CLASS XI BUSINESS STUDIES

CHAPTER VII
SOURCES OF BUSINESS FINANCE
Business Finance: Business finance is concerned with acquisition and utilization of capital to
carry out various business activities of an organization. The initial capital contributed by the
entrepreneur is not always sufficient to meet all financial needs of the business. A business
man, therefore, has to look for different sources from where the need for funds can be met.
Thus, business finance refers to money and credit employed in a business firm in order to
carry out its operation smoothly. Business finance may be defined as planning, raising,
managing and controlling all types of funds needed for a business.
Significance of business finance: Finance plays a vital role in the functioning of modern
enterprises. It is said to be the lifeblood of business. Finance is needed in at every stage in the
life of a business. It must be available at the proper time. It must be adequate for the purpose
for which it is needed. Insufficient fund may affect the growth of the firm adversely. Finance
is required to start a business, to operate it, as well as for modernization and expansion. While
starting a business, money is needed to purchase fixed assets and also to meet day-to-day
expenses.
TYPES OF FINANCE
1. Long term finance: Long-term finance refers to the funds which are to be invested in the
business for a long period, say for a period over 5 years. Such finance is used for investment
in fixed assets like land, building, plant, machinery, furniture etc. This is known as fixed
capital requirements of an organization. Long term finance is acquired through issue of
shares, debentures or loan from specialized financial institutions. The volume of long-term
fund required by a business depends up on the nature and size of the business unit.
Manufacturing concerns requires more long -term finance than trading concerns. Long term
finance is required for financing capital expenditure. They are also known as fixed capital or
block capital.
2.Short term finance (working capital): Short term finance is raised for a period of less than
one year. It is required to meet the day to day needs of the business. It is known as working
capital of an organization. It is the amount required for investment in current assets like stock
of raw materials, debtors, bills receivable also funds required for current expenses such as,
wages, salaries, rent etc. The current assets can be converted in to cash within a short period.
Trading concerns require more short-term finance than manufacturing concerns. Amount of
working capital determines the length of operating cycle. Lesser short-term finance will be
required, if the gap between production and sales is lesser and vice versa. Main sources of
short-term finance are trade credit, bank loan, customer advance etc. Short-term finance is
also known as revolving capital or circulating capital.

Classification on the basis of ownership

The business can raise its required finance from two main sources. They are
(1) Owners’ funds
(2) Borrowed funds.
1. Owners Fund: Owned capital refers to the amounts contributed by the owners into the
business. In a sole proprietorship, the proprietor brings the owned funds from his personal
property. In a partnership, the capital contributed by the partners is called owned funs. Funds

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raised by the issue of shares and retained earnings are the owned funds in a joint stock
company. It will remain in the business over a long period and is not expected to be
withdrawn otherwise than on the winding up of the business.
2. Borrowed funds: Borrowed funds refer to fund raised from external borrowings. The
sources of borrowed funds include issue of debentures, public deposits, trade credit and loans
from financial institutions and banks. Periodical payments of interest and repayment of loan
amount on expiry date are required even if there is no profit. Moreover, borrowed funds are
available only on mortgage of fixed assets.
DIFFERENCE BETWEEN OWNERS’ FUNDS AND BORROWED FUNDS
BASIS OWNERS’ FUNDS BORROWED FUNDS
MEANING It refers to funds contributed by It refers to all funds available
owners as well as retained by way of loans & credit.
earnings.
TIME PERIOD Source of permanent capital For a fixed period of time.
SECURITY No security required. Generally raised against
security of assets.
CONTROL Have controlling power. Don’t have the right to
control.
SOURCES Shares & retained earnings. Debentures, loans, trade
credit, public deposits.
RETURN No right to get regular return in Right to get regular return in
form of dividend. form of interest.
RISK BEARERS Primary risk bearers. Borrowed funds security
holders don’t have any risk.

SOURCES OF
FUNDS

OWNERS FUNDS BORROWED

FUNDS

EQUITY SHARES DEBENTURES

PREFERENCE LOANS FROM

SHARES FINANCIAL
INSTITUTIONS

RETAINED COMMERCIAL
EARNINGS BANKS

PUBLIC DEPOSITS

ICD

TRADE CREDIT

EQUITY SHARES
The holders of these shares are the real owners of the company. They have a voting right in
the meetings of shareholders of the company. They have a control over the working of the

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company. Equity shareholders are paid dividend after paying it to the preference shareholders.
The amount of share capital which is raised by issue of equity share is known as equity share
capital. The rate of dividend on these shares depends upon the profits of the company. They
may be paid a higher rate of dividend or they may not get anything. These shareholders take
more risk as compared to preference shareholders. Equity capital is paid after meeting all
other claims including that of preference shareholders. They take risk both regarding dividend
and return of capital. Equity share capital normally cannot be redeemed during the life time of
the company.
Features of equity shares
1) Risk bearers: Equity shareholders are entitled to receive what is left after all prior claims
have been paid. They provide funds to the company not on the basis of any security.
2) No fixed rate of dividend: The rate of dividend on equity capital depends upon the
availability of surplus funds. There is no fixed rate of dividend on equity capital. It is paid out
of the residual profits after paying interest on debentures and dividend on preference shares.
3) Right to vote: Equity shareholders have voting rights and elect the management of the
company.
4) Permanent source of finance: Equity share capital remains permanently with the
company. It is returned only when the company is wound up.

PREFERENCE SHARES

Preference shares are those shares which have preferential right over equity share in case of
A. payment of dividend and
B. repayment of capital at the time of winding up.
They are entitled to a fixed rate of dividend before any dividend is paid to equity share-
holders. Preference shares are better suited to the needs of cautious and conservative investors
who wants certainly of income and security of their investment. However, the rate of dividend
specified in preference shares is not guaranteed. If any year’s profit is not sufficient to declare
dividend on shares the preference shareholders will not get dividend. There is also a
restriction on their voting rights. They have right to vote only on matters affecting their
interest like nonpayment of dividend.
Features of preferences shares
1. Preference If there is profit and dividend is declared, dividend at a fixed rate must be paid
first to the preference shareholders. The balance, if any, can be districted among equity share-
holders. They also have the preference in case of repayment of capital.
2. Restricted voting right Preferences shares carry limited rights over the management of the
company.
3. Fixed percentage of dividend Preferences shareholders get only fixed percentage

RETAINED PROFIT (Ploughing back of profit) Out of total profits earned by a company
in a particular year, a certain percentage is retained in the business without distributing as
dividend among shareholders, this undistributed profit is known as retained profit. It is a
source of internal financing or self-financing. It is also known as ‘ploughing back of profit’. It
is treated as an ownership fund and will serve the purpose of long term and medium-term
financing. It is a usual practice of a company to transfer a part of its profit to general reserve
every year. When these reserves are accumulated into a large amount, after a few years, this
can be employed in modernization, expansion etc. of the business.

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FEATURES OF RETAINED EARNINGS:
1. Retained earnings is a permanent source of funds available to an organisation.
2. It does not involve any explicit cost in the form of interest, dividend or floatation cost.
3. The profit available for ploughing back in an organisation depends on many factors like net
profits, dividend policy and age of the organisation.
4. with retained earnings, there is no increase in number of shareholders. Thus, it doesn’t
involve any risk of dilution of control.

TRADE CREDIT: is the credit extended by one trader to another for the purchase of goods
and services. Trade credit facilitates the purchase of goods without immediate payment. Such
credit appears in the book of the buyer as sundry creditors. It is commonly used by the
business organization as a short-term source of financing. The volume and period of trade
credit depends on factors such as reputation of the purchasing firm, financial position of the
seller, volume of purchase, competition in the market etc.
FEATURES OF TRADE CREDIT:
1. It is available without any special efforts on the part of the trader.
2. There are no rigid rules & regulations and can be easily adjusted as per the requirements.
3. No cost is involved in raising funds through trade credit.

PUBLIC DEPOSITS: The deposits that are raised by organisations directly from the public
as loan or debt are called public deposits. Companies advertise in newspapers for inviting
general public to invest their savings in public deposits. Companies generally invite public
deposits for a period up to three years. It is a source of medium term or short-term finance.
FEATURES OF PUBLIC DEPOSITS:
1. Public deposits are unsecured loans and the depositors are like ordinary creditors.
2. Rate of interest offered on public deposits are usually higher than that offered on bank
deposits.
3. The amount raised from public deposits is usually used for meeting the requirements of
working capital.
4. The process to raise funds through public deposits is simple & doesn’t involve lengthy
process.

ISSUE OF DEBENTURES Debenture is an important instrument for raising long term debt
capital. A company can raise funds through issue of debentures, which bear a fixed rate of
interest. A debenture is a certificate or document issued by a company under its seal as an
acknowledgement of its debt. It is also an undertaking by the company to repay specified
borrowed sum to the debenture holder. Debenture holders are creditors of the company.
Debenture holders are paid a fixed stated amount of interest at specified intervals.
Features of Debenture:
1. A debenture is a certificate is an acknowledgement of debt of a company.
2. Debenture represents borrowed capital.
3. Interest on debenture is payable at a fixed rate.
4. Debenture holders are creditors of the company
5. Debenture holders have no voting rights.
6. Interest on debenture is a charge against profit.
7. It can write as an expense on the debit side of the profit and loss account.
8. Debenture may involve a charge on the assets of the company.

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 DIFFERNENCE BETWEEN SHARES AND DEBENTURES
BASIS SHARES DEBENTURES
Position A shareholder is an owner of the A debenture holder is a
company creditor of the company
Return on investment Shareholders get dividend as the Debenture holders get interest
return as the return
Guarantee of return Rate of return is fluctuating, Rate of interest is fixed
depending upon the earnings of irrespective of profit or loss of
the company the business
Voting right Shareholders have voting rights Debenture holders have no
voting rights
Redeemability Shares can’t be redeemed Debentures are redeemed after
(except redeemable preference the specific time period.
shares) during the life of the
company
Security No charge is created on the The debentures are generally
assets of the company secured by creating a charge
on the assets of the company
Priority for repayment At the time of winding up of the Debentures are repayable in
of investment company, share capital is priority over share capital
payable after meeting all outside
liabilities

LOANS FROM FINANCIAL INSTITUTIONS The government has established a number

of financial institutions all over India to provide finance to business organizations. They
provide both owned capital and loan capital for long and medium-term financial
requirements. As these institutions aim in promoting the industrial development of a country,
these are also called development banks. Examples for development banks are
-Industrial Finance Corporation of India (IFCI),
State Finance Corporation of India (SFC),
Industrial Credit and Investment Corporation of India (ICICI),
Industrial Development Bank of India (IDBI) etc.
Functions of development banks
1. Long term and medium-term financial assistance to industries at a reasonable rate of
interest.
2. Subscribe shares and debentures issued by companies.
3. Underwrite the issue of shares and debentures of companies.
4. Give guarantee for loans obtained by such companies from other financial institutions and
banks.
5. Give loans in foreign currency for industries to import machinery.

COMMERCIAL BANKS: Commercial banks occupy an important position as they provide

funds for different purpose as well as for different time period. Banks extend loan to firms in
many ways like cash credit (CC), over draft (OD), term loans, discounting bills of exchange
etc. The borrower is required to some security or create charge on the assets of the firm before
a loan is sanctioned by a commercial bank. Bank credit is not a permanent source of funds.

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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. The three types of Inter Corporate Deposits
are:
(i) Three months deposits;
(ii) Six months deposits;
(iii) Call deposits.
Interest rate on ICDs may remain fixed or may be floating. The rate of interest on these
deposits is higher than that of banks. These deposits are usually considered by the borrower
company to solve problems of short-term funds deficiency. The biggest advantage of ICD is
the transactions are free from legal and bureaucratic hassles.

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