Business finance

The money required for carrying out business activities

A clear assessment of financial needs and the identification of various sources of finance is very essential for any
business organisation
Need for business finance :
1. To start and establish business
2. To purchase plant and machinery and other fixed assets
3. Funds are required for day today activities – payment to suppliers
for the purchase of raw material , to pay salaries to employees etc .
4. To expand business operations and modernize and update its
operations
Financial needs of a business can categorised as
follows

Fixed capital requirements

Working capital requirement

 Fixed capital requirement : fixed capital is the money invested in fixed assets . Fixed capital remains
invested in the business for a long period of time .
Fixed capital requirement of a business depends on :
1. Nature of the business : A manufacturing business needs more funds as compared to a trading and
service organisation
2. Scale of operations : A large scale business needs more investment compared to a small scale
business
3. Expansion plans : business organisation with plans to expand or diversify may need more funds as
compared to single product selling business .
Working capital requirements:
the fund which is required for its day –to-day operations .
The working capital is required for holding current assets such as stock of material ,
bills receivable and for meeting current expenses like salaries , wages , taxes and
rent .
•Working capital requirements
•Salaries , wages and rent

•Selling and distribution expenses

•Purchase of raw material

•Payment to suppliers

•Operating expenses
Amount of working capital depends on :

a) Rate of stock turnover : if a business sells its goods at a slower rate it will need more working capital
b) Credit policy of the business : need of working capital largely depends on the credit period extended
by the business to its customer and the credit period received by business from its suppliers .
c) A business selling goods on credit rather cash basis needs high amount of working capital.
d) Seasonal business : if a business deals in seasonal goods then it may need larger funds to maintain
high levels of stock to meet demands during season
 Classification of sources of funds

Sources of
fund

Period Generation Ownership

basis basis basis

Owners
Long term Internal
fund

Borrowed
Medium term External
funds

short term
 Classification of sources of funds on the basis of period

Long term sources : if a enterprise require funds for a period or more than five years
then the source from which the funds are raised are called as long term source . Long
term funds are usually raised to fund fixed capital requirements .
Example : equity shares , debentures , loans from bank or financial institution .
Medium term sources : medium term sources fund the finance requirement for a
period or more than year but less than five years . A business may use medium term
sources to raise funds for research and development , update technological changes or
to launch a new product .
example : borrowing from commercial banks , public deposits , lease financing
Short term sources : short term sources fulfil the financial requirements for a period of
one year . Short term sources are used to finance current assets like purchasing of
inventories to build stock level for anticipated demand , payment to creditors or meet
day to day expenses
Example : trade credit , bank loan , commercial papers
•Ownership basis: funds can be raised either by owner from his personal
sources or through borrowing
•Owner funds:- the provided by the owner of an enterprise it includes – capital and profit re invested in the business for
longer duration and it is not required to be refunded during the life period of the business - equity share capital and retained
earnings –two important source of business fund

•Borrowed funds :these funds are raised through loans or borrowing . The source for raising borrowed funds include
loans from commercial bank , loans from financial institute , issue of debentures – these sources provide fund for specified period
on certain contains . A fixed rate of interest is paid by the company and these funds are repaid after the expiry of that period .
 1.Equity shares represents the ownership of a
company and thus capital raised by issue of such
shares represent
•Equity shares arethe ownership
those capitaldo. not carry any special or preferential rights in respect of payment of annual
shares which
2.Equity
dividendshare holders do of
and repayment not .
get a fixed
capital
dividend but paid on the basis of earnings by a
company . They are also called as residual
owners. Equity share holders have right to
• participate in the management as they have
voting rights .
•
•Preference shares

•Preference shares are those shares ,which enjoy certain priorities regarding the payment of dividend at a fixed rate and
return of the investment .
•As compared to equity share holders preference share holders have preferential claim over dividend and repayment of
capital .
•Equity shares FEATURES :
•Risk bear capital – they are primary risk bearers , they enjoy the reward as well as bear the cost

•Voting rights : every equity share holder have voting rights in proportion to the shares held by share holders . They have a right to participate
in company’s management

•maturity : equity shares provide permanent capital to the company and can not be redeemed during the life time of the company

•Return: the return earned by equity share holders are referred to as “dividend ” which varies with earning of the company .

•Claim over residual income: equity shareholders are referred as residual owners “ as they get dividend , only after all other
claims on the company income and assets have been settled
•Limited liability : the liability of the equity share holders is limited to the extent of capital contributed by them in the company

•Preference shares
•Fixed rate of dividend : preference share holders receive dividend at a fixed rate before any dividend is paid to equity share holders .

•Repayment of capital : preference share holders have preferential right as to the redemption of capital at the time of winding up of a
company .

•No voting rights : preference share holders generally do not enjoy any voting rights .

•no charge on assets : preference shares are also issued without creating any charge on the fixed assets of the company .

•
•Merits of equity shares
•1.Equity shares are suitable for investors who are willing to assume risk for higher returns.
•2. Payment of dividend to equity share holders is not compulsory . So no burden on company .
•3. Equity share capital is serves as permanent capital as it is to be repaid only at the time of liquidation of a company . As it stan
least in the list of claims .
•4. Equity capital provides credit worthiness to companies and confidence to prospective loan providers .
•5.Funds can be raised through equity issue without creating any charges on the assets of the company
•6.Democratic control over management of company .
•
•Limitations of equity shares
•1. Investors who want steady income may not prefer equity shares as it gets fluctuating returns
•2. The cost of equality shares is generally more as compared to the cost of raising funds through other sources.
•3. Issue of additional equity shares dilutes the voting power and earnings of existing equity share holders .
•4. More formalities and procedural delays are involved while raising funds through issue of equity shares .
 MERITS AND LIMITATIONS

•1. Preference shares provide reasonably steady income in the form of fixed rate of return and safety of
investment
•2. Preference shares are useful for those investors who want fixed rate of return with comparatively low risk .
•3. Preference holders have a preferential right of payment over equity shareholders in the event of
liquidation of a company .

•1.Preference shares are not suitable for those investors who are willing to take risk and are interested in
higher returns .
•2.Prefernce capital dilutes the claims of equity shareholders over assets of the company .
•3.The rate of dividend on preference shares is generally higher than the rate of interest on debentures .
 Types of preference shares :

Cumulative preference shares :preference shares which enjoy the right to accumulate unpaid dividends in
the future years (in case if it is not paid in the same year)
Non – cumulative preference shares : for these share dividend will not be accumulated later if it is not paid
in a particular year .

Participating preference shares : preference shares which have a right to participate in the further surplus
of a company .( after paying dividends to equity share holders )
Non participating preference shares : these shares do not have any such privileges or right to participate in
the surplus profit of the company .

Convertible preference share : preference shares which can be converted in to equity shares within a
specified period of time .
Non convertible preference shares : these category of preference shares can not be converted in to equity
share capital
Stages of issue of shares

•SEBI approval
•Issue of prospects
•Filling prospectus

•Appointment of bankers , brokers ,underwriters

•Application to stock exchange

•Allotment of shares
Retained earning :

It is a source of internal financing or self financing ploughing back profits. A company generally does not
distribute all its earnings amongst the share holders as dividends . The undistributed profit is retained
earning .
A portion of the net earning can be retained in the business for the use in future it is called as retained
earning .
Merits of retained earning :
1.Retained earning 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 flotation cost .
3.As the funds are generated internally . There is a greater degree of optional freedom and flexibility .
4. It enhances the capacity of the business to absorb unexpected loss
5 the amount of retained earning depends on the net profit earned , companies dividend policy .

Demerits of retained earning :

1. Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower
dividends .
2. It is an uncertain source of funds as the profits of business are fluctuating .
3. The opportunity cost associated with these funds is not recognised by many firms . This may lead to sub –
optimal use of the funds .
 • Borrowing represent the funds raised from
external sources in the form of loans or
borrowings repayable after a fixed period of

Borrowed time
• They carry a fixed cost in the form of interest
payable annually till they are repaid . Payments
funds of interest is to be made even during the
earning are low or business incurs losses.
• Borrowing may be provided against security of
fixed assets
 Loans from
commercial
bank
Trade
credits

Loans from
Borrowed financial
funds institutes

Debentures
/bonds public
deposit
Loans from
banks
Public deposits : these are the sources of finance where the funds are raised from share holders , employees or
general pubic . A business enterprise needs to advertise in leading news paper to invite public deposits . Any
individual can deposit money with company as deposit by filling a prescribed form.
The company in return issues deposit – receipt as acknowledgment of the debt
Features : Merits Demerits :
• Rate of interest is higher
than that offered on bank 1. Procedure to obtain 1.It is difficult for new
deposits . deposits is simple and does companies to generate fund
• Person who is interested in not contain restrictive through public deposits .
depositing money in an conditions . 2. It is an un reliable source of
organisation can do so by 2. cost of public deposits is finance as the public may not
filling up prescribed form . generally lower than the respond when company needs
• Public deposit can take care cost of borrowing from money .
of both medium and short
banks and financial institute 3. Collection of public deposits
term financial requirements
of a business .
3. Public deposits do not may prove difficult . Particularly
• The deposits are beneficial usually create any charge when the size of deposit
to both the depositor as well on the assets of the required is large .
as to the organisation . company .
• Generally public deposit are 4. As depositors do not have
invited for a period up to 3 voting rights the control of
years . company is not diluted .
• The acceptance of public
deposit is regulated by RBI
Debentures : These are important instrument for raising long term debt capital .
A company can raise funds through issue of debentures which bear a fixed rate of interest.
Debenture holders are the creditors of the company as debenture issued by the company is an acknowledgement
that company has borrowed a certain amount of money which it promises to repay at future date .
Debenture holders are paid fixed rate of interest at specified intervals say six months to one year .
Financing through debentures is less costly as compared to cost of preference or equity capital as the interest
payment on debentures is tax deductible .

CRISIL: credit rating and information service of India Ltd – an agency which rates the company based on
following – company profitability , debt servicing capacity , credit worthiness and perceived risk of lending .
Important points Merits Demerits

Debenture bear fixed rate of interest . It is the preferred way of investment by the investors as it As debentures requires fixed rate of interest
gives fixed return in the form of interest . payable it burdens the company when there is
fluctuation in the earnings of the company

Debentures holders are creditors of the company as The issue of debentures is suitable in situation when the In case of redeemable debentures the
company has borrowed certain amount which is sales and earnings are relatively stable . company has to make provisions for
repayable at a future date . repayment even in
the case of financial difficulty .

Interest is paid to the debenture holders As debentures do not carry voting rights , financing
periodically [6 months / annually ] through debentures does not dilute the control of equity
share holders

CRISIL rates the issues of debentures on the basis The interest payment on debentures in tax deductible so
profitability , credit worthiness, debt serving it is beneficial to the company
capacity

Secured and unsecured
Secured debentures : company
assets are given as security for
these debentures .
Unsecured : unsecured
debentures do not carry any
kind of security mortgaged .
Types of debentures
Registered and bearer Convertible and non convertible
Registered debentures : these Convertible : these debentures can
debentures are recorded in the books be converted in to a equity shares
of company . They can be transferable after the period of expiry .
only through regular instrument . Non convertible debentures : these
Bearer debentures can be transferred can not be convertible in to equity
by mere delivery . shares .
First and second
These classification based on the repayment
First debenture : repayment of these
debentures are done primarily .
Second debentures : these debentures are
repaid after the repayment of first debentures
.
 Loans from commercial bank
Commercial banks
Commercial banks are vital source of
business finance
They provide loans on period basis –
long term , medium and short .
Loans are provided by the commercial
banks : cash credit , overdraft , term
loans .
The rate of interest charged by the banks
depends on various factors :
characteristic of the firm , level of
interest rate in economy , method of
loan repayment [instalment or lump sum
]
The borrower [company] has to give
some security to avail loans from bank .
Merits
Timely assistance : bank provide timely
assistance by providing fund
Secrecy : business secret can be
maintained as the information provided
to the bank is kept confidential .
Simple formalities : no issue of prospects
, underwriting required while raising
fund from bank
Flexibility : loan can repayable in
advance , amount can be increased
without much formalities .
Limitations
Funds are generally available for short
period and renewal is uncertain and
difficult .
Procedure to obtain loan is complex as
company has to provide details
regarding financial structure , security of
assets and personal assets .
Difficult terms and conditions on
mortgaged goods and assets
Loans from financial institute : the government has established a number of financial institutions at central or at state level
to provide finance to business organisations . They supplement the commercial banks for providing both owned capital and
borrowed capital fro short , medium and long term fund requirement .

Few important points Merits Limitations :

1.These institutes provide support in
market surveys , technical and
managerial assistance .
2.These institutions are also called as
developing banks as they contribute
towards industrial development of the
country .
3. These institute will assisting the
business in the expansion ,
development of the business by
providing long term fund .
Medium and long term funds : funds are
provided for long and medium term
requirements .
Assistance in business : these institute
provide financial , managerial and
consultancy service to business firms
Source of goodwill:
easy repayment scheme : these loans
can be repayable easily in instalments
source of goodwill : receiving loans
from financial institute helps to build
reputation of the company in the capital
market .
Finance even during depression : funds
can be raised from financial institution
even during periods of depression or
recession .
Difficult procedure : A number of
formalities are required to obtain loan
from financial institute . It makes the
procedure time consuming and
expensive .
Restrictive clauses : financial institute
may also impose certain restrictions on
the borrowing company.
interference in the management :
financial institutions may intervene in
the management of the company by
nominating its representative in board
of directors of the borrowing company .
Industrial finance corporation of India
IFCI
State financial corporation
SFC
Industrial credit and investment
corporation of India
ICICI
Industrial development bank of India
IDBI
Other financial institutes
Established in July 1948 as a statutory corporation under financial corporation
act with the primary objective of providing long term and medium term finance
to large industrial enterprises . Its objective includes – regional development ,
encouraging new entrepreneurs to enter in to priority sectors .
To provide financial assistance to proprietary and partnership firms as well as
companies most of the states in India established SFC under state financial
corporation act . These institutes offer long tern finance through subscription of
debentures , offer guarantee to loans raised from other institute , take up under
writing for public issue of shares and debentures made by companies
It was established under the companies act as public limited company for
providing long term loans to the companies up to the period of 15 years and
subscribe their shares and debentures for the ultimate purpose of creation ,
expansion and modernization of industrial enterprises exclusively in private
sector
It was set up in 1964 as subsidiary to reserve bank of India with an objective to
co ordinate the activities of other financial institute including commercial banks
and providing financial assistance to all types of Industries without any
restrictions and amount of fund . It discounts and rediscounts commercial bill of
exchange and undertake under writing of the public issue .
State industrial development corporation ,
Unit trust of India
Industrial investment bank of India
 Loan from financial institutions
1. These institutes are established by
state government and central
government .
2. These institutions are also known as
development banks as they aim at
promoting industrial development of the
company .
3. These Industries conduct market
surveys and provide technical assistance
and managerial service to people who
run the enterprise .
4. These funds are suitable for to raise
large funds for long term requirement for
expansion , re organisation and
modernization of an enterprise .
Merits of loans from financial institute
Medium and long term finance : these
institute provide medium and long term
finance
Assistance to business : financial institute
also provide financial , managerial and
technical advice and consultancy to
business firm .
Source of goodwill : obtaining loan from
financial institution increase the goodwill
of the borrowing company and it can
raise funds easily from other source as
well
Easy repayment scheme : loan from
financial institution does not lead to high
burden on the business as loan can be
easily repaid in instalment
Limitations of loans fro financial institute
Difficult procedure : A number of
formalities are required to obtain loan
from financial institutions . It makes the
procedure time consuming and expensive
.
Restrictive clause : financial institutions
may also impose certain restriction on
payment of dividend
Interference in management : financial
institute may intervene in the
management of company by nominating
its representative in the board of
directors of the borrowing company .
 Trade credit : trade credit refers to the credit extended by one trader to
another trader for the purchase of goods and service . It facilitates the
purchase goods and service . It facilitates the purchase of supplies without
immediate payment .

Features : Merits : Limitations:

1.Trade credit is extended by the
supplies of business enterprise
2.Trade credit allows business
enterprise to purchase on credit and
pay within the specified period of time
3. It does not involve any payment of
interest
4. It reduces the need of working
capital
2. It is short term source of finance ,
recorded as current liability
3. Trade credit depends on the firms
credit worthiness ,purchase volume ,
market competition , financial status of
buyer and seller
1.Trade credit is the most on the most
convenient and continuous sources of
funds .
2.It does not involve any formalities to
be met . It is received on the basis of
relationship between buyer and seller .
3. Trade credit facilities higher volume
of purchase and thus increased sales .
4. It enables to maintain high stock
levels to meet the expected increase in
demand due to seasonal business
,festivals etc
5. Trade credit can be obtained without
creating any charge against business
assets .
1. Easy and flexible credit facilities
may prompt business to purchase
goods more than required leading
to high stock volumes , increasing
the financial burden of the firm .
2. The value of funds generated
remains limited .
3. The value of funds generated
remains limited .
4. The seller increases the price of the
goods thus making them expensive
and less competitive to sell .
Commercial paper –CP- commercial paper is an unsecured promissory note issued by a firm having good credit –
worthiness to raise funds for short period varying fro m 7 days to 364 days .
1. Commercial paper is regulated by Merits : Limitations :
the reserve bank of India. 1. A commercial paper is issued on an 1.commercial paper can be issued only
2. It is a source of short term finance . unsecured basis without any restrictive by those firms who are financially
3. Both private and public companies conditions or any charge on the assets . sound and highly rated . New firms can
can raise funds by the issue of 2. Free transferability of commercial not raise funds through commercial
commercial papers paper makes it highly liquid . paper .
4. It is issued for period varying from 3. It can be issued by firms with good 2.The amount of funds raised through
7 days to 364 days credit rating as the debt is totally commercial paper depends on the
5. it can be issued by firms with good unsecured . surplus funds available with supplies
credit rating as the debt is totally 4. Amount raised through commercial with the supplies of funds at the time
unsecured paper is usually large . of need .
6. Amount raised through commercial 5. Commercial paper are usually issued Commercial paper is an impersonal
paper is usually large . to other business firms ,insurance method of financing thus extension of
7. Commercial paper are usually companies ,pension funds and banks . maturity period may not be possible in
issued to other business firms , times of financial difficulties
insurance companies.
Lease financing : it is a contractual agreement where by one party the owner of an asset grants the other party the right
to use the asset in return for a periodic payment . It is renting of an asset for some specified period .
Lessor : the owner of the asset is called “lessor “
Lessee: the party that uses the assets is known as the “lessee”. He pays fixed amount of rental to the lessor for the use of
the asset and at the end of the lease period the asset will be returned back to the owner [lessor ]
Lease finance provides an important Merits : Limitations :
means of modernization to the firm .
It reduces the burden of the company 1. Business can use assets without 1. A lease arrangement may impose
to invest on fixed asset investing on it . certain restrictions on the use of asset
Lease finance is suitable when the cost 2. Lease rentals are business expenses 2.The normal business operations may
of owning the asset is more expensive ,therefore they reduce firms tax be affected in case the lease is not
than leasing liabilities renewed .
3. The risk of obsolescence is borne by 3. The lessee never becomes the owner
the lessor . This gives greater flexibility of the asset . It deprives him the
to the lessee to replace the asset . residual value of the asset
4. It provides finance without diluting 4. It may result in higher pay-out
the ownership or control of business obligations in case the equipment is
not found useful
5. A lessor may impose certain
restrictions on the use of assets where
lessee may not be allowed to modify
and alter the asset
 Factoring : factoring is a financial service under which the factor renders various service .
The various service provided by the factoring agencies are :
1. Discounting the bills
2. Providing information about credit worthiness of prospective client .
Features : Merits : obtaining funds through factor Demerits :1. this source is considered
1. Discounting the bills and collection of is cheaper than financing through other expensive when there are numerous
clients debts : bills receivable on means such as bank credit invoices .
account of sale of goods and services 2. As factor is a third party between
are sold to the factor at certain discount customer and company . The customer
.factor becomes responsible for debt may not feel comfortable in dealing
collection from the buyer . with factor .
2. Providing information about credit Factoring generates cash , facilitating
worthiness of prospective client etc as prompt and timely payment of liabilities
factors hold large amount of
information about the trading histories
of the firm
RBI has taken imitative to introduce Factoring provides security against risk
factoring in Indian financial scene . The of bad debts
organisation provides factoring service
are : SBI factors and commercial service
International financing :

As business organisation are becoming global , business finance can be raised internationally.
Indian companies have an access to funds in global capital market .
These international sources of business finance are as follows :

Commercial banks International agencies and International capital market

development bank

• They are the important sources
of financing non trading
international operations .
• Standard chartered banks is
major source of international
finance .
• The types of loans and services
provided by bank vary from
country to country .
• To provide long and medium
term loans and grants to
promote the development of
economically backward area in
the world, number of
international agencies set up
over the years to provide
financial support.
• The main institute among them
are
• International finance corporation.
• Asian development bank-ADB
• EXIM bank
• Multinational companies depend
upon sizable borrowings in rupees as
well as in foreign currency .
• Prominent financial instruments are:
• Global depository receipts –GDR
• American Depositary Receipts :ADR
• Foreign currency convertible
Bonds[FCCB]
Features of GDR or global depositary receipt :
The local currency shares of a company are delivered to the depositary bank.
The depositary bank issues depositary receipts against these shares .
These depositary deposit are denominated in US dollar are known as global depositary receipts .
GDR is a negotiable instrument and can be traded freely like any other security .
The holders of GDR do not carry any voting rights . He receives dividend and capital appreciation

A GDR is an instrument issued abroad by an Indian company to raise funds in some foreign currency and is
listed and traded in on a foreign stock exchange .
American depositary receipts : ADR’s

The depositary receipts issued by a company in the USA are known as American Depositary Receipts .ADR s are bought and sold
in American markets like regular stocks . It is similar to a GDR except that it can be issued only to American citizen and can be
listed and traded on a stock exchange of USA

Foreign currency convertible bonds {FCCB}:

FCCB are equity linked debt securities that are to be converted in equity or
depositary receipts after a specific period.
The holder of FCCB has the option of either converting them in to equity
shares at a predetermined price or exchange rate or retaining the bond .
FCCB s are listed and traded in foreign stock exchanges .
 These funds are loaned or
Owners fund refers to the money Quick revision borrowed from others in
that is invested in the business by the exchange for the fixed assets
owners of the company that act as a security .
It also includes the profit that are re
invested in the business by the
owner . 1. Sources of loans are
financial institutions –
commercial banks,
Equity share company also issue
Retained earning
capital debentures , trade credit,
public deposit.
2. Borrowed funds are risky
and they burden business
with responsibility to pay
interest and debt even
when income is low