Sources of Business Finance

SOURCES OF BUSINESS FINANCE

❖ Business Finance
➢ Meaning
It refers to the funds required for the setting up of businesses and carrying out their
various operations.

➢ Nature of Business Finance

i. Required to carry out various business operations and activities
ii. Primarily involves the estimation of the amount of funds that are needed by the
business
iii. The requirement for business finance differs across business types and across time
iv. Required for maintaining continuity of business operations

➢ Need for Business Finance

The following are the reasons why a business needs funds:
a. A business requires funds for the purchase of fixed assets (fixed capital requirement)
such as building, machinery and furniture.
b. Funds are required to finance the day-to-day operations (working capital requirement)
such as purchase of raw materials and payment of wages.

❖ Classification of Business Finance

Business finance can be classified on the basis of the following:

➢ On the basis of period

• Long-term funds
• Medium-term funds
• Short-term funds
➢ On the basis of ownership
• Owners’ funds
• Borrowed funds
Owners’ Funds vs Borrowed Funds

Basis of Difference Owners’ Funds Borrowed Funds

Invested by the owners of the
Investor Invested by outsiders
company
Not a permanent
Type Permanent source of capital
source of capital
Security No security required Security required
Return No returns are paid. Returns are paid.
Does not grant any
Grants control over the
Control control over the
company
company
It is called risk capital of the Carries less risk as
business as neither the both the principle the
Risk
principle nor the returns are returns are
guaranteed guaranteed.

➢ On the basis of source of generation:

• External sources
• Internal sources

Internal Sources vs External Sources:

 Basis of Difference Internal Sources External Sources
Refers to the funds
Refers to funds generated
Meaning generated outside the
within the business
business
Can be controlled by the Cannot be controlled by
Control
management the management
Can be used for financing
Can be used for financing large financial
Extent of funding
limited needs of a business requirements of a
business
No such obligations as interest Obligation to pay interest
Obligations
payment and principle amount

❖ Various Sources of Finance

➢ Retained Earnings
It refers to the part of profits retained by the business after distributing dividends to the
shareholders.

➢ Merits
i. As these funds are raised internally, they do not involve any kind of explicit costs in the
form of interest, dividend or floatation.
ii. High retained earnings may lead to an increase in the price of equity shares.
iii. These earnings act as a cushion at the time of crises, thereby helping the business in
reducing the burden of unexpected losses.
iv. As these funds remain invested in the business for longer periods, they act as a
permanent source of finance for the business.
v. The internal generation of funds provides greater flexibility and operational freedom.
vi. Financing through this source does not create any charge on the assets of the
company.
vii. They do not dilute the control of management over the company.

➢ Limitations
i. As retained earnings depend on the profits earned, they are an uncertain source of
finance.
ii. Higher retained earnings → Lower dividends → Dissatisfaction among the
shareholders
iii. Funds may be misused or sub-optimally utilised.
iv. Using the funds to issue bonus shares to equity shareholders can result in over-
capitalisation.

❖ Trade Credit
It refers to the sale of goods and services by the supplier to the purchaser without
immediate receipt of payment but with an agreement of payment at some future date.

➢ Merits
i. It helps business firms in inventory accumulation for meeting any increase in the
demand.
ii. It is a simple arrangement that does not involve any rights over the assets by the
creditor.
iii. It is an easy and convenient source of finance, as it does not involve any legal paper
work, security mortgage, etc.
iv. It helps in promoting the sales, as the purchaser need not make immediate cash
payments.

➢ Limitations
i. Easy availability of trade credit can result in over-trading, which, in turn, can increase
the future liabilities of the buyer.
ii. The amount of trade credit extended varies as per the financial reputation or the
goodwill of the buyer.
iii. The seller of goods on trade credit may charge a higher price for the commodities.
iii. If the supplier asks for bank guarantee or other such formalities, then it may cause an
unnecessary delay in getting the trade credit.

❖ Factoring
It refers to an arrangement under which the financial service providers known as ‘factors’
agree to provide certain types of services to their clients.

➢ Types of Financial Services Provided under Factoring

i. Collection of debts on behalf of clients and discount on bills: The clients sell their bill
receivables at a discount to the factors who then become responsible for getting the bills
cleared.
ii. Verification of finances: Factors provide useful information regarding the financial
position of the firms with which their clients wish to enter a contract. In this way, they
prevent their clients from entering into contracts with firms that are in a poor financial
position.

➢ Merits
i. Factoring does not create any charge on the assets of the companies.
ii. By collecting debts and discounting bills on behalf of their clients, it provides security
against bad debts.
iii. It relieves the firms from the burden of credit control, particularly in case of bad
debts.
iv. It is a cheaper source of raising funds compared to bank credit.
v. Factoring ensures a continuous source of finance, thereby enabling firms to meet
their liabilities on time.

➢ Limitations
i. At times, factoring becomes an expensive source of financing, particularly when there
are a large number of invoices of a small amount.
ii. Under factoring, the client sells bill receivables at a discount to the factors. This rate of
discount may be higher than the market interest rate.
iii. As the factors are the third parties, customers may not feel so comfortable in dealing
with them.

❖ Lease Financing
It refers to an agreement wherein the owner of an asset (lesser) grants the other (lessee)
the right to use his/her assets for a specific period of time in return for a specific amount
(lease rental).

➢ Merits
i. The rent paid for using the leased asset is tax-deductible.
ii. It does not cause dilution of the ownership of a firm.
iii. It does not affect the debt-raising capacity of the firm.
iv. Lease financing provides greater flexibility to the lessee in terms of replacement of
the asset, as in this agreement, the lesser bears the burden of the obsolescence of the asset.
v. It does not involve any investment on part of the lessee for using the asset.
vi. There are no lengthy documentation requirements involved under lease financing.

➢ Limitations
i. Any delay in renewing the lease may affect the normal functioning of the business
enterprise concerned.
ii. It cannot claim the residual values of the asset, as in this agreement, the lessee is not
the owner of the asset.
iii. The lease agreement may, at times, impose certain restrictions on the use of the asset
by the lessee. This imposition of restrictions on the use of assets, in turn, may affect the
functioning of the business enterprise.
iv. In case the lessee terminates the agreement before the due date, the payout obligations
become large.

❖ Public Deposits
It refers to the deposits raised directly from the public to finance. The rate of return on
such deposits is generally higher than that on bank deposits.

➢ Merits
i. Raising funds through public deposits is very simple and involves only a few
regulations.
ii. It involves lesser cost than that involved in borrowing loans from commercial banks.
iii. It does not involve dilution of ownership, as the depositors do not have any voting or
management rights.
iv. It does not create any charge on the assets of the firm.
v. It is more flexible, in the sense that funds can be raised through public deposits as and
when needed.

➢ Limitations
i. The amount of money that can be raised from public deposits is limited, as it depends
on the availability of funds and the willingness of the people to invest in the company
concerned.
ii. Generally, it is difficult for new companies to raise capital through public deposits, as
people lack faith in such deposits.
iii. It does not prove to be suitable in case of a large requirement of funds.
iv. It involves an obligation regarding the payment of interest, irrespective of whether
the firm earns profit or loss.

❖ Commercial Paper
These are unsecured promissory notes used by one firm towards other firms to obtain
short-term finance (maturity period ranging from 90 days to 364 days) for their
businesses.

➢ Merits
i. It involves lesser cost compared to the cost of securing loans from commercial banks.
ii. It is a highly liquid asset, as it can be transferred to anyone at any time.
iii. It proves to be an attractive source for investing surplus funds, as the investors earn
good returns.
iv. It provides a continuous source of finance to firms, as the maturing funds can be repaid
by issuing fresh commercial paper.
v. As commercial papers are unsecured promissory notes, they do not involve any
restrictive conditions.

➢ Limitations
i. As commercial papers are unsecured securities, they can only be used by firms that
have a strong market position.
ii. The amount of money that can be raised through commercial paper is limited, as it
depends on the availability of funds with buyers at the time of its issue.
iii. It is said to be impersonal in the sense that if a firm is unable to redeem its commercial
papers on time, then it cannot extend the time period of the commercial papers.

❖ Equity Shares
These shares represent the ownership of a firm. The holders of such shares are known as
equity shareholders; they are the ones who enjoy a say in the management.

➢ Features of Equity Shares

i. Equity shareholders are the primary risk bearers of the company, in the sense that they
bear the losses of the company.
ii. The dividends payable to the equity shareholders are uncertain, as they vary with the
amount of profits, that is, higher the profits, higher the dividends payable.
iii. Equity shareholders are entitled to equal voting rights in the company.
iv. Equity shares cannot be redeemed before the winding-up of the company.
v. Equity shareholders can claim only the residual income of the company. A residual
income is the income that is left after settling the claims of creditors, preference
shareholders and other outsiders.
➢ Merits
i. They are a permanent source of capital, in the sense that funds raised from the issue of
equity shares remain invested in the business till the liquidation of the company.
ii. There is no obligation on the company to pay dividends to the equity shareholders, as
equity shareholders are only the residual claimants or residual owners of the company,
iii. Equal voting rights of equity shareholders in the company yields to a democratic
management of the company.
iv. They do not create any charge on the assets of the company.
v. They provide a good means of investment to those willing to take risks.
vi. High equity capital raises the credit worthiness of the company.

➢ Limitations
i. Issue of equity shares results in the dilution of the control of the management of the
company.
ii. The dividends payable to the shareholders are uncertain, as they vary with the
amount of profits, that is, higher the profits, higher the dividends payable.
iii. Issue of equity shares require lengthy formalities; thus, they result in delays in fund
raising.

❖ Preference Shares
These shares provide shareholders a preferential right regarding the repayment of capital
and payment of earnings after a certain specified period of time as governed by Section 80
of the Companies Act, 1956.

➢ Types of Preference Shares

1. Cumulative Shares Non- cumulative Shares
In which the unpaid dividend can be In which the dividend cannot get
accumulated. accumulated.
2. Participating Shares
Which enjoy a participating right in the Non-Participating Shares
profits of the company after dividend is Which do not enjoy participating
paid to equity shareholders. rights.

3. Convertible Shares Non-Convertible Shares

Which can be converted into equity shares Which cannot be converted into
within a specific period. equity shares.

➢ Features of Preference Shares

i. Preference shares do not carry any voting rights (except for in certain situations).
ii. Redeemable preference shares can be refunded before the winding-up of the company.
iii. Convertible preference shares can be converted into equity shares.
iv. Under cumulative preference shares, the unpaid dividend for a particular event can be
accumulated.
➢ Preferential rights enjoyed by preference shareholders
i. They entitle their holders the right to receive dividends at a fixed rate or of a fixed
amount.
ii. They entitle their holders the preferential right to receive the repayment of
capital before their equity counterparts at the time of liquidation of the company.

➢ Merits
i. The rate of return on preference shares is fixed; thus, the risk of uncertainty is less.
ii. As preferential shareholders do not have any voting rights in the company, there is
no dilution of control by the management.
iii. Preferential rights prove to be suitable for the investors who want a fixed rate of
return at comparatively low risk.
iv. As the return on preference shares is fixed, it renders greater flexibility regarding
payment for equity share holders.
v. Preference shareholders enjoy preferential rights over equity shareholders.
vi. Preferential rights do not create any charge on the assets of the company.

➢ Limitations
i. The dividends on preference shares are uncertain, as they are paid only when the
company earns profits.
ii. The return on preference shares is not tax-deductible and thus does not result in any tax
savings for investors.
iii. As the return on preference shares is fixed, such shares are not suitable for those
investors who are willing to bear a high risk in exchange of a higher return.
iv. They dilute the equity shareholders’ claim on the assets of the company.
v. The rate of dividend that a company must pay is higher than the rate of interest for
debentures.

Difference between Preference Shares and Equity shares

Basis of Difference Preference Shares Equity Shares

Receive a fixed rate of
Receive dividends
dividend before any payment
Return from profits left after
is made to the equity
paying the outsiders
shareholders
Do not have any voting rights
(except for in case of non- Carry equal voting
Voting rights
repayment of dividend for rights
two years)
Suitable for risk-averse Suitable for risk-
Type of investors
individuals loving individuals.
Preference shareholders are Equity shareholders
Repayment of
repaid before the equity are the last ones to be
capital
shareholders. repaid.
Can be redeemed on the
Redemption Cannot be redeemed
expiry of a fixed period
Can be converted into equity
Convertibility Not convertible
shares

❖ Debentures
These are the financial instruments that represent the loan capital of a company; they are
used to raise long-term debt capital.

➢ Features of Debenture
i. It is a debt instrument issued by a company.
ii. It is issued under a seal of a company specifying the way of repayment of principal
sum and interest on specific intervals. It also specifies the date of its redemption.
iii. It is a transferable instrument and thus can also be considered a movable property of
the company.

➢ Types of Debentures
1. Secured/mortgaged Debentures Unsecured Debentures
They are secured against certain assets of a They are not secured against
company. any assets of a company.
 Bearer Debentures
2. Registered Debentures
The company does not
The company has to maintain a record of
maintain any record of the
the debenture holders.
debenture holders.
3. First hand Debentures Second hand Debentures
That are repaid before any other That are paid after the first
debentures are repaid hand debentures are paid

➢ Merits
i. The rate of interest on debentures is tax-deductible.
ii. Issuing debentures neither dilutes the ownership nor affects profitability of a
company.
iii. Debentures are less risky securities, as they carry a fixed rate of return.
iv. They do not depend on the profits of the company.
v. Debentures are suitable for the companies that have stable earnings.

➢ Limitations
i. The legal boundation of a company to pay interest on debentures increases its payment
obligations (particularly in the event of losses).
ii. The borrowing capacity of a company gets limited with further issue of debentures.

➢ Difference between Shares and Debentures

Basis of Difference Shares Debentures

Grant ownership and Do not carry any rights over
Control
control to the holders ownership or management
Do not have any fixed rate
Returns Carry a fixed rate of return
of return
 Do not create any charge Create a charge on the assets
Charge on assets
on the assets of the company
Are redeemable on the expiry
Redemption Cannot be redeemed
of a fixed period
Cannot be converted into
Conversion Can be converted into shares
debentures
Payment to the
shareholders is made after
Payment to the debenture
the settlement of all
Repayment priority holders is made before the
external liabilities, that is,
shareholders.
after paying debenture
holders.

❖ Commercial Banks
Commercial Banks issue bank credit in the form of loans and advances on which an interest
rate is charged.

➢ Merits
i. Banks maintain secrecy over information related to their customers.
ii. Bank credit provides flexibility to the borrower, as the amount of credit can be altered
as per the need.
iii. Banks provide funds to the firms whenever required, thereby providing timely
assistance.
iv. There are not much formalities involved in raising credit from commercial banks.
➢ Limitations
i. The funds provided by the commercial banks are only for a fixed period. Extension of
the period is difficult and uncertain.
ii. The banks often impose restrictive conditions; they can restrict the sale of goods
mortgaged to them by the borrowers.
iii. Mortgage of assets or other such requirements makes it difficult to obtain funds.

❖ Financial Institutions
Financial institutions are the institutions established by the central or state government to
finance business operations for expansion, modernisation and reorganisation.

➢ Merits
i. Financial institutions provide funds for a relatively longer period compared to
commercial banks.
ii. Borrowing funds from financial institutions enhances the goodwill of the company in
the capital market, thereby making borrowing easy.
iii. They also provide easy repayment facilities to its borrowers.
iv. They provide funds to the borrower even in weak economic situations.
v. Many financial institutions also provide various other services including consultancy
and advisory services to the borrowers.

➢ Limitations
i. Borrowing from financial institutions is a lengthy, rigid procedure, with too many
complex and time-consuming formalities.
ii. Financial institutions often impose restrictions such as dividend payments on the
borrowers.
iii. They may appoint their members to be the board of directors of the company,
thereby restricting the management and control of the company.

❖ International Financing
Raising funds from international markets is known as international financing.
The following are some of the international sources of funds:
• Commercial banks- These banks are located globally and provide credit in international
currencies to enable firms to undertake international business operations.
• International agencies and development banks- These agencies and banks are set up
by the government of the developed nations to finance the development projects of the
economically backward areas of the world.
• International capital markets- International capital markets are the institutes having
their operations globally, with a sizeable amount of domestic as well as foreign currency.
Some of the instruments used for this purpose are as follows:
i. Global Depository Receipts (GDRs)- These are the instruments issued abroad by a
domestic company to raise funds in foreign currency. They can be converted at any point of
time into an equitable number of shares.
ii. American Depository Receipts (ADRs)- These are the instruments issued in the US by a
domestic company to raise funds. They are sold only to the American citizens and are
traded in the U.S. securities market only.
iii. Foreign Currency Convertible Bonds (FCCBs)- FCCBs are the debt securities that are
converted into equity shares or depository receipts after a specific period of time. They are
traded in foreign stock exchanges.

❖ Factors Affecting Choice of Source of Funds

The following factors affect the choice of source of business finance:

i. Cost of raising funds- Raising finance through different sources involves costs such as
interest obligations, procurement cost and utilisation cost.
Higher cost → Less preference for the source and vice versa.

ii. Payment obligations- A business must honour the payment obligations of capital as
well as the return on investment. The company should opt for those sources where
payment obligations are non-binding in nature.

iii. Dilution of control involved- The company should also consider the extent to which
the owners are ready to share their control over the business.

iv. Impact on credit worthiness of the issuer- High dependence on secured debentures
hampers the interest of the unsecured creditors. As a result, they may not extend further
credit to the company.

v. Associated tax benefits- Interest paid on most of the borrowed funds is tax-deductible,
which, in turn, helps in reducing the overall cost of the company.

vi. Ease of obtaining and repayment- The length of the procedures and formalities and
time must be weighed before choosing the source of finance.

vii. Financial strength and stability in operations-

Stable financial position → Debentures are preferred
Unstable financial position → Shares are preferred

viii. Form of organisation and legal status- The form of business organisation affects the
choice of source of funds, as only the company is permitted to issue equity shares.

ix. Purpose and time period- The choice of source also depends on the time period for
which the funds are needed. For short-term finance requirements, bank loans or
commercial papers may be selected.