Notes on Sources of Business Finance Business Studies Class 11

Business finance refers to funds required for conduct of business.

Funds are required in a business to carry out various activities. 

Finance is called the lifeblood of any business. 

Need for Business Finance

Business finance is needed for the following purposes:

• To start a business.
• To purchase assets such as machinery, furniture etc.
• To pay day to day expenses such as rent, salary, wages etc.
• To grow and expand the business

On the basis of ownership, sources of business finance can be classified as:

• Owners' Funds
• Borrowed Funds

Owners Funds:

• Funds which are contributed by owners of the business.
• Permanent source of capital.
• Does not require security of asset.
• Providers of owners' funds enjoy control over the business.
• No burden of repayment. 
• Sources include shares, retained earnings, GDRs, ADRs, IDRs etc.

Borrowed Funds:

• Funds raised with the help of loans or borrowings. 
• Not a permanent source of capital.
• May require security of asset.
• Providers of borrowed Funds do not get control over the business.
• Puts burden on the business as repayment of borrowed funds and payment of interest is compulsory even in case of losses. 
• Sources include debentures, loan from banks, loan from financial institutions. 

Owners' Funds

Retained Earnings: 

• A company generally does not distribute all its earnings among the shareholders as dividends.
• Retained Earnings refers to the portion of earnings which is retained in the business for future use.
• It is a source of internal financing or self financing or ploughing back of profits.
• A company is not under any obligation to repay any amount or pay interest or dividend on it. But there is an opportunity cost involved. 
• It is an uncertain source of finance because profits of a business keep on fluctuating. 

Shares

• The capital obtained by issue of shares is known as share capital.
• Share capital of a company is divided into smaller units called shares.
• The person holding the share is known as a shareholder.

Types of Shares

1.  Equity shares
2. Preference shares

Equity Shares

Money raised by issue of equity shares is called equity share capital.

• Represents the owners' capital of a company as equity shareholders are the real owners of the company. 
• Prerequisite to the creation of a company.
• Equity shareholders do not get a fixed dividend but are paid on the basis of earnings of the company.
• Equity shareholders are called residual owners since they receive what is left after all other claims on the company's income and assets have been settled.
• Suitable for investors who want higher returns and are also ready to undertake high risk.
• Equity shareholders have right to vote and participate in the management of the company.
• The liability of equity shareholders is limited to the extent of capital contributed by them. 

Preference Shares

Money raised by issue of preference shares is called preference share capital.

Preference Shareholders get two preferential rights over equity shareholders:

• They get dividends before any dividend is paid to the shareholders. 
• Their capital is repaid before equity share capital at the time of liquidation of the company. 

Global Depository Receipts (GDRs)

• GDR is an instrument issued by a company to raise funds in foreign currency and is traded and listed on foreign stock exchange.
• It is a negotiable instrument and can be traded like any security.
• No voting rights are given to the holder of GDR.
• The first Indian company to issue GDR was Reliance Industries.

American Depository Receipts (ADRs)

Similar to GDR except that it can be issued to citizen of USA and it can be listed and traded on a stock exchange of the USA.

Indian Depository Receipts (IDRs)

• Similar to GDR except that it is issued to Indian citizens.
• Through IDR, foreign companies raise funds from the Indian market.
• Standard Chartered  became the first global company to file for an issue of Indian depository receipts in India in 2010.

Debentures 

• A debenture is an acknowledgement of debt taken by the company. 
• Debentures are an important source for raising long term funds.
• Debentureholders are the creditors of the company.
• A fixed rate of Interest is payable on debentures.
• Interest on debentures is a charge against profits of the company. 
• Debentures do not carry voting rights.
• It is a burden on the company to repay the principal amount of debentures along with interest.

Loans from Commercial Banks:

• Commercial Banks provide loans for different purposes as well as for different time periods.
• Banks provide loans in many ways like cash credits, overdrafts, term loans, discounting of bills etc.
• It is an easier source of finance because formalities such as issue of prospectus and underwriting are not required.
• The loan may be repaid either in lump sum or in installments.
• It is not a permanent source of funds.
• It is generally required to provide some security of assets of the firm for taking loans from banks.

Loans from Financial Institutions:

• Financial Institutions are established by the central as well as state governments.
• Provide loans for medium and long term requirements.
• Provide technical assistance and managerial services.
• Repayment of loan can be made in easy installments. 
• Taking loans from financial institutions may involve too many restrictions and formalities. 

Public Deposits:

• Deposits raised directly from the public.
• Usually raised for a period upto 3 years. As such, it is suitable for meeting short term and medium term fund requirements of the company. 
• In order to attract investors, the company offers a higher rate of interest on public deposits as compared to bank deposits.
• It is beneficial for both the company and the investors. The investors get higher interest rate in comparison to the bank deposits. At the same time, the company is able to raise funds at a cost which is less than the cost of borrowings from the bank. 
• The depositors do not get any voting rights. 
• Public deposits are usually unsecured and, therefore, do not create any charge or mortgage on the company's assets.
• It is difficult for a new company to raise funds from this source.

Inter-Corporate Deposits:

Inter Corporate Deposits refers to the unsecured short term borrowings raised by one company from another company.

• A company with surplus funds would lend to another company which is in need of funds.
• Helpful in meeting working capital requirements. 
• It is a simple source of finance. 
• Not suitable for long term financial needs. 
• No security of assets is to be kept. 
• Higher interest rates are charged on ICDs. 

Inter-Corporate Deposits are of three types:

1. Call Deposits - can be withdrawn by the lender by giving a one day notice. 
2. Three Month Deposits 
3. Six Month Deposits

Trade Credit:

• Credit given by one trader to another for purchase of goods and services.
• It is a convenient source of finance and readily available. 
• It helps the seller in increasing the sales.
• Trade credit is given without any security of assets.
• It may not be suitable for a new or uncreditworthy business.