UNIT 7

SOURCES OF BUSINESS FINANCE

SYLLABUS
1. Business finance
a. Concept
b. Importance

2. Owners’ funds
a. Equity Shares
b. Preferences Shares
c. Retained Earnings

3. Borrowed funds
a. Debentures
b. Bonds
c. Loan from Financial Institutions
d. Loan from Commercial Banks
e. Public Deposits
f. Trade Credit
g. Inter Corporate Deposits (ICD)

4. Difference between Owners’ Funds and Borrowed Funds.

BUSINESS FINANCE
CONCEPT
Business finance refers to the funds that a company needs to support its various activities and
operations.
It is often described as the lifeblood of a business, as it enables everything from day-to-day operations
to long-term investments.
Essentially, business finance encompasses all the financial resources required for a company to function
effectively, grow, and achieve its objectives.
IMPORTANCE
A business cannot operate effectively without sufficient funds, making business finance essential. While
initial capital from an entrepreneur is crucial, it often falls short of covering all financial needs. As soon
as a business is launched, the need for funds arises for various purposes.
 1. Fixed Capital Requirements:

To start a business, funds are necessary for acquiring fixed assets like land, buildings, machinery,
and furniture. This investment, known as fixed capital, is typically long-term. The amount needed
varies based on the type and size of the business; for example, a manufacturing firm usually
requires more fixed capital than a trading concern.
2. Working Capital Requirements:

In addition to fixed assets, businesses need funds for daily operations, referred to as working
capital. This covers expenses such as raw materials, salaries, and other current liabilities. The
working capital requirement varies significantly between businesses; for instance, a company
selling on credit, or having a slow sales turnover, will need more working capital than one that
sells for cash.

As a business grows, its financial needs expand, necessitating further investment in technology,
inventory, and operational upgrades. Therefore, understanding and evaluating diverse sources of
funding is crucial for sustaining and scaling a business.
 OWNERS’ FUNDS
Owner’s funds are financial resources provided by the owners of an enterprise, which may include sole
traders, partners, or shareholders. It includes
o Initial capital invested by the owners plus additional capital introduced.
o Profits that are reinvested into the business.
Owner’s capital remains invested in the business for a long period and is not required to be repaid
during the business's lifetime.
This capital forms the basis for the owners’ rights to control and manage the enterprise.

EQUITY SHARES
Equity shares represent ownership in a company and are the primary source of long-term capital. They
provide capital known as ownership capital and are essential for establishing a company.
Equity shareholders do not receive fixed dividends; instead, their returns depend on the company’s
earnings. As "residual owners," they receive profits after all other claims are settled, sharing in both
the rewards and risks of ownership. Their liability is limited to the extent of capital contributed by them
in the company and they have the right to vote, allowing them to participate in the company’s
management.
Merits
i. Suitable for investors willing to take risks for higher returns.
ii. Dividend payments are not compulsory, easing the company’s financial burden.
iii. Serves as permanent capital, repaid only upon liquidation, providing a cushion for creditors.
iv. Enhances the company’s creditworthiness and instills confidence in lenders.
v. Funds can be raised without charging company assets, keeping them available for other
borrowings.
vi. Voting rights ensure democratic control over management.
Limitations
i. Not suitable for investors seeking steady income due to fluctuating returns.
ii. Higher cost compared to raising funds through other sources.
iii. Issuing additional shares dilutes existing shareholders' voting power and earnings.
iv. Involves more formalities and procedural delays in raising funds.

PREFERENCES SHARES
The capital raised by issue of preference shares is called preference share capital.
The preference shareholders enjoy a preferential position over equity shareholders in two ways:
1. preferential claim over dividend (receive a fixed rate of dividend, out of the net profits of the
company, before any dividend is declared for equity shareholders)
2. preferential claim over repayment of capital (receive their capital after the claims of the
company’s creditors have been settled and before equity shareholders, at the time of liquidation)
Preference shares have some characteristics of both equity shares and debentures
• Preference shares resemble debentures as they bear fixed rate of return.

• As the dividend is payable only at the discretion of the directors and only out of profit after tax,
to that extent, these resemble equity shares.
Merits
i. Provide reasonably steady income in the form of fixed rate of return and safety of investment;
ii. Suitable for investors who want fixed rate of return with comparatively low risk;
iii. Preference shareholders have a preferential right of repayment over equity shareholders in
the event of liquidation of a company;
iv. Preference capital does not create any sort of charge against the assets of a company.
v. 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;
vi. Does not affect the control of equity shareholders over the management as preference
shareholders don’t have voting rights;

Limitations
i. Unsuitable for investors who are willing to take risk and are interested in higher returns;
ii. Dilutes the claims of equity shareholders over assets of the company;
iii. Rate of dividend on preference shares is generally higher than the rate of interest on
debentures;
iv. No assured return for preference shareholders, as the dividend on these shares is to be paid
only when the company earns profit, there
v. No tax saving as the dividend paid is not deductible from profits as expense.

RETAINED EARNINGS
Retained earnings are the accumulated net profits of a company that have not been distributed to
shareholders as dividends. Instead, these funds are reinvested in the business for growth, debt
repayment, or other purposes.
It is a source of Internal Financing/ Self Financing/ Ploughing back of profits.
Merits
i. Permanent source of funds available to an organisation;
ii. Does not involve any explicit cost in the form of interest, dividend or floatation cost;
iii. Greater degree of operational freedom and flexibility;
iv. Enhances the capacity of the business to absorb unexpected losses;
v. May lead to increase in the market price of the equity shares of a company.
Limitations Retained earnings as a source of funds has the following limitations: (i) Excessive
i. Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would
get lower dividends;
ii. Uncertain source of funds as the profits of business are fluctuating;
iii. Many firms overlook the opportunity cost of retained earnings, leading to sub-optimal use of
those funds.
 BORROWED FUNDS
Borrowed funds are funds raised through loans or borrowings. It includes:
• Loans from commercial banks.
• Loans from financial institutions.
• Issuance of debentures.
• Public deposits.

Borrowed funds are provided for a specified period and come with specific terms and conditions and
must be repaid after the agreed-upon period.
Borrowers pay a fixed rate of interest on these funds, which can become a financial burden, especially
during low earnings or losses.
Borrowed funds are often provided against the security of fixed assets.

DEBENTURES
• Debentures are used by companies to raise long-term debt capital with a fixed interest rate.
• They are an acknowledgment of borrowed funds, with a promise to repay at a future date.
• Debenture holders are creditors of the company and receive fixed interest payments at regular
intervals (e.g., six months or one year).
• Public issuance of debentures requires a credit rating by agencies like CRISIL, assessing factors
such as company track record, profitability, debt servicing ability, creditworthiness, and lending
risk.
• Types of debentures include Zero Interest Debentures (ZID), where the return is the difference
between the face value and purchase price.
Merits
i. Preferred by investors seeking fixed income with lower risk.
ii. Fixed charge funds that don’t participate in company profits.
iii. Suitable for companies with stable sales and earnings.
iv. Does not dilute control of equity shareholders, as debentures carry no voting rights.
v. More cost-effective than preference or equity capital, as interest payments are tax-deductible.

Limitations
i. Fixed charges create a permanent burden on company earnings, increasing risk if earnings
fluctuate.
ii. For redeemable debentures, repayment provision must be made on the due date, regardless
of financial condition.
iii. Debenture issuance reduces a company's borrowing capacity for future funding needs.
BONDS
"Bonds" refers to a type of debt security or instrument issued by companies, governments, or other
organizations to raise funds.
• Bonds are long-term debt instruments where the issuer (government, corporation, etc.) borrows
money from investors and agrees to pay it back after a certain period, called the maturity period.
• The issuer also pays interest to the bondholder at regular intervals, which is called the coupon
rate.
• At the end of the maturity period, the bondholder gets back the principal amount (face value)
along with the final interest payment.
Bonds are a way for entities to raise funds from the public, where they commit to repaying the borrowed
amount along with periodic interest payments.

DIFFERENCE BETWEEN BONDS AND DEBENTURES

Basis BONDS DEBENTURES
Issuer Typically issued by governments or large Generally issued by private companies or
corporations. public corporations.

Security Bonds are generally secured. Debentures may be secured or unsecured

Interest Rate Typically offer a fixed interest rate, May offer a fixed or floating interest rate.
(Coupon which is paid regularly to the Floating rates fluctuate with market
Rate): bondholders. conditions.
Risk Considered to be low-risk (especially Generally, carry a higher risk as they are
government bonds) due to the secured unsecured, relying only on the issuer’s
nature and backing by governments or reputation.
large corporations.
Priority in In case of liquidation or bankruptcy, Debenture holders are paid after
Repayment bondholders have a higher priority in bondholders in the event of liquidation.
repayment compared to debenture
holders.
Convertibility Generally, bonds are non-convertible into Debentures may be convertible or non-
equity shares. convertible into equity shares/ debentures
of the issuing company.
LOAN FROM COMMERCIAL BANKS
Commercial banks play a crucial role in financing businesses, offering funds for various purposes and
durations. They provide financial support to companies of all sizes through different means like cash
credits, overdrafts, term loans, bill discounting, and letters of credit. The interest rates on bank loans
vary based on factors like the company’s profile and the economic interest rate levels. Bank loans are
typically repaid in lump sums or instalments.
Key Features of Bank Credit:
• Not a Permanent Source: Bank credit is usually for medium to short-term needs, though banks
have started offering some long-term loans.
• Security Requirement: Loans require security or asset charges before approval.
Types of Bank Credit:
1. Cash Credit
2. Overdrafts
3. Term Loans
4. Bill Discounting
5. Letters of Credit
Merits of Bank Credit:
1. Timely Assistance: Banks provide quick funds as per business needs.
2. Confidentiality: Banks keep borrower information confidential, maintaining business secrecy.
3. Ease of Access: Raising funds from a bank doesn’t require formalities like prospectus issuance,
making it simpler than public fund-raising.
4. Flexibility: Loan amounts can be adjusted according to business needs, and repayment can be
made in advance if funds are no longer required.
Limitations of Bank Credit:
1. Short-Term Nature: Bank loans are often short-term, and extensions or renewals can be
uncertain.
2. Detailed Investigations: Banks conduct thorough assessments of the borrower’s financial
status and may demand asset security, making the process more complex.
3. Restrictive Conditions: Sometimes, banks impose stringent terms, such as restrictions on
selling mortgaged goods, potentially affecting business operations.
LOAN FROM FINANCIAL INSTITUTION
The government has established various financial institutions across the country to provide funding to
business organizations. These institutions, created by both central and state governments, play a crucial
role in supplementing traditional financing sources like commercial banks. Often referred to as
development banks, they focus on promoting industrial development by offering both owned capital
and loan capital for long- and medium-term needs.
Features
• Long-Term Financing: Financial institutions primarily provide long-term and medium-term
funds, which are typically not available through commercial banks.
• Additional Support Services: Besides financial assistance, these institutions also conduct
market surveys and offer technical and managerial support to businesses.
• Suitable for Expansion: They are particularly useful for enterprises requiring substantial funds
for expansion, reorganization, and modernization.
Merits
1. Availability of Long-Term Finance: They offer long-term financing options that are generally
unavailable from commercial banks.
2. Advisory Services: Many institutions provide managerial and technical advice alongside
financial support, enhancing business operations.
3. Enhanced Goodwill: Securing a loan from a reputable financial institution can improve a
company’s reputation in the capital market, facilitating easier access to additional funding
sources.
4. Flexible Repayment Terms: Loans can be repaid in easy installments, reducing the financial
burden on businesses.
5. Funding During Economic Downturns: Financial institutions continue to provide funds even
during economic depressions when other sources may dry up.
Limitations
1. Rigid Loan Criteria: Financial institutions adhere to strict lending criteria, which can make the
loan approval process lengthy and costly due to excessive formalities.
2. Restrictions on Borrowers: They may impose restrictions, such as limitations on dividend
payments, affecting the financial autonomy of the borrowing company.
3. Influence on Governance: Financial institutions may appoint their nominees to the Board of
Directors of the borrowing company, which can limit the company’s decision-making powers.
PUBLIC DEPOSITS
Public deposits allow companies to raise funds directly from the public for short- and medium-term
needs, generally at a higher interest rate than bank deposits. The Reserve Bank of India (RBI) regulates
these deposits, which are held for periods of 6 months to 3 years.
Key Features
1. Simple Process: Easier to obtain with fewer formalities.
2. Cost-Effective: Often cheaper than bank loans.
3. No Asset Collateral: Company assets remain free for other loans.
4. Maintained Control: Depositors lack voting rights, keeping control with shareholders.
5. Tax Benefits: Interest paid is tax-deductible, reducing the company’s tax burden.
6. Preference for Stable Companies: Attracts more investment when the company's financial health
is strong.
Advantages
• Ease of Access: Fewer restrictions than typical loans.
• Lower Cost: Generally cheaper than borrowing from banks.
• Asset Flexibility: Assets are not tied up as collateral.
• No Control Dilution: Company control stays with existing shareholders.
Limitations
• Challenging for New Companies: Harder for startups to attract public deposits.
• Unreliable in Emergencies: Public deposits may be difficult to secure during financial downturns.
• Difficult to Raise Large Amounts: Collecting substantial deposits can be challenging.
TRADE CREDIT
Trade credit is short-term credit extended by one trader to another for purchasing goods and services
without immediate payment. It appears on the buyer’s records as ‘sundry creditors’ or ‘accounts
payable.’ This form of financing is generally granted to customers with good financial standing and
reputation. The terms, volume, and period of credit vary based on factors like the buyer's reputation,
seller's financial position, purchase volume, payment history, and market competition.
Merits
1. Convenient and Continuous: A readily available source of funds.
2. Promotes Sales: Helps boost sales by facilitating purchases.
3. Inventory Financing: Allows firms to increase inventory levels for anticipated sales growth.
4. No Asset Collateral: Does not require assets as collateral.
Limitations
1. Risk of Overtrading: Easy access may lead to excessive trading, increasing financial risks.
2. Limited Funds: Only a limited amount can be raised through trade credit.
3. Higher Cost: Generally, more expensive than other financing options.
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. Interest rate on ICDs may remain
fixed or may be floating.
The three types of Inter Corporate Deposits are:
i. Three months deposits;
ii. Six months deposits;
iii. Call deposits.
Advantages:
• Higher Returns: Lenders receive a higher return than with traditional bank deposits.
• Quick Liquidity for Borrowers: Companies can quickly access funds without extensive banking
formalities.
Disadvantages:
• Higher Risk: The unsecured nature of ICDs increases the risk of default.
• Restricted Access for Smaller Companies: Newer or smaller companies may find it challenging
to secure ICDs due to creditworthiness requirements.

DIFFERENCE BETWEEN OWNERS’ FUNDS AND BORROWED FUNDS

Basis Owners’ Funds Borrowed Funds
Definition Capital invested by the owners of the Funds borrowed from external sources like
business, i.e., shareholders in the case of banks, financial institutions, debenture
a company, partners in case of holders, etc.
Partnership.
Examples Equity shares, preference shares, Debentures, Bonds, Loan from Financial
retained earnings, reserves and surplus. Institutions, Loan from Commercial Banks,
Public Deposits, Trade Credit, Inter
Corporate Deposits (ICD)

Risk Carries no obligation for dividend Increases financial risk due to the
associated payment and repayment of principal obligation to repay the loan and interest.
amount, hence less financial risk.
Reward Owners receive dividends as a return, Lenders receive fixed interest irrespective
which depends on the profits. of the profits of the business.
Control Owners retain control over the business Lenders do not have any control over
Considerations as they have voting rights. business decisions.

Cost Dividends are paid out of profits, not Interest is tax deductible, Floatation cost is
compulsory, and are not tax deductible. also lower, hence debt is cheaper compared
Floatation cost is also higher (except to equity.
retained earnings)
Time Horizon Generally considered long-term capital Borrowed funds can be short-term or long-
as it remains in the business as long as term depending on the nature of the loan
it operates (Excluding redeemable or borrowing instrument; temporary
preference shares); permanent source source of funds
of funds
Security The Owner’s Funds are not backed by The Borrowed Funds are generally backed
any security of any asset. by the security of assets.
Priority The owners get second priority in The borrowers get first priority in terms of
terms of return of capital. The dividend return of capital. The interest on the
on the Owner’s Fund is paid only after Borrowed Funds gets paid before the
the payment of interest on the payment of dividend on the Owner’s Funds.
Borrowed Funds.