Sources of Business Finance

• Introduction to Business Finance

  • Meaning: Money required for carrying out business activities.
  • Need & Importance:
    • Setting up the business
    • Running day-to-day operations (Working Capital)
    • Expansion and diversification
    • Meeting contingencies

• Classification of Funds

  • Based on Time Period
    • Long-term sources: More than 5 years (Fixed capital)
    • Medium-term sources: 1 to 5 years
    • Short-term sources: Less than 1 year (Working capital)
  • Based on Ownership
    • Owner’s Funds: Provided by owners, permanent capital, control rights.
    • Borrowed Funds: Raised through loans or borrowings, has a fixed maturity and interest.
  • Based on Generation Source
    • Internal Sources: Generated from within the business.
    • External Sources: Raised from outside agencies.

• Internal Sources of Finance

  • Retained Earnings
    • Ploughing back of profits
    • Self-financing method
    • Merits: Permanent, no dilution of control, cheap.
    • Demerits: Uncertain, may lead to dissatisfaction among shareholders if dividends are low.

• External Sources of Finance

  • Equity Shares
    • Meaning: Ownership securities, highest risk, residual claim on income and assets.
    • Merits: Permanent capital, no fixed burden, voting rights.
    • Demerits: Risk of fluctuation in returns, dilution of control, high cost of issue.
  • Preference Shares
    • Meaning: Preferential right to dividend repayment and capital refund.
    • Merits: Steady income, attractive to cautious investors, no voting dilution.
    • Demerits: Fixed dividend burden, costly compared to debt, no voting rights.
  • Debentures and Bonds
    • Meaning: Creditorship securities, acknowledgement of debt.
    • Merits: Fixed return, tax deductibility of interest, suitable for stable earnings.
    • Demerits: Fixed obligation, charge on assets, reduction in credit capacity.
  • Retained Earnings / Public Deposits
    • Deposits raised directly from the public.
    • Merits: Simple procedure, cheaper than bank loans, no security required.
    • Demerits: Risky for investors, limited amount, "fly-by-night" risk.

• Financial Institutions (Development Banks)

  • Meaning: Specialized institutions established by Central/State Governments (e.g., IFCI, ICICI, SFCs).
  • Merits: Long-term finance, managerial advice, easy loans during depressions.
  • Demerits: Rigorous formalities, restrictions on dividend policy, high interference.

• Commercial Banks

  • Role: Provide short-term and medium-term loans, cash credit, overdraft, and discounting bills.
  • Merits: Timely assistance, confidentiality maintained, flexible.
  • Demerits: Short-term availability generally, difficult formalities, charge on assets required.

• International Sources of Finance

  • Commercial Banks: Loans in foreign currency.
  • International Agencies: World Bank, IFC, ADB.
  • Global Depository Receipts (GDR): Shares traded in foreign markets denominated in USD.
  • American Depository Receipts (ADR): Shares traded in US markets.
  • Foreign Currency Convertible Bonds (FCCB): Equity-linked debt securities.

• Factors Affecting Choice of Source of Finance

  • Cost: Procurement cost and servicing cost.
  • Financial Risk: Fixed obligation vs. fluctuating returns.
  • Control: Dilution of voting power.
  • Durability/Time Period: Matching tenure with asset life.
  • Flexibility and Ease: Simplicity of raising funds.
  • Tax Benefits: Interest on debt is tax-deductible.