by business to carry out its various activities is called business finance. Importance / Significance of 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 Business Finance fixed capital requirements of the enterprise. The funds required in fixed assets remain invested in the business for a long period of time. Different business units need varying amount of fixed capital depending on various factors such as : 1) Nature of Business : A trading concern for example, may require small amount of fixed capital as compared to a manufacturing concern. 2) Scale of Operations : The need for fixed capital investment would be greater for a large enterprise, as compared to that of a small enterprise. 3) Growth and Expansion of Business : The requirement for working capital increases with the growth and expansion of business. The financial requirements of an enterprise do not end with the procurement of fixed assets. A business needs funds for its day-to-day operations. This is known as working capital of an enterprise, which is used for holding current assets such as stock of material, bills receivables and for meeting current expenses like salaries, wages, taxes, and rent. A business unit selling goods on credit, or having a slow sales turnover would require more working capital as compared to a concern selling its goods and services on cash basis or having a speedier turnover. The requirement for working capital increases with the growth and expansion of business. Larger funds may be required for building higher inventories for the festive season or to meet current debts or expand the business or to shift to a new location. Difference between Owner’s Funds and Borrowed Funds Basis Owner’s Funds Borrowed Funds Owner’s funds means funds that are provided by the owners of an enterprise, which may be a sole trader or partners or Borrowed funds refer to the funds raised through loans Meaning shareholders of a company. Apart from capital, it also includes or borrowings. profits reinvested in the business. Equity shares Debentures and Bonds Preference shares Loan from Financial Institutions Retained earnings Loan from Commercial Banks Sources GDR Public Deposits ADR Trade Credit IDR Inter Corporate Deposits (ICD) The owner’s capital remains invested in the business for a longer Such sources provide funds for a specified period, on Time duration and is not required to be refunded during the life certain terms and conditions and have to be repaid Period period of the business. after the expiry of that period. Return on owner’s funds (e.g. equity an preference shares) is A fixed rate of interest is paid by the borrowers on such called dividend, which is a part of profit after tax distributed funds. At times it puts a lot of burden on the business Return among the shareholders. Dividend is payable only when there as payment of interest is to be made even when the are profits available to the company. earnings are low or when loss is incurred. Generally, borrowed funds are provided on the security Security It does not require any security. of some fixed assets. Such capital forms the basis on which owners acquire their right Control of control of management. It does not carry any right of control of management. Various Sources of Owner’s Funds Equity Equity shares represent the ownership of a company and thus the capital Shares raised by issue of such shares is known as ownership capital or owner’s funds.
Note Features / Merits
The capital obtained by issue of shares is known as share 1) Payment of dividend to the equity shareholders is not capital. compulsory. Therefore, there is no burden on the The capital of a company is divided into small units called company in this respect. shares. Each share has its nominal value/face value/par value. For 2) Equity capital serves as permanent capital as it is to be example, if a company issues 1,00,000 shares of ₹ 10 each, repaid only at the time of liquidation of a company. As then ₹ 10 is the face value/nominal value/par value of it stands last in the list of claims, it provides a cushion each share. for creditors, in the event of winding up of a company. The person holding the share is known as shareholder. 3) Funds can be raised through equity issue without There are two types of shares normally issued by a creating any charge on the assets of the company. The company. These are equity shares and preference shares. assets of a company are, therefore, free to be The money raised by issue of equity shares is called equity share capital, while the money raised by issue of mortgaged for the purpose of borrowings, if the preference shares is called preference share capital. need be. The capital raised by issue of preference shares is called preference share capital. The preference shareholders enjoy a preferential position over equity shareholders Preference in two ways : a) Receiving a fixed rate of dividend, out of the net profits of the company, before Shares any dividend is declared for equity shareholders; and b) Receiving their capital after the claims of the company's creditors have been settled, at the time of liquidation.
Preference shareholders generally do not enjoy any voting rights.
Notes Preference shares resemble debentures as they bear fixed rate of return.
Features / Merits 1) Preference shares provide reasonably steady income in the form of fixed rate of return. Thus, preference shares are useful for those investors who want fixed rate of return. 2) It does not affect the control of equity shareholders over the management as preference shareholders don't have voting rights. 3) Payment of fixed rate of dividend to preference shares may enable a company to declare higher rates of dividend for the equity shareholders in good times. 4) Preference shareholders have a preferential right of repayment over equity shareholders in the event of liquidation of a company. 5) Preference capital does not create any sort of charge against the assets of a company. A portion of the net earnings may be retained in the Retained business for use in the future. This is known as
Earnings retained earnings. It is a source of internal financing
or self-financing or 'ploughing back of profits'.
Features / Merits 1) Retained earnings is a permanent source of funds available to an organisation. 2) It does not involve any explicit cost in the form of interest, dividend or floatation cost. 3) As the funds are generated internally, there is a greater degree of operational freedom and flexibility. 4) It enhances the capacity of the business to absorb unexpected losses. 5) It may lead to increase in the market price of the equity shares of a company. Debentures & Bonds
Loan from Financial Institutions
Loan from Commercial Banks
Trade Credit
Inter Corporate Deposits (ICD)
Debentures and Bonds Debentures are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures, which bear a fixed rate of interest.
Features / Merits 1) It is preferred by investors who want fixed income at lesser risk. 2) Debentures are fixed charge funds and do not participate in profits of the company. 3) As debentures do not carry voting rights, financing through debentures does not dilute control of equity shareholders on management. 4) Financing through debentures is less costly as compared to cost of preference or equity capital as the interest payment on debentures is tax deductible.
Bonds are also debt instrument that does not carry a specific rate of interest, but issued at a heavy discount. The difference between nominal valve and issue price is treated as the amount of interest related to the duration of bonds. The government has established a number of Loan From Financial Institutions financial institutions all over the country to provide finance to business organizations. These institutions are established by the central as well as state governments. They provide loan capital for long and medium term requirements. This source of financing is considered suitable when large funds for longer duration are required for expansion, reorganization and modernization of an enterprise.
Features / Merits 1) Financial institutions provide long term finance, which are not provided by commercial banks. 2) Obtaining loan from financial institutions increases the goodwill of the borrowing company in the capital market. Consequently, such a company can raise funds easily from other sources as well. 3) As repayment of loan can be made in easy installments, it does not prove to be much of a burden on the business. 4) The funds are made available even during periods of depression, when other sources of finance are not available. Loan from Commercial Banks Commercial banks occupy a vital position as they provide funds for different purposes as well as for different time periods. Banks extend loans to firms of all sizes and in many ways : a) Cash credits b) Bank overdrafts c) term loans d) Purchase/discounting of bills Issue of letter of credit. The rate of interest charged by banks depends on various factors such as the characteristics of the firm and the level of interest rates in the economy. The loan is repaid either in lump sum or in installments. Bank credit is not a permanent source of funds. Though banks have started extending loans for longer periods, generally such loans are used for medium to short periods. The borrower is required to provide some security or create a charge on the assets of the firm before a loan is sanctioned by a commercial bank.
Features / Merits 1) Banks provide timely assistance to business by providing funds as and when needed by it. 2) Secrecy of business can be maintained as the information supplied to the bank by the borrowers is kept confidential. 3) Formalities such as issue of prospectus and underwriting are not required for raising loans from a bank. This, therefore, is an easier source of funds. 4) Loan from a bank is a flexible source of finance as the loan amount can be increased according to business needs and can be repaid in advance when funds are not needed. Trade Credit Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. The borrower does not receive any cash. But gets it supplies on credit. Such credit appears in the records of the buyer of goods as 'sundry creditors' or 'accounts payable'. Trade credit is commonly used by business organizations as a source of short-term financing. It is granted to those customers who have reasonable amount of financial standing and goodwill. Normally, trade credit is granted for a period ranging 30 to 90 days. The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market.
Features / Merits 1) Trade credit is a convenient and continuous source of funds. 2) Trade credit may be readily available in case the credit worthiness of the customers is known to the seller. 3) Trade credit needs to promote the sales of an organisation. 4) If an organisation wants to increase its inventory level in order to meet expected rise in the sales volume in the near future, it may use trade credit to, finance the same. 5) It does not create any charge on the assets of the firm while providing funds. 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. These deposits are usually considered by the borrower company to solve problems of short-term funds insufficiency. 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 : a) Three months deposits b) Six months deposits c) 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.
Note In case of Inter Corporate Deposits, the deal takes place between two companies through commission agents.
