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.

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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

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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:

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Table 8.1 Classification of Sources of Funds

BUSINESS STUDIES
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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.

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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;

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(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.

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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;

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(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

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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.

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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;

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(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

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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

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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.

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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

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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.

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(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.

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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

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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.

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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

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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.

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(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.

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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

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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

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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

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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.

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