deposits may (v) Companies can park their excess prove difficult, particularly when funds in commercial paper the size of deposits required is large. thereby earning some good return on the same. 8.4.6 Commercial Paper (CP) Commercial Paper emerged as a source Limitations of short term finance in our country in (i) Only financially sound and highly the early nineties. Commercial paper is rated firms can raise money an unsecured promissory note issued through commercial papers. New by a firm to raise funds for a short and moderately rated firms are period, varying from 90 days to 364 not in a position to raise funds by days. It is issued by one firm to other this method; 2019-20 196 BUSINESS STUDIES (ii) The size of money that can be dividend but are paid on the basis raised through commercial paper of earnings by the company. They is limited to the excess liquidity are referred to as ‘residual owners’ available with the suppliers of since they receive what is left after funds at a particular time; all other claims on the company’s (iii) Commercial paper is an impersonal income and assets have been method of financing. As such if a settled. They enjoy the reward as firm is not in a position to redeem well as bear the risk of ownership. its paper due to financial Their liability, however, is limited difficulties, extending the maturity to the extent of capital contributed of a CP is not possible. by them in the company. Further, through their right to vote, these 8.4.7 Issue of Shares shareholders have a right to The capital obtained by issue of shares participate in the management of is known as share capital. The capital the company. of a company is divided into small units Merits called shares. Each share has its nominal value. For example, a The important merits of raising funds company can issue 1,00,000 shares through issuing equity shares are given of Rs. 10 each for a total value of as below: Rs. 10,00,000. The person holding the (i) Equity shares are suitable for share is known as shareholder. There investors who are willing to are two types of shares normally issued assume risk for higher returns; by a company. These are equity shares (ii) Payment of dividend to the equity and preference shares. The money shareholders is not compulsory. raised by issue of equity shares is called Therefore, there is no burden on equity share capital, while the money the company in this respect; raised by issue of preference shares is (iii) Equity capital serves as called preference share capital. permanent capital as it is to be (a) Equity Shares repaid only at the time of Equity shares is the most liquidation of a company. As it important source of raising long stands last in the list of claims, it term capital by a company. Equity provides a cushion for creditors, shares represent the ownership of in the event of winding up of a a company and thus the capital company; raised by issue of such shares is (iv) Equity capital provides credit known as ownership capital or worthiness to the company and owner’s funds. Equity share confidence to prospective loan capital is a prerequisite to the providers; creation of a company. Equity (v) Funds can be raised through shareholders do not get a fixed equity issue without creating 2019-20 SOURCES OF BUSINESS FINANCE 197 any charge on the assets of the and (ii) receiving their capital after company. The assets of a company the claims of the company’s are, therefore, free to be mortgaged creditors have been settled, at the for the purpose of borrowings, if the time of liquidation. In other words, need be; as compared to the equity (vi) Democratic control over shareholders, the preference management of the company is shareholders have a preferential assured due to voting rights of claim over dividend and repayment equity shareholders. of capital. Preference shares resemble debentures as they bear Limitations fixed rate of return. Also as the The major limitations of raising funds dividend is payable only at the through issue of equity shares are as discretion of the directors and only follows: out of profit after tax, to that extent, (i) Investors who want steady income these resemble equity shares. may not prefer equity shares as Thus, preference shares have some equity shares get fluctuating characteristics of both equity returns; shares and debentures. Preference (ii) The cost of equity shares is shareholders generally do not generally more as compared to the enjoy any voting rights. A company cost of raising funds through other can issue different types of sources; preference shares (see Box B). (iii) Issue of additional equity shares dilutes the voting power, and Merits earnings of existing equity The merits of preference shares are given shareholders; as follows: (iv) More formalities and procedural (i) Preference shares provide delays are involved while raising reasonably steady income in the funds through issue of equity form of fixed rate of return and share. safety of investment; (b) Preference Shares (ii) Preference shares are useful for The capital raised by issue of those investors who want fixed preference shares is called rate of return with comparatively preference share capital. The low risk; preference shareholders enjoy a (iii) It does not affect the control of preferential position over equity equity shareholders over the shareholders in two ways: management as preference (i) receiving a fixed rate of dividend, shareholders don’t have voting out of the net profits of the rights; company, before any dividend is (iv) Payment of fixed rate of dividend declared for equity shareholders; to preference shares may enable a 2019-20 198 BUSINESS STUDIES company to declare higher rates (iv) As the dividend on these shares is of dividend for the equity to be paid only when the company shareholders in good times; earns profit, there is no assured (v) Preference shareholders have a return for the investors. Thus, preferential right of repayment these shares may not be very over equity shareholders in the event attractive to the investors; of liquidation of a company; (v) The dividend paid is not (vi) Preference capital does not create deductible from profits as expense. any sort of charge against the Thus, there is no tax saving as in assets of a company. the case of interest on loans. Limitations 8.4.8 Debentures The major limitations of preference Debentures are an important shares as source of business finance instrument for raising long term debt are as follows: capital. A company can raise funds (i) Preference shares are not suitable through issue of debentures, which for those investors who are willing bear a fixed rate of interest. The to take risk and are interested in debenture issued by a company is an higher returns; acknowledgment that the company has (ii) Preference capital dilutes the borrowed a certain amount of money, claims of equity shareholders over which it promises to repay at a future assets of the company; date. Debenture holders are, therefore, (iii) The rate of dividend on preference termed as creditors of the company. shares is generally higher than the Debenture holders are paid a fixed rate of interest on debentures; stated amount of interest at specified 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. 2019-20 SOURCES OF BUSINESS FINANCE 199 intervals say six months or one year. Limitations Public issue of debentures requires Debentures as source of funds has that the issue be rated by a credit rating certain limitations. These are given as agency like CRISIL (Credit Rating and follows: Information Services of India Ltd.) on (i) As fixed charge instruments, aspects like track record of the debentures put a permanent company, its profitability, debt burden on the earnings of a servicing capacity, credit worthiness company. There is a greater risk and the perceived risk of lending. A when earnings of the company company can issue different types of fluctuate; debentures (see Box C and D). Issue of (ii) In case of redeemable debentures, Zero Interest Debentures (ZID) which the company has to make do not carry any explicit rate of interest provisions for repayment on the has also become popular in recent specified date, even during periods years. The difference between the face of financial difficulty; value of the debenture and its purchase (iii) Each company has certain price is the return to the investor. borrowing capacity. With the issue of debentures, the capacity of a Merits company to further borrow funds The merits of raising funds through reduces. debentures are given as follows: 8.4.9 Commercial Banks (i) It is preferred by investors who want fixed income at lesser risk; Commercial banks occupy a vital (ii) Debentures are fixed charge funds position as they provide funds for and do not participate in profits of different purposes as well as for different the company; time periods. Banks extend loans to (iii) The issue of debentures is suitable firms of all sizes and in many ways, like, in the situation when the sales and cash credits, overdrafts, term loans, earnings are relatively stable; purchase/discounting of bills, and (iv) As debentures do not carry issue of letter of credit. The rate of voting rights, financing through interest charged by banks depends debentures does not dilute control on various factors such as the of equity shareholders on characteristics of the firm and the level management; of interest rates in the economy. The (v) Financing through debentures is loan is repaid either in lump sum or in less costly as compared to cost of installments. preference or equity capital as the Bank credit is not a permanent interest payment on debentures is source of funds. Though banks have tax deductible. started extending loans for longer 2019-20 200 BUSINESS STUDIES periods, generally such loans are used (iv) Loan from a bank is a flexible for medium to short periods. The source of finance as the loan borrower is required to provide some amount can be increased security or create a charge on the assets according to business needs and of the firm before a loan is sanctioned can be repaid in advance when by a commercial bank. funds are not needed. Merits Limitations The merits of raising funds from a The major limitations of commercial commercial bank are as follows: banks as a source of finance are as (i) Banks provide timely assistance to follows: business by providing funds as (i) Funds are generally available for and when needed by it. short periods and its extension or (ii) Secrecy of business can be maintained as the information renewal is uncertain and difficult; supplied to the bank by the (ii) Banks make detailed investigation borrowers is kept confidential; of the company’s affairs, financial (iii) Formalities such as issue of structure etc., and may also ask for prospectus and underwriting are security of assets and personal not required for raising loans from sureties. This makes the procedure a bank. This, therefore, is an easier of obtaining funds slightly source of funds; difficult; 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. 2019-20 SOURCES OF BUSINESS FINANCE 201 (iii) In some cases, difficult terms and (ii) Besides providing funds, many of conditions are imposed by banks. these institutions provide financial, for the grant of loan. For example, managerial and technical advice restrictions may be imposed on the and consultancy to business firms; sale of mortgaged goods, thus (iii) Obtaining loan from financial making normal business working institutions increases the difficult. goodwill of the borrowing company in the capital market. 8.4.10 Financial Institutions Consequently, such a company The government has established a can raise funds easily from other number of financial institutions all over sources as well; the country to provide finance to (iv) As repayment of loan can be made business organisations (see Box E). in easy instalments, it does not These institutions are established by prove to be much of a burden on the central as well as state governments. the business; They provide both owned capital and loan capital for long and medium term (v) The funds are made available even requirements and supplement the during periods of depression, when traditional financial agencies like other sources of finance are not commercial banks. As these available. institutions aim at promoting the industrial development of a country, Limitations these are also called ‘development The major limitations of raising funds banks’. In addition to providing from financial institutions are as given financial assistance, these institutions below: also conduct market surveys and provide technical assistance and (i) Financial institutions follow rigid managerial services to people who run criteria for grant of loans. Too many the enterprises. This source of financing formalities make the procedure is considered suitable when large funds time consuming and expensive; for longer duration are required for (ii) Certain restrictions such as expansion, reorganisation and restriction on dividend payment are modernisation of an enterprise. imposed on the powers of the borrowing company by the Merits financial institutions; The merits of raising funds through (iii) Financial institutions may have financial institutions are as follows: their nominees on the Board of (i) Financial institutions provide long- Directors of the borrowing term finance, which are not company thereby restricting the provided by commercial banks; powers of the company. 2019-20 202 BUSINESS STUDIES 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. 8.5 INTERNATIONAL FINANCING development banks have emerged over the years to finance international trade In addition to the sources discussed and business. These bodies provide above, there are various avenues for long and medium term loans and organisations to raise funds grants to promote the development of internationally. With the opening up of economically backward areas in the an economy and the operations of the world. These bodies were set up by the business organisations becoming Governments of developed countries of global, Indian companies have an the world at national, regional and access to funds in global capital market. international levels for funding various Various international sources from projects. The more notable among them where funds may be generated include: include International Finance (i) Commercial Banks: Commercial Corporation (IFC), EXIM Bank and banks all over the world extend foreign Asian Development Bank. currency loans for business purposes. (iii) International Capital Markets: They are an important source of Modern organisations including financing non-trade international multinational companies depend upon operations. The types of loans and sizeable borrowings in rupees as well services provided by banks vary from as in foreign currency. Prominent country to country. For example, financial instruments used for this Standard Chartered emerged as a purpose are: major source of foreign currency loans (a) Global Depository Receipts to the Indian industry. (GDR’s): The local currency shares (ii) International Agencies and of a company are delivered to the Development Banks: A number depository bank. The depository of international agencies and bank issues depository receipts 2019-20 SOURCES OF BUSINESS FINANCE 203 against these shares. Such (b) American Depository Receipts depository receipts denominated in (ADRs): The depository receipts US dollars are known as Global issued by a company in the USA Depository Receipts (GDR). GDR is a are known as American Depository negotiable instrument and can be Receipts. ADRs are bought and sold traded freely like any other security. in American markets, like regular In the Indian context, a GDR is an stocks. It is similar to a GDR except instrument issued abroad by an that it can be issued only to Indian company to raise funds in American citizens and can be listed some foreign currency and is listed and traded on a stock exchange and traded on a foreign stock of USA. exchange. A holder of GDR can at any (c) Indian Depository Receipt time convert it into the number of (IDRs): An Indian Depository shares it represents. The holders of Receipt is a financial instrument GDRs do not carry any voting rights denominated in Indian Rupees in but only dividends and capital the form of a Depository Receipt. It appreciation. Many Indian is created by an Indian Depository companies such as Infosys, Reliance, to enable a foreign company to Wipro and ICICI have raised money raise funds from the Indian through issue of GDRs (see Box F). securities market. The IDR is a 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. 2019-20 204 BUSINESS STUDIES specific Indian version of the similar 8.6 FACTORS AFFECTING THE CHOICE global depository receipts. OF THE SOURCE OF FUNDS The foreign company issuing IDR deposits shares to an Indian Depository Financial needs of a business are of (custodian of securities registered with different types — long term, short term, the Securities and Exchange Board of fixed and fluctuating. Therefore, India). In turn, the depository issues business firms resort to different types receipts to investors in India against of sources for raising funds. Short-term these shares. The benefits of the borrowings offer the benefit of reduced underlying shares (like bonus, cost due to reduction of idle capital, but dividends, etc.) accrue to the IDR long – term borrowings are considered holders in India. a necessity on many grounds. Similarly According to SEBI guidelines, IDRs equity capital has a role to play in the are issued to Indian residents in the scheme for raising funds in the same way as domestic shares are corporate sector. issued. The issuer company makes a As no source of funds is devoid of public offer in India, and residents can limitations, it is advisable to use a bid in exactly the same format and combination of sources, instead of method as they bid for Indian shares. relying only on a single source. A ‘Standard Chartered PLC’ was the number of factors affect the choice of first company that issued Indian this combination, making it a very Depository Receipt in Indian securities complex decision for the business. The market in June 2010. factors that affect the choice of source (d) Foreign Currency Convertible of finance are briefly discussed below: Bonds (FCCBs): Foreign currency (i) Cost: There are two types of cost viz., convertible bonds are equity linked the cost of procurement of funds and debt securities that are to be cost of utilising the funds. Both converted into equity or depository these costs should be taken into receipts after a specific period. Thus, account while deciding about the a holder of FCCB has the option of source of funds that will be used by either converting them into equity an organisation. shares at a predetermined price or (ii) Financial strength and stability exchange rate, or retaining the of operations: The financial bonds. The FCCB’s are issued in a foreign currency and carry a fixed strength of a business is also a key interest rate which is lower than the determinant. In the choice of source rate of any other similar non- of funds business should be in a convertible debt instrument. sound financial position so as to be FCCB’s are listed and traded in able to repay the principal amount foreign stock exchanges. FCCB’s and interest on the borrowed are very similar to the convertible amount. When the earnings of the debentures issued in India. organisation are not stable, fixed 2019-20 SOURCES OF BUSINESS FINANCE 205 charged funds like preference schedule for both the principal and shares and debentures should be the interest. The interest is required carefully selected as these add to the to be paid irrespective of the firm financial burden of the organisation. earning a profit or incurring a loss. (iii) Form of organisation and (vi) Control: A particular source of legal status: The form of business fund may affect the control and organisation and status influences power of the owners on the the choice of a source for raising management of a firm. Issue of money. A partnership firm, for equity shares may mean dilution of example, cannot raise money by the control. For example, as equity issue of equity shares as these can share holders enjoy voting rights, be issued only by a joint stock financial institutions may take company. control of the assets or impose (iv) Purpose and time period: conditions as part of the loan Business should plan according to agreement. Thus, business firm the time period for which the funds should choose a source keeping in are required. A short-term need for mind the extent to which they are example can be met through willing to share their control over borrowing funds at low rate of business. interest through trade credit, (vii) Effect on credit worthiness: The commercial paper, etc. For long dependence of business on certain term finance, sources such as issue sources may affect its credit of shares and debentures are more worthiness in the market. For appropriate. Similarly, the purpose example, issue of secured for which funds are required need debentures may affect the interest to be considered so that the source of unsecured creditors of the is matched with the use. For company and may adversely affect example, a long-term business their willingness to extend further expansion plan should not be loans as credit to the company. financed by a bank overdraft which (viii) Flexibility and ease: Another will be required to be repaid in the aspect affecting the choice of a short term. source of finance is the flexibility (v) Risk profile: Business should and ease of obtaining funds. evaluate each of the source of Restrictive provisions, detailed finance in terms of the risk involved. investigation and documentation For example, there is a least risk in in case of borrowings from banks equity as the share capital has to and financial institutions for be repaid only at the time of winding example may be the reason that a up and dividends need not be paid business organisations may not if no profits are available. A loan on prefer it, if other options are readily the other hand, has a repayment available. 2019-20 206 BUSINESS STUDIES (ix)Tax benefits: Various sources interest paid on debentures and may also be weighed in terms of loan is tax deductible and may, their tax benefits. For example, therefore, be preferred by while the dividend on preference organisations seeking tax shares is not tax deductible, advantage. 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. 2019-20 SOURCES OF BUSINESS FINANCE 207 External sources of capital, on the other hand are those that are outside the business such as finance provided by suppliers, lenders, and investors. 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 2019-20 208 BUSINESS STUDIES of 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. International financing: With liberalisation and globalisation of the economy, Indian companies have started generating funds from international markets. The international sources from where the funds can be procured include foreign currency loans from commercial banks, financial assistance provided by international agencies and development banks, and issue of financial instruments (GDRs/ ADRs/ FCCBs) in international capital markets. Factors affecting choice: An effective appraisal of various sources must be instituted by the business to achieve its main objectives. The selection of a source of business finance depends on factors such as cost, financial strength, risk profile, tax benefits and flexibility of obtaining funds. These factors should be analysed together while making the decision for the choice of an appropriate source of funds. EXERCISES Multiple Choice Questions Tick (ü) the correct answer out of the given alternatives 1. Equity shareholders are called (a) Owners of the company (b) Partners of the company (c) Executives of the company (d) Guardian of the company 2019-20 SOURCES OF BUSINESS FINANCE 209 2. The term ‘redeemable’ is used for (a) Preference shares (b) Commercial paper (c) Equity shares (d) Public deposits 3. Funds required for purchasing current assets is an example of (a) Fixed capital requirement (b) Ploughing back of profits (c) Working capital requirement (d) Lease financing 4. ADRs are issued in (a) Canada (b) China (c) India (d) USA 5. Public deposits are the deposits that are raised directly from (a) The public (b) The directors (c) The auditors (d) The owners 6. Under the lease agreement, the lessee gets the right to (a) Share profits earned (b) Participate in the by the lessor management of the organisation (c) Use the asset for a (d) Sell the assets specified period 7. Debentures represent (a) Fixed capital of the company (b) Permanent capital of the company (c) Fluctuating capital of (d) Loan capital of the the company company 8. Under the factoring arrangement, the factor (a) Produces and distributes (b) Makes the payment on the goods or services behalf of the client (c) Collects the client’s debt (d) Transfer the goods from or account receivables one place to another 9. The maturity period of a commercial paper usually ranges from (a) 20 to 40 days (b) 60 to 90 days (c) 120 to 365 days (d) 90 to 364 days 10. Internal sources of capital are those that are (a) generated through outsiders (b) generated through loans such as suppliers from commercial banks (c) generated through issue (d) generated within of shares the business 2019-20 210 BUSINESS STUDIES 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. 5. Discuss the financial instruments used in international financing. 6. What is a commercial paper? What are its advantages and limitations. 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. 2019-20