Chapter-7, Sources of business finance

Topics Discussed
• 1. Finance Meaning
• 2. Finance Requirements
o i) Fixed Capital Requirement
o ii) Working Capital Requirement
• 3. Types of Business Finance
o i) On the Basis of Period
▪ a) Short-Term Funds
▪ b) Medium Term Funds
▪ c) Long-Term Funds
o ii) On the Basis of Ownership
▪ a) Owner’s Fund
▪ b) Borrowed Funds
o iii) On the Basis of Generation
▪ a) Internal Sources
▪ b) External Sources
• 4. Retained Earnings
o i) Merits
o ii) Demerits
• 5. Trade Credit
o i) Merits
o ii) Demerits
• 6. Issue of Shares
o i) Equity Shares
▪ Merits
▪ Demerits
o ii) Preference Shares
▪ Merits
▪ Demerits
• 7. Difference Between Equity and Preference Shares
• 8. Debentures
o Merits
o Demerits
• 9. Difference Between Shares and Debentures
• 10. Lease Financing
o Merits
o Demerits
• 11. Commercial Banks
o Merits
 o Demerits
• 12. Public Deposits
o Merits
o Demerits
• 13. Types of Debentures
o a) First and Second Debentures
o b) Secured and Unsecured Debentures
o c) Registered and Bearer Debentures
o d) Convertible and Non-Convertible Debentures
• 14. Types of Preference Shares
o a) Cumulative and Non-Cumulative
o b) Participating and Non-Participating
o c) Convertible and Non-Convertible
• 15. Financial Institutions
o Merits
o Demerits
• 16. International Financing
o a) Commercial Banks
o b) International Agencies & Development Banks
o c) International Capital Market
▪ i) Global Depository Receipts (GDR), American Depository Receipts
(ADR), and Indian Depository Receipts (IDR)

Q1. Explain Business Finance and it’s

requirements in business.
1. Finance Meaning
Finance refers to the management, creation, and study of money, investments,
and other financial instruments. It involves the processes of acquiring funds
and managing them effectively to achieve business objectives.

Finance Requirements
i) Fixed Capital Requirement

Fixed capital refers to the long-term investments in physical assets that are
essential for the business’s operations. This includes purchasing property,
buildings, machinery, and equipment.
Fixed capital requirements are crucial for starting a business and for long-term
growth. It involves significant financial outlay and is generally less liquid,
meaning these investments are not quickly convertible to cash.

ii) Working Capital Requirement

Working capital is the funds necessary for the day-to-day operations of a

business. It covers short-term expenses such as inventory, accounts receivable,
and other operational costs.

Adequate working capital ensures that a business can meet its short-term
liabilities and continue its operations smoothly.

Q2. What are the types of business finance?

Types of Business Finance
i) On the Basis of Period

a) Short-Term Funds

Short-term funds are required for a period of up to one year. Examples include
loans or credit facilities used to manage operational expenses, such as buying
inventory or covering accounts payable.

b) Medium Term Funds

Medium-term funds are typically required for 1 to 5 years. They are often used
for purchasing equipment or financing expansion projects. An example is a
bank loan for machinery.

c) Long-Term Funds

Long-term funds are needed for periods exceeding five years, often used for
significant investments such as infrastructure or large-scale projects. An
example is issuing bonds for long-term capital requirements.
ii) On the Basis of Ownership

a) Owner’s Fund

Owner’s fund refers to the capital invested by the owners of the business.
Types include:

• Equity Shares: Ownership shares in a company, offering

dividends and voting rights.
• Retained Earnings: Profits reinvested in the business instead of
being distributed as dividends.
b) Borrowed Funds

Borrowed funds are sourced from external parties and need to be repaid with
interest. This includes loans from banks, debentures, and other financial
instruments.

iii) On the Basis of Generation

a) Internal Sources

Internal sources refer to funds generated within the business. Types include:

• Disposing of Surplus Inventory: Selling off excess stock to

generate cash.
• Retained Earnings: Using profits reinvested in the business.
b) External Sources

External sources refer to funds raised from outside the business. Types include:

• Issue of Debentures: Long-term securities yielding fixed interest.

• Borrowings from Banks: Loans taken for operational or
expansion needs.
• Borrowings from Financial Institutions: Funds obtained from
institutions specializing in financing.
• Public Deposits: Money collected from the public for a fixed
period at a specified interest rate.
Q3. Define Retained Earnings?
Retained earnings are profits that are reinvested in the business rather than
distributed to shareholders.

i) Merits

1. No Interest Payment: Unlike loans, retained earnings don’t

require interest payments.
2. Control Retention: Using retained earnings helps maintain
control without diluting ownership.
3. Reinvestment Flexibility: Provides the business with flexibility to
invest in growth opportunities.
ii) Demerits

1. Limited Capital: The amount available is dependent on past

profits and may not suffice for large projects.
2. Opportunity Cost: Funds retained could be invested elsewhere
for potentially higher returns.
3. Market Perception: Excessive reliance on retained earnings may
signal a lack of growth opportunities to investors.
Q4. What is Trade Credit and it’s merit and
demerit?
Trade credit is a short-term financing option allowing businesses to purchase
goods or services and defer payment.

i) Merits

1. Cash Flow Management: Helps manage cash flow by delaying

payments.
2. No Interest Charges: Typically does not incur interest if paid
within the agreed period.
3. Building Supplier Relationships: Regular use can strengthen ties
with suppliers.
ii) Demerits

1. Limited Amount: Trade credit is usually limited to certain

amounts and terms.
 2. Potential Strain on Relationships: Late payments can damage
supplier relationships.
3. Higher Prices: Suppliers may charge higher prices for credit
terms.
Q5. Define Issue of Shares.
i) Equity Shares

Equity shares represent ownership in a company.

Merits

1. Voting Rights: Shareholders have a say in company decisions.

2. No Repayment Obligation: Companies are not required to repay
equity capital.
3. Potential for High Returns: Capital gains and dividends can be
substantial.
Demerits

1. Dilution of Control: Issuing more shares can dilute existing

ownership.
2. Dividend Variability: No guaranteed dividends; dependent on
profits.
3. Market Fluctuations: Share prices can be volatile, affecting
capital stability.
ii) Preference Shares

Preference shares provide certain privileges over equity shares, such as fixed
dividends.

Merits

1. Fixed Dividend: Provides certainty with fixed dividends.

2. Priority on Assets: Preference shareholders have priority over
equity shareholders in liquidation.
3. Less Risky: Generally considered safer than equity shares.
Demerits

1. No Voting Rights: Preference shareholders typically do not have

voting rights.
2. Limited Upside: Capital appreciation is usually less compared to
equity shares.
3. Obligation to Pay Dividends: Dividends must be paid before
equity dividends.
Q6. Differentiate between Equity Share and
Preference Share.
Difference Between Equity and Preference
Shares
Equity Preference
Basis
Shares Shares

Ownership Fixed-income
Meaning stake in a shares with
company priority

Variable
Face Fixed face
market
Value value
value

Voting
Yes No
Rights

Risk Higher risk Lower risk

Dividend Variable Fixed

 Equity Preference
Basis
Shares Shares

Payment After
Before equity
of preference
dividends
Dividend dividends

Refund
Last in Prior to equity
of
liquidation shareholders
Capital

Q7. Define Debentures.

Debentures are long-term securities that yield fixed interest and are a form of
borrowed capital.

Merits

1. Fixed Interest Rate: Provides predictable interest payments.

2. No Ownership Dilution: Issuing debentures does not affect
ownership control.
3. Tax Benefits: Interest payments are tax-deductible.
Demerits

1. Repayment Obligation: Companies must repay the principal

amount at maturity.
2. Interest Payment Risk: Fixed interest payments can strain cash
flow during downturns.
3. Potential for Insolvency: Over-reliance on debt can lead to
financial distress.
Q8. Differentiate between Shares and
Debentures?
Difference Between Shares and Debentures
Basis Shares Debentures

Ownership
Debt
Meaning in the
instrument
company

Nature Equity Debt

Owners of Creditors of
Status the the
company company

Voting
Yes No
Rights

Influence
on No
Control
company influence
decisions

Risk Higher risk Lower risk

May or
Redeemed
Redemption may not be
at maturity
redeemed
Q9. Explain Lease Financing.
Lease financing involves renting assets instead of purchasing them.

Merits

1. Preserves Capital: Reduces initial capital outlay.

2. Tax Benefits: Lease payments are often tax-deductible.
3. Up-to-date Equipment: Easy access to the latest technology.
Demerits

1. No Ownership: At the end of the lease, the asset is not owned.

2. Total Cost: Long-term leasing may be more expensive than
buying.
3. Obligatory Payments: Lease commitments can strain cash flow.
Q10. What do you mean by Commercial Banks?
Commercial banks provide a wide range of financial services including loans,
deposits, and payment services.

Merits

1. Accessibility: Broad range of services available to businesses.

2. Financial Expertise: Banks offer professional financial advice.
3. Security: Funds deposited are usually insured.
Demerits

1. Stringent Conditions: Loans often come with strict eligibility

criteria.
2. High Interest Rates: Borrowing costs can be significant.
3. Limited Flexibility: Rigid loan terms can restrict business
operations.
Q11. Define Public Deposits.
Public deposits are funds raised from the public for a specified term at a fixed
interest rate.
Merits

1. Cost-Effective: Generally lower interest rates compared to bank

loans.
2. Flexible Terms: Various deposit schemes to suit different needs.
3. Quick Access: Relatively easy to arrange and access funds.
Demerits

1. Reliance on Public Trust: Requires maintaining public

confidence.
2. Interest Rate Risk: Must remain competitive with other
investment options.
3. Limited Amount: Total funds raised can be limited.
Q12. What are the types of Debentures?
Types of Debentures
Debentures are a crucial source of finance for companies and can be
categorized based on different characteristics:

a) First and Second Debentures

• First Debentures: These have a priority claim over other debts in

case of liquidation. They are secured by company assets,
providing security to investors.
• Second Debentures: These are subordinate to first debentures
and only get paid after first debentures have been settled. They
usually carry a higher interest rate to compensate for increased
risk.
b) Secured and Unsecured Debentures

• Secured Debentures: Backed by specific assets of the company. If

the company defaults, debenture holders have a claim over the
assets.
• Unsecured Debentures: Not backed by collateral. These carry
higher risk, which is often reflected in the higher interest rates
offered to investors.
c) Registered and Bearer Debentures

• Registered Debentures: These are recorded in the company’s

register of debenture holders. The company keeps a record of
ownership, which makes transferability less straightforward.
• Bearer Debentures: Not registered in any name; the holder
possesses them. They can be transferred easily, making them
more liquid but also riskier due to potential loss or theft.
d) Convertible and Non-Convertible Debentures

• Convertible Debentures: These can be converted into equity

shares at a predetermined rate after a specific period. This offers
investors potential upside if the company performs well.
• Non-Convertible Debentures: These cannot be converted into
shares. They typically offer a higher fixed interest rate as a trade-
off for lack of conversion benefits.
Q13. What are the types of Preference Shares?
Types of Preference Shares
Preference shares are classified based on the rights they confer upon holders:

a) Cumulative and Non-Cumulative

• Cumulative Preference Shares: If dividends are not paid in a

given year, they accumulate and must be paid in the future before
any dividends are paid to equity shareholders.
• Non-Cumulative Preference Shares: These do not accumulate
unpaid dividends. If a dividend is not declared, shareholders lose
their right to receive it in the future.
b) Participating and Non-Participating

• Participating Preference Shares: These allow holders to receive

additional dividends beyond the fixed rate if the company
performs well.
• Non-Participating Preference Shares: Holders receive only the
fixed dividend and do not benefit from additional profits.
c) Convertible and Non-Convertible

• Convertible Preference Shares: These can be converted into

equity shares after a certain period, providing potential for capital
gains.
• Non-Convertible Preference Shares: These cannot be converted
into equity, providing only fixed returns without equity ownership.
Q14. Define Financial Institutions.
Financial institutions play a vital role in the economy by providing various
financial services, including loans, investments, and insurance.

Merits

1. Financial Intermediation: They mobilize savings from individuals

and channel them into productive investments, contributing to
economic growth.
2. Risk Management: They offer products like insurance and
hedging options to manage risks associated with investments and
operations.
3. Expertise and Advice: Financial institutions provide professional
advice and management services, assisting businesses in financial
planning and investment decisions.
Demerits

1. High Costs: Services provided by financial institutions can come

with high fees, which may impact profitability for businesses.
2. Regulatory Constraints: They are subject to strict regulations,
which can limit their flexibility and responsiveness to market
changes.
3. Dependence on Economic Conditions: Their performance and
ability to lend can be significantly affected by economic
downturns, affecting businesses reliant on their services.
Q15. Explain International Financing.
International financing involves raising capital or obtaining funds from sources
outside a country, and it includes several types:
a) Commercial Banks

Commercial banks provide loans and credit facilities to businesses operating

internationally. They facilitate foreign trade through services like letters of
credit and trade financing.

b) International Agencies & Development Banks

These organizations provide funds for development projects, often focusing

on poverty alleviation, infrastructure, and social development. Examples
include the World Bank and the International Monetary Fund (IMF).

c) International Capital Market

This refers to the market where international securities are traded, providing a
platform for raising capital from global investors.

i) Global Depository Receipts (GDR), American Depository

Receipts (ADR), and Indian Depository Receipts (IDR)

• Global Depository Receipts (GDR): These are instruments used

to raise capital in foreign markets. They represent shares in a
foreign company and are traded in multiple markets.
• American Depository Receipts (ADR): A type of GDR specifically
for American investors. ADRs allow U.S. investors to buy shares in
foreign companies without dealing with foreign stock exchanges.
• Indian Depository Receipts (IDR): Similar to ADRs but for Indian
investors. IDRs allow foreign companies to raise capital in India by
issuing shares through a local depository.
These instruments facilitate cross-border investments, allowing investors to
diversify their portfolios internationally while offering companies access to
global capital.