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Sources of Business Finance

🏫 MP BoardClass 11Business Studies

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Class 11 Business Studies

Chapter: Sources of Business Finance

1. Introduction to Business Finance

Finance is the lifeblood of any business. Business Finance refers to the money required for establishing, running, and expanding a business enterprise.

  • Financial Needs of a Business:
    • Fixed Capital Requirements: Funds needed to purchase fixed assets (like land, building, machinery, furniture) for long-term use.
    • Working Capital Requirements: Funds needed for day-to-day operations (like purchasing raw materials, paying wages, rent, taxes).

2. Classification of Sources of Funds

Sources of business finance are generally categorized based on three parameters:

  1. Based on Time Period:

    • Long-term sources: Period exceeding 5 years (e.g., Shares, Debentures, Long-term loans).
    • Medium-term sources: Period between 1 to 5 years (e.g., Commercial banks loans, Public deposits).
    • Short-term sources: Period up to 1 year (e.g., Trade credit, Bank overdraft, Factoring).

  2. Based on Ownership:

    • Owner’s Funds: Provided by owners (shareholders, partners, sole proprietor). Permanent capital, high risk, gives control. (e.g., Equity shares, Retained earnings).
    • Borrowed Funds: Raised through loans or borrowings. Temporary capital, fixed return, creates a charge on assets. (e.g., Debentures, Bonds, Loans).

  3. Based on Source of Generation:

    • Internal Sources: Generated from within the business (e.g., Retained earnings).
    • External Sources: Generated from outside the business (e.g., Commercial banks, Public deposits, Trade credit).

3. Detailed Breakdown of Sources of Finance

A. Equity Shares (समता अंश)

  • Definition: The most important source of raising long-term capital. Equity shareholders are the actual owners of the company.
  • Key Features:
    • They bear ultimate risk (Residual claimants of income and assets).
    • They carry voting rights (Control the management).
    • Dividend is not fixed (depends on profits).

B. Preference Shares (पूर्वाधिकार अंश)

  • Definition: Shares that get preferential rights over equity shares regarding payment of dividend and repayment of capital at the time of winding up.
  • Key Features:
    • Fixed rate of dividend.
    • No voting rights in general.
    • Suitable for investors who want steady income with low risk.

C. Debentures (ऋणपत्र)

  • Definition: An instrument raised by a company acknowledging a debt under its common seal. Debenture holders are creditors of the company.
  • Key Features:
    • Fixed rate of interest (payable whether company makes profit or loss).
    • Do not carry voting rights.
    • Usually secured against company assets.

D. Retained Earnings (प्रतिधारित उपार्जन / स्व-वित्तीयन)

  • Definition: A portion of net profits kept back in the business for future use. It is also known as plowing back of profits.
  • Merits: No cost of floatation, permanent source, provides financial stability.
  • Demerits: May lead to dissatisfaction among shareholders if dividends are low; uncertain source.

E. Trade Credit (व्यापारिक साख)

  • Definition: Credit extended by one trader to another for the purchase of goods and services without immediate cash payment.
  • Key Features:
    • Facilitates purchase of supplies without immediate cash outlay.
    • Short-term source of finance.
    • Depends on the reputation and creditworthiness of the firm.

F. Commercial Banks (व्यापारी बैंक)

  • Forms of Bank Credit:
    • Term Loans: Lump sum loans for a specific period.
    • Cash Credit (CC): Facility to borrow up to a certain limit against current assets.
    • Bank Overdraft (OD): Permission to withdraw more than the balance in a current account.
    • Discounting Bills of Exchange: Getting bills encashed from the bank before maturity.

G. Public Deposits (जन निक्षेप)

  • Definition: Deposits raised directly from the general public by a company for a period ranging from 6 months to 3 years.
  • Merits: Simple procedure, cost is usually lower than borrowing from banks, does not dilute control.
  • Demerits: Unreliable during financial crunch, risky for investors, not suitable for new companies.

H. Inter-Corporate Deposits (ICDs)

  • Definition: Short-term loans advanced by one company to another company. Usually utilized to tide over short-term cash mismatches.

4. International Sources of Finance

When a business expands globally, it requires international finance:

  1. Commercial Banks: Foreign currency loans provided by global banks (e.g., Citi Bank, HSBC).
  2. International Agencies & Development Banks: Provided by institutions like IFC, ADB, and World Bank for major projects.
  3. GDRs (Global Depository Receipts): Negotiable instrument issued abroad by an Indian company denominated in US Dollars, traded on foreign stock exchanges.
  4. ADRs (American Depository Receipts): Receipts issued by an American bank, traded in American stock markets only.
  5. FCCBs (Foreign Currency Convertible Bonds): Foreign bonds that give the investor the option to convert them into equity shares at a fixed price after a certain period.

5. Factors Affecting the Choice of Source of Finance

While selecting a source of finance, a business must consider the following factors:

  • Cost: Initial cost (floatation cost) and ongoing cost (interest/dividend).
  • Financial Risk: Borrowed funds carry higher risk due to fixed obligations compared to owner's funds.
  • Control: Equity dilution leads to dilution of management control.
  • Period / Duration: Short-term needs should be met via short-term sources; long-term needs via long-term sources.
  • Purpose and Asset: Long-term assets should be financed through long-term sources (matching principle).
  • Flexibility and Ease: The ease with which the fund can be raised without rigid legal formalities.