D.M.

ACADEMY CLASSES
ACCOUNTANCY & BUSINESS STUDIES By –Legacy Gupta

Sources of Business Finance

The term finance means money or fund. The requirements of funds by business to carry out its various activities
is called business finance. Finance is needed at every stage in the life of a business. A business cannot function unless
adequate funds are made available to it.

# Nature of Business Finance

#NEED OF BUSINESS FINANCE

1. Fixed Capital Requirement: In order to start a business, funds are needed to purchase fixed assets like land and building, plant and
machinery. The funds required in fixed assets remain invested in the business for a long period of time.

2. Working Capital Requirement: A business needs funds for its day to day operation. This is known as working Capital requirements.
Working capital is required for purchase of raw materials, to pay salaries, wages, rent and taxes.

3. Diversification: A company needs more funds to diversify its operation to become a multi-product company e.g. ITC.

4. Technology upgradation: Finance is needed to adopt modern technology for example uses of computers in business
5. Growth and expansion: Higher growth of a business enterprise requires higher investment in fixed assets. So finance is needed for

growth and expansion.

#Classification of sources
of funds:

1. Long Term Finance (Fixed capital) – It refers to the funds

raised for a long period, (minimum 5 /-10Years) and it is
used for investment in fixed assets which required for
permanent needs of the business. Usually, long term
finance is raised from shareholders, debenture holders,
financial institutions, retained earnings etc

. 2. Medium term finance – It is used for the modernization

and expansion of business, usually it is raised for a period of 1 to 5 /10years. It is also raised from the debenture
holders, financial institutions, commercial banks, public deposits etc.

3.Short term finance – It is raised for a period of less than a year and is used for meeting the short term needs of the
business such as investment in working capital. E.g. purchase of materials, payment of wages and salaries, rent ETC.

 Owners’ funds or Ownership capital

It is the amount of capital contributed by the owner, partners or the share holders as the case may be. Issue of shares and
retained earnings are the two important sources of company finance.

Features :

a. Risk capital – all the risk with regard to the enterprise lies on the shoulders of the owners and hence their capital bears
all the risks.
 b. It is a permanent source of
capital to the business.

c. No security is required. d. It
provides the right to manage and
control the business.

Two types of shares are issued by companies to raise its capital such as Equity shares and Preference
Shares

Equity shares
Merits
1. Suitable for risk takers.
2. No obligation for dividend.
3. Permanent capital.
4. Provides creditworthiness to the company.
5. No charge against assets.
6. They have voting rights – Companies follow
democratic management.
Limitations
1. Income is not steady – Fluctuation in dividend
based on profit.
2. High cost – Cost of raising equity capital is
very high.
3. Dilution in control for existing share holders
when the company makes fresh issues.
4. Complex legal formalities – for the issue of shares.

Privileges of a Preference Shareholder

i. Right to get the dividend first at a fixed rate, before it is given to the equity shareholders.
2. Right to get the repayment of capital on winding up, before it is paid to the
equity shareholders.

Preference Shares
Limitations
Merits
 Retained Earnings or Ploughing
Back of Profits
  Borrowed Funds
It refers to the funds raised through loans or borrowings. It may be from the debenture holders, or from public
deposits, financial institutions, commercial banks etc.
Features
a. Raised for a fixed period.
b. Fixed interest rate to be paid even if there is loss.
c. Charge on assets.
d. No sharing of control in management.

Choice of Source of Finance – A business can raise funds from various sources by way of issue of shares,
retained earnings, issue of debentures, loans from financial institutions and commercial banks, public deposits
etc. Each of them are having its own merits and demerits, the entrepreneurs have to take decisions regarding
their choice based on their situation and purpose.

 Trade Credit

 Merits
1. Convenient source of financing.
2. Readily available.
3. Increased sales.
4. Helps in maintaining higher inventory level.
5. No charge on the assets.
 Limitations
1. Chances of overtrading – bulk trading than
required.
2. Limited funds can only be generated.
3. Higher cost – by charging high price.

Commercial Banks
Merits
1. Timely assistance – Banks provide timely help by providing funds as and when needed.
2. Secrecy – Information furnished to the bank by the borrower is kept confidential.
3. Less formalities – Formalities like issue of prospectus etc. not required.
4. Flexible – The loan amount can be increased or decreased or even repaid whenever required.
Limitations
1. Meeting short term needs only – Most of the bank loans are short period in nature. It’s extension or renewal is uncertain.
2. Detailed investigation – Banks may conduct detailed investigation about company’s affairs, financial structure and also ask
for securities. All these make the procedure difficult.
3. Too many restrictions – Banks may impose difficult terms for granting loans, which may affect the smooth functioning of
the business. Eg: Restriction on the sale of mortgaged asset.

 Loans from Financial Institutions

They are not only

providing financial
assistance, but conducting market surveys, providing technical and managerial services etc
Merits
1. Long term finance – They provide long term finance, which is not provided by commercial banks.
2. Additional services – They are also conducting market surveys, providing managerial and technical services etc.
3. Increases goodwill of the company – Obtaining funds from these financial institutions often increased the reputation of
the firm.
4. Easy repayments – It reduces burden for the business.
5. Reliable source – Funds are available even during depression, when other sources are not available.

Limitations
 Merits
1. Fixed income at lesser risk –
Suitable to conservative investors
who are not willing to take much
risk.
2. No participation in profit – Debentures are fixed interest bearing securities.
3. No dilution in control – Debenture holders have no voting rights.
4. Suitable during stable earnings – If the sales and profits are stable, it is better to raise funds through issue
of debentures.
5. Less costly – Debenture financing is relatively cheaper than other sources
Limitations
1. Permanent burden - Interest is to be paid even if there is no profit
2. . 2. Repayment difficulty – Company has to accumulate enough funds for the repayment of debentures on
redemption even if on financial difficulties.
3. 3. Reduces borrowing capacity – As debenture itself is a debt for the company, they cannot raise
additional funds by borrowings.

Types of Debentures
1. Secured or Mortgage Debentures – Issued with a charge on assets of the company.
2. Simple or Naked or Unsecured Debentures – Issued without any charge (security) on assets.
3. Registered Debentures – Names of debenture holders are entered in the ‘Register of Debenture holders’.
4. Bearer Debentures – Issued without the name of the owner. They are transferable by mere delivery
. 5. Convertible Debentures (CD) – Issued with an option to convert them into equity shares after a particular
period.
6. Non – Convertible Debentures (NCD) – It will not be converted into equity shares.
7. First Debentures – They are repayable before other debentures are repaid.
8. Second Debentures – Repayable after the first debentures have been paid back.

Public deposits
 Lease
Financing

Commercial Paper (CP) –

 Merits
1. No restrictive conditions – Since it is unsecured it has no restrictive conditions.
2. High liquidity – Freely transferable.
3. Economical – Cost of raising fund is cheaper than a bank loan.
4. Continuous source – Repayment of a CP can be made by issuing new CPs
. 5. Investment of excess funds – Companies can keep their excess funds in CPs to earn more returns

Limitations
1. Only sound firms can issue.
2. Limited funds can be raised.
3. Impersonal financing – Extension of maturity period is not possible in case of difficulties.

 Factoring

Services rendered by Factors:

INTERNATIONAL SOURCE OF BUSINESS FINANCE:

INTERNATIONAL CAPITAL MERKET:

feature of GDR:
1. GDR can be listed and traded on a stock exchange of any foreign
country other than America.
2. It is negotiable instrument.
3. A holder of GDR can convert it into the shares.
4. Holder of GDR gets dividends.
5. Holder of GDR does not have voting rights.
6. Many Indian companies such as Reliance, Wipro and ICICI have issue
GDR.

Feature of ADR:
1. It can be issued only to American Citizens.
2. It can be listed and traded is American stock exchange.
3. Indian companies such as Infosys, Reliance issued ADR
 Features of IDRs
1. IDRs are issued by any foreign company
2. The IDRs can be listed on any Indian stock
exchange.
3. A single IDR can represent more than one share,
such as one IDR = 10shares.
4. The holders of IDR have no right to vote in the
company.
5. The IDRS are in rupee denomination.

Advantages of IDR
1. It provides an additional investment opportunity to Indian Investors for overseas investment.
2. It satisfies the capital need of foreign companies.
3. It provides listing facility to foreign companies to list on Indian Equity Market.
4. It reduces the risk of Indian Investors who want to take their money abroad.

Inter-Corporate Deposits (ICD)

Inter-Corporate Deposits are unsecured short term deposits made by one company with another company. These deposits
are essentially brokered deposited, which led the involvement of brokers. The rate of interest on their deposits is higher
than that of banks and other markets. The biggest advantage of ICDS is that the transaction is free from legal hassles.

Type of lCDS
1. Three Months Deposits - These deposits are most popular type of ICDS.These deposits are generally considered by
borrowers to solve problems of short term capital adequacy. The annual rate of interest for these deposits is around 12%.
2. Six months Deposits - It is usually made first class borrowers. The annual rate of interest for these deposits is around
15%
3. Call deposits - This deposit can be withdrawn by the lender on a day’s notice. The annual rate of interest on call
deposits is around 10%
Features of ICDS
1. These transactions takes place between two companies.
2. There are short term deposits.
3. These are unsecured deposits.
4. These transactions are generally completed through brokers.
5. These deposits have no organized market.
6. These deposits have no legal formalities.
7. These are risky deposits from the point of view of lenders.

# Factors affecting the choice of the Source of Funds