 Sources of business finance

Question 1. What is business finance? Why do businesses need funds?

Explain.

Answer: Business is concerned with production and distribution of

goods and services for the satisfaction of the needs of society. A
business cannot function unless adequate funds are made available to
it. The need for funds arises from the stage when an entrepreneur
makes a decision to start a business. Some funds are needed
immediately. The financial need of a business can be categorized in the
following ways:

Fixed Capital Requirements: In order to start business, funds are

required to purchase fixed assets like land and building, plant and
machinery, and furniture and fixtures. This is known as the fixed capital
requirement of an enterprise.

Working Capital Requirements: The financial requirements of an

enterprise do not end with the procurement of fixed assets. No matter
how small or large a business, it needs funds for its day-to-day
operations. This is known as the working capital of an enterprise which
is used for holding current assets like stock, bill receivable, current
expenses etc. Therefore, a business needs funds to meet its fixed as
well as working capital requirements.

Question 2. List sources of raising long-term and short term finance.

Answer: Sources of raising long term and short term finance are shown
in the chart given below
_

Question 3. What is the difference between internal and external

sources of raising funds? Explain.

Answer: The differences between interned and external sources of

raising funds are summarized in the table given as follows:

Question 4. What preferential rights are enjoyed by preference

shareholders? Explain.
Answer: Following preferential rights are enjoyed by the preference
shareholders:

They get dividend at a fixed rate and dividend is given on these shares
before any dividend on equity shares.

When a company winds up, preference shares are paid before equity
shares.

Preference shares also have a right to participate in excess profits left

after payment being made to equity shares.

They also have a right to participate in the premium at the time of

redemption. In lieu of these preferential rights, their voting rights are
taken i.e. they are not eligible for voting.

Question 5. Name any three special financial institutions and state

their objectives.

Answer: Given below are three financial institutions along with their
objectives:

1.Industrial Credit and Investment Corporation of India (ICICI): It came

into existence in 1955 as a public limited company under the
Companies Act, 1956. Objective: ICICI assists the expansion and
modernization of industrial enterprises exclusively in the private sector.
The corporation has also encouraged the participation of foreign capital
in the country.
Industrial Development Bank of India (IDBI): It came into existence in
1964 under the Industrial Development Bank of India Act, 1964.

Objective: Its objective was to coordinate the activities of other

financial institutions including commercial banks. The bank performed
three types of functions namely, assistance to other financial
institutions, direct assistance to industrial concerns and promotion and
coordination of financial technique service.

Life Insurance Corporation of India (LIC): It came into existence in 1956

under the LIC Act 1956 after nationalizing 245 existing insurance
companies.

Objective: It mobilizes the community saving in the form of insurance

premia and makes it available to industrial concerns. Both public as well
as private, in the form of direct loan and underwriting of a subscription
to shares and debentures.

Question 6. What is the difference between GDR and ADR? Explain.

Answer: Global Depository Receipts (GDRs): GDR is an instrument

issued by a company to raise funds in some foreign currency and is
listed and traded on a foreign stock

exchange. American Depository Receipts (ADRs): The depository

receipts issued by the company in the USA are called American
Depository Receipts.

GDR and ADR are similar to each other except:

GDR can be issued to anyone but ADRs can be issued only to an
American citizen.

GDR can be listed and traded in stock exchange of any country but
ADRs can be listed and traded only in the stock exchange of the USA.

Long Answers Questions

Question 1. Explain trade credit and bank credit as sources of short

term finance for business enterprises.

Answer: Trade Credit: Trade credit is the credit extended by the trader
to another to purchase goods and services. It facilitates the purchase of
supplies without immediate payment. In books of accounts they are
shown as “creditors’ or ‘ills payable’.

Merits of Trade Credit

It is a convenient and continuous source of finance.

It is readily available.

It helps in promoting sales of an organization.

If an organization wants to expand its inventory level so as to meet

expected rise in demand, it may use trade credit.

It does not demand any security.

Demerits of Trade Credit

 When easy and flexible trade credit is available, it may induce

the firm to indulge in over trading.
 Trade credit can meet only limited financial needs. Funds
required for inventory can be met through it but not others like
 plant and machinery, land and building or salaries of
employees etc.

Bank Credit: Borrowings from banks are an important source of

finance to companies. Bank lending is still mainly short term,
although medium-term lending is quite common these days.

Short term lending may be in the form of:

 An overdraft, which a company should keep within a limit set

by the bank. Interest is charged (at a variable rate) on the
amount by which the company is overdrawn from day to day.
 A short-term loan, for up to three years.
 Medium-term loans are loans for a period of three to ten
years.

The rate of interest charged on medium-term bank lending to

large companies will be a set margin, with the size of the margin
depending on the credit standing and risk of the borrower. A loan
may have a fixed rate of interest or a variable interest rate, so that
the rate of interest charged will be adjusted every three, six, nine
or twelve months in line with recent movements in the Base
Lending Rate.

Merits of Bank Credit

 Economical: Rate of interest charged by banks is quite

nominal and is therefore economical.
 Maintains business secrecy: Banks maintain secrecy of the
business. They do not disclose the information shared to any
third party.
 Less formalities: As compared to issue of shares,
debentures or accepting public deposits, it has less legal
formalities..
  Flexible source: It can be increased or decreased as per the
requirements of the business. It is not so that once a loan is
taken it can’t be reduced.

Limitations of Bank Credit

 Short-term financing: It does not provide loans for long term

as shares and debentures do.
 Difficult procedure: As compared to commercial papers and
trade credit, it involves many legal and paper formalities. It
makes its procedure difficult.
 Restrictive clauses: Bank credit has many restrictive clauses
which includes mortgage on company’s assets or ineligibility
to raise funds from specific sources.

Question 2. Discuss the sources from which a large

industrial enterprise can raise capital for financing
modernization and expansion.
Answer: A large industrial enterprise can raise capital from the
following sources.

1. Equity Shares: Equity shares are the most important source

of raising long term capital by a company. They represent the
ownership of a company and therefore, the capital raised by
issue of these shares is called owner’s funds. These
shareholders do not get a fixed dividend. They get according
to the earnings of the company. They receive what is left after
all other claims on the company’s income and assets have
been settled. They enjoy the reward and also bear the risk of
ownership. They have voting rights. Using their voting rights,
they get participation in management of the company.
2. Preference Shares: Preference shareholders are called so
because they enjoy some preferential rights over equity
shares. They get dividend at a fixed rate and dividend is
given on these shares before any dividend on equity shares.
 When company winds up, preference shares are paid before
equity shares. Preference shares also have a right to
participate in excess profits left after payment being made to
equity shares. They also have a right to participate in the
premium at the time of redemption. In lieu of these
preferential rights, their voting rights are taken i.e. they are
not eligible for voting. Preference shares have some
characteristics of equity shares as well as debentures. They
are safer investment with stable return from investor’s point of
view and free from control from owner’s point of view.
3. Debentures: Debenture is an acknowledgement by a
company that the company has borrowed certain amount
from the debenture holder which it promises to pay on a
specific date. It is an important source for raising long term
debt capital. Debentures bear a fixed rate of interest. In
recent times, issue of zero interest debentures has also
become popular which do not carry any explicit rate of
interest. But they are issued at discount and redeemed at a
premium or at par. It is the return on the debenture. Public
issue of debentures requires that issue of debentures should
be rated by a credit rating agency like CRISIL (Credit rating
and Information Services of India Limited).
4. Loans from Financial Institutions: The government has
established many financial institutions like LIC, IDBI, ICICI etc
all over the country to provide finance to these organizations.
These institutions are established by central and state
government both. These institutions provide owned capital as
well as borrowed capital for long term and short term
requirements. They provide financial and technical advice
and consultancy to business firms. Obtaining loan from a
financial institution increases goodwill of a company. These
sources are available even during depression. Loans can be
repaid in easy installments.
5. Loans from Commercial Banks: Borrowings from banks are
an important source of finance to companies. Bank lending is
 still mainly short term, although medium- term lending is quite
common these days. The rate of interest charged on medium-
term bank lending to large companies will be a set margin,
with the size of the margin depending on the credit standing
and risk of the borrower. A loan may have a fixed rate of
interest or a variable interest rate, so that the rate of interest
charged will be adjusted every three, six, nine or twelve
months in line with recent movements in the Base Lending
Rate. Short term lending may be in the form of:
(i) An overdraft, which a company should keep within a limit
set by the bank. Interest is charged (at a variable rate) on the
amount by which the company is overdrawn from day to day.
(ii) A short-term loan, for up to three years.
(iii) Medium-term loans are loans for a period of three to ten
years.
6. Retained Earnings: For any company, the amount of
earnings retained within the business has a direct impact on
the amount of dividends. Profit re-invested as retained
earnings is profit that could have been paid as a dividend.
The management of many companies believes that retained
earnings are funds which do not cost anything, although this
is not true. However, it is true that the use of retained
earnings as a source of funds does not lead to a payment of
cash. In practice, the dividend policy of the company is
determined by the directors. From their standpoint, retained
earnings are an attractive source of finance because
investment projects can be undertaken without involving
either the shareholders or any outsiders. The use of retained
earnings as opposed to new shares or debentures avoids
issue costs. The use of retained earnings avoids the
possibility of a change in control resulting from an issue of
new shares. Another factor that may be of importance is the
financial and taxation position of the company’s shareholders.
For example, because of taxation considerations, they would
rather make a capital profit (which will only be taxed when
 shares are sold) than receive current income, then finance
through retained earnings would be preferred to other
methods.

Question 3. What advantage does issue of debentures

provide over the issue of equity shares?
Answer: Debentures provide following advantages over issue of
equity shares.

1. Voting Rights: Voting rights are not given to debentures

while equity shareholders have voting rights.
2. Dilution of Controlling Power: Since voting power is not
given, therefore, if funds are raised by issue of debentures
then controlling power does not get diluted.
3. Redeemable: Debentures are redeemable. Therefore, funds
become flexible. When funds are not required permanently
but for 5 or 10 years, debentures are more suitable.
4. Fixed Rate of Interest: Debentures are to be paid at fixed
rate of interest. However, we need to share profits with equity
shareholders.
5. Creditor versus Owner: Debenture holder is a creditor of the
company and cannot take part in the management of the
company while a shareholder is the owner of the company. It
is the basic distinction between a debenture and a share.
6. Convertibility: Shares cannot be converted into debentures
whereas debentures can be converted into shares.

Question 4. State the merits and demerits of public deposits

and retained earnings as methods of business finance.
Answer: Public Deposits: Deposits accepted from public directly
by the companies are called public deposits. These deposits
generally carry a rate of interest higher than the deposits in
commercial banks.
Merits of Public Deposits
  The procedure of obtaining deposits is simple and does not
contain restrictive conditions.
 Cost of public deposits is generally lower than the cost of
borrowings from banks and financial institutions.
 Public company usually does not create a charge on the
assets of the company.
 As the depositors do not have voting rights, it does not dilute
control in the company.

Demerits of Public Deposits

 It is difficult for a newly established company to be able to get

funds from public deposits.
 It is dependent on public response and can’t be relied on if
financial needs are urgent.
 It is difficult especially when size of deposits is large.

Retained Earnings: For any company, the amount of earnings

retained within the business has a direct impact on the amount of
dividends. Profit re-invested as retained earnings is profit that
could have been paid as a dividend.

Merits of Retained Earnings:

 The management of many companies believes that retained

earnings are funds which do not cost anything, although this
is not true. However, it is true that the use of retained
earnings as a source of funds does not lead to the payment
of cash.
 The dividend policy of the company is in practice determined
by the directors. From their standpoint, retained earnings are
an attractive source of finance because investment projects
can be undertaken without involving either the shareholders
or any outsiders.
  The use of retained earnings as opposed to new shares or
debentures avoids issue costs.
 The use of retained earnings avoids the possibility of a
change in control resulting from an issue of new shares.
 Another factor that may be of importance is the financial and
taxation position of the company’s shareholders. For
example, because of taxation considerations, they would
rather make a capital profit (which will only be taxed when
shares are sold) than receive current income, then finance
through retained earnings would be preferred to other
methods.

Demerits of Retained Earnings:

 A company must restrict its self-financing through retained

profits because shareholders should be paid a reasonable
dividend, in line with realistic expectations, even if the
directors would rather keep the funds for re-investing.
 At the same time, a company that is looking for extra funds
will not be expected by investors (such as banks) to pay
generous dividends, nor over-generous salaries to owner-
directors.
 Scope of retained earnings is limited by amount of profits. A
loss incurring firm has no source called retained earnings.

Question 5. Discuss the financial instruments used in

international financing.
Answer: Following financial instruments are used in international
financing:

1. Global Depository Receipts (GDRs): The local currency

shares of a company are delivered to the depository bank.
The depository bank issues depository receipts against these
shares. When these depository receipts are denominated in
US $, they are called GDR. It is a bank certificate issued in
 more than one country for shares in a foreign company. The
shares are held by a foreign branch of an international bank.
The shares trade as domestic shares, but are offered for sale
globally through the various bank branches. A financial
instrument used by private markets to raise capital
denominated in either U.S. dollars or Euros. These
instruments are called EDRs when private markets are
attempting to obtain Euros. It is a negotiable instrument and
can be traded freely like any other security. A holder of GDR
can convert it into any other security at any time. Holders of
GDR are eligible only for capital appreciation and dividend
but no voting rights.
2. American Depository Receipts (ADRs): When a company
in the USA issues depository receipts, they are termed as
American Depository Receipts (ADRs). These are bought and
sold in stock markets of the USA. They are similar to GDR
except that these can be issued only to American citizens and
these can be listed and traded on a stock exchange of USA.
3. Foreign Currency Convertible Bonds (FCCBs): Foreign
Currency Convertible Bonds are equity linked debt securities
that are to be converted into equity or depository receipts
after a specific period. Foreign Currency Convertible Bonds
are listed and traded in Foreign Stock Exchanges. A holder of
Foreign Currency Convertible Bonds has the option of
converting them into equity shares at a pre-determined price.
Foreign Currency Convertible Bonds are issued in foreign
currency. Their rate of interest is lower than rate of any other
similar non convertible debt instrument.

Question 6. What is commercial paper? What are its

advantages and limitations?
Answer: Commercial Paper:

 Commercial paper is an unsecured, short-term debt

instrument issued by a corporation, typically for the financing
 of accounts receivable, inventories and meeting short-term
liabilities.
 Maturities on commercial paper can range up to 365 days.
The debt is usually issued at a discount, reflecting prevailing
market interest rates.
 Commercial paper is not usually backed by any form of
collateral, so only firms with high-quality debt ratings will
easily find buyers without having to offer a substantial
discount (higher cost) for the debt issue.

Advantages and Limitations of Commercial Paper

Advantages:

 For the most part, commercial paper is a very safe

investment because the financial situation of a company can
easily be predicted over a few months.
 Typically only companies with high credit ratings and
creditworthiness issue commercial paper. Hence the
companies issuing them enjoy (a) the prestige associated
with such issuance and (b) the ability to issue large quantum
without much hassles like other types of financing which
requires restrictions from regulatory bodies.
 Interest rate is generally lower compared to others like bank
loans and other types of short term financing

Disadvantage:

 It does not have any flexibility with regard to repayments.