CBSE 11 | BST
SOURCES OF BUSINESS FINANCE
BUSINESS FINANCE: The requirements of funds by business to carry out its various activities is called business finance.
It said to be the lifeblood of any business.
The need for funds arises in all stages of business
1. For starting a business - funds needed for the purchase of fixed assets
2. For day-to-day operations, say to purchase raw materials, pay salaries to employees, etc.
3. For business modernisation and expansion
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FINANCIAL NEEDS OF AN ENTERPRISE
FIXED CAPITAL REQUIREMENT
WORKING CAPITAL REQUIREMENT
Funds required for starting a business
1. Funds required for day-to-day operations
Required to purchase fixed assets
2. Required for Current Assets & Current Expenses
Remains invested for long time
3. Gets used up in working and needed repeatedly
Will vary depending upon nature of business
4. Will vary depending upon Sales policy
i. Trading Concern – Less Fixed Capital
i. Credit Sales – more Working Capital
ii. Manufacturing Concern – High Fixed Capital
ii. Cash Sales – less Working Capital
CLASSIFICATION OF SOURCE OF BUSINESS FINANCE
TIME
PERIOD
OWNERSHIP
SOURCE
LONG TERM – EXCEEDING 5 YEARS
 Financing of Fixed Assets
 Eg. Shares, Debentures and loans from Financial Institutions
MEDIUM TERM – 1 YEAR TO 5 YEARS
 Modernisation of business or Project Financing
 Eg. Loan from banks, public deposits and lease financing
SHORT TERM – LESS THAN 1 YEAR
 Financing Current Assets and Current Expenses
 Eg. Trade Credit, Factoring, Banks, etc.
OWNER’S FUNDS
 Fund provider is treated as owner of the business – has control over enterprise
 Permanently Invested in the business
 No obligation to repay or return
 Unsecured source of finance
 Eg. Retained Earnings and Equity Shares
BORROWED FUNDS
 Fund provider is treated as a creditor of the business – no control over enterprise
 Provide funds for a specific time period and repayment required
 Fixed interest is paid compulsory (even in case of loss)
 Secured against fixed assets
 Eg. Loans, debentures, public deposits and trade credit.
INTERNAL SOURCES
 Generated within the business
 Cheaper Source of Finance (No explicit cost involved)
 No Collateral required – borrowing capacity intact
 Limited needs of business
 Eg. Ploughing back (Reinvesting) profit, early collection of debt, disposing inventory, etc.
EXTERNAL SOURCES
 Generated outside an enterprise
 Costlier Source of Finance (Explicit Cost involved)
 Collateral Required
 Satisfied greater needs of business
 Eg. Debentures, borrowing from banks & public deposits
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RETAINED EARNINGS (Self Financing / Ploughing Back of Profit / Accumulated Profits)
Company may not distribute all the profit that it earns, a part of it may be retained for use in the future.
Amount of Retained Earnings is dependent on Net Profit + Dividend Policy + Age of Enterprise
MERITS
DEMERITS
Permanent source of funds
1. Dissatisfaction to shareholders - lower dividends
No explicit cost in the form of interest, dividend or 2. Uncertain source of funds (profits are fluctuating)
floatation cost
3. Opportunity cost not recognised. This may lead to
Greater degree of operational freedom and flexibility
sub-optimal use of the funds.
Enhances capacity to absorb unexpected losses
Increase in the market price of shares
TRADE CREDIT
Trade credit is the purchase of supplies without immediate payment. It is granted to those customers who have
financial standing and goodwill. Terms of trade credit may vary from person to person.
MERITS
DEMERITS
1. Convenient and continuous source of funds
1. Easy and Flexible – may lead to overtrading (Risk ↑)
2. Readily available if credit worthiness is known
2. Limited source of finance
3. Promotes sales for an enterprise
3. Costly source of finance (Goodwill / Reputation is at
4. Seasonal increase in inventory may be financed
stake)
through trade credit
5. Does not create any charge on the assets
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PUBLIC DEPOSIT
The deposits that are raised by organisations directly from the public are known as public deposits.
Rates of interest on public deposits are usually higher than bank deposits.
Companies generally invite public deposits for a period up to three years.
The acceptance of public deposits is regulated by the Reserve Bank of India.
MERITS
DEMERITS
Readily available if credit worthiness is known
1. Difficult for new companies (No public trust)
Simple procedure with no restrictive conditions like 2. Unreliable source - public may not respond when the
company needs money
a loan agreement
3. Collection of public deposits may be difficult, when
Low Cost of Borrowing
the size of deposits required is large
No charge on the assets – can raise loans in future
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5. No dilution of control - depositors are creditors
Lease Financing & Commercial Paper – Excluded from syllabus for Academic Session 2022 – 23. Inform if it is being
taught in your school. It will be explained separately.
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DEBENTURES
Debenture = acknowledgment of a long-term debt with promise to repay at a future date.
Debenture holders are creditors and are paid a fixed interest at specified intervals.
Public Issue of debentures must be rated by a credit rating agency like
CRISIL (Credit Rating and Information Services of India Ltd.)
MERITS
DEMERITS
Preferred by investors who want fixed income at 1. Fixed interest - permanent burden on the earnings.
lesser risk
Greater risk when earnings fluctuate
Fixed charge funds with no participation in profits
2. For redeemable debentures – compulsory payment
Suitable when sales and earnings are stable
even during financial difficulty
No dilution of control – no voting rights
3. Debentures – usually secured - further capacity
Less costly as the interest payment is tax deductible.
borrow funds reduces.
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EQUITY SHARES (Owner’s Fund)
Prerequisite for creation of a company and most important source of long-term capital.
Represent the ownership of a company (highest risk and reward) and
have a right to vote and participate in the management of the company.
Don’t get a fixed dividend and are called ‘residual owners’ since they receive what is left after all other claims.
MERITS
DEMERITS
1. Suitable for investors who want high risk & high 1. Not suitable for Investors who want steady income
returns
2. Cost of equity shares is high (due to high risk)
2. No fixed burden - Payment of dividend is not
3. Additional equity shares dilute the voting power, and
compulsory.
earnings of existing equity shareholders
3. Permanent capital and repaid only at the time of 4. More formalities and procedural delays are involved
liquidation of a company.
while raising funds through issue of equity share.
4. Equity capital provides credit worthiness to the
company and loan providers
5. No charge on the assets – future borrowing possible
6. Democratic control – decisions through voting
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PREFERENCE SHARES
The preference shareholders have a preferential claim over dividend and repayment of capital.
Resemble Debentures and Equity Shares
Like debentures – Preference Shares bear fixed rate of return and have no voting rights (generally)
Like Equity Shares - dividend is payable at the discretion of the directors and only out of Profit After Tax
(Appropriation of Profit)
MERITS
DEMERITS
Provide reasonably steady income in the form of 1. Not suitable for investors who want high risk and
fixed rate of return and safety of investment
higher returns
Useful for investors low risk & fixed return
2. Dilutes the claims of equity shareholders over assets
No voting rights – no dilution of control
of the company
Fixed rate of dividend may allow higher dividend for 3. Dividend on preference shares > interest on
the equity shareholders in good times
debentures (Higher cost of capital to company)
Preferential right in the event of liquidation
4. No assured return – paid only out of profits
No charge against the assets of a company.
5. Dividend paid is not an expense - no tax saving
TYPES OF PREFERENCE SHARES
Cumulative and Non-Cumulative
Cumulative - right to accumulate unpaid dividends in the future years if not paid in a particular year
Non-cumulative shares - dividend is not accumulated if it is not paid in a particular year.
Participating and Non-Participating
Participating Preference Shares - right to participate in further surplus of a company
Non-Participating Preference - No rights of participation in the profits of the company
Convertible and Non-Convertible
Convertible Preference shares – can be converted into equity shares within a specified period of time
Non-Convertible shares – cannot be converted into equity shares (Repaid in cash)
Basis of Difference
Meaning
Time Period
Security
Control
Sources
Right to Return
Risk Bearer
Owned Fund
Funds contributed by owners & retained
earnings
Permanent Capital
No security
Control the company – voting right
Capital & Retained Earnings
No right to get regular return
Primary risk bearers
Borrowed Fund
External Borrowings as loans or credit
Fixed period of time
Secured against assets
No right to control – No voting right
Debentures, Loans, etc.
Fixed Returns
No Risk bearing
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