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Business Studies Notes

Tanvi Khutliwala

Sources Of Business Finance


Business is concerned with the production and distribution of goods and services

for the satisfaction of the needs of the society. Business Finance is defined as the requirements of funds by the business to carry out its various activities.
Nature/Significance of Business Finance

o o o o

Business can procure fixed assets and meet its day-to-day expenses. The firm can meet its liabilities on time. The firm can face competition more strongly. The firm can adopt latest technology and new innovative methods of production. o The firm can face recession and depression period of trade cycle. 1- Fixed Capital Requirement: Funds required to purchase fixed assets like land and building, land and machinery, and furniture and fixtures is called fixed capital requirements of business. These remain invested in business for a long time. 2- Working Capital Requirement: Funds required to carry on day-to-day activities and to meet current expenses like salaries, wages, taxes and rent is known as working capital requirements of the firm. It is used to purchase current assets, which get converted into cash in one year. Example- stock of material, bills receivables etc.

Financial Needs Of Business are categorized as follows:

Classification of Sources of Funds

1- On the basis of Period y The long-term sources fulfill the financial requirements of an enterprise for a period exceeding 5 years and include sources such as shares and debentures, long- term borrowings and loans from financial institutions. Such finance is required for the purchase of fixed assets such as equipment, plant etc. y The medium term sources of finance are required for a period of more than one year but less than 5 years. These sources include borrowings from commercial banks, public deposits, lease financing and loans from financial institutions y The short-term funds are those, which are required for a period not exceeding one year. These funds include trade credit, loans from commercial banks and commercial papers.

2-On the basis of Ownership y Owner s funds are the funds provided by the owners of an enterprise, which may be a sole trader or partners or shareholders of a company. Issue of equity shares and retained earnings are the two important sources from where owner s fund can be obtained. y Borrowed funds refer to the funds raised through loans or borrowings. The sources for these funds include loans from commercial banks, loans from financial institutions, issue of debentures, public deposits and trade credit. 3- On the basis of Sources of Generation y Internal sources are those that are generated from within the business. They can fulfill only limited needs of the business. Example- ploughing back of profits and collection of receivables. y External sources of funds include those sources that lie outside an organization, such as suppliers, lenders and investors.
Sources Of Finance

1-Retained Earnings A part of the net earnings that is retained in the business for use in the future is known as retained earnings. It is a source of internal financing or self financing or ploughing back of profits. Merits y It is a permanent source of fund available to an organization. y It does not involve any explicit cost in the form of interest, dividend or floatation cost. y These funds provide greater degree of operational freedom and flexibility. y It enhances the capacity of the business to absorb unexpected losses. y It may lead to increase in the market price of the equity shares of a company. Demerits y Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividend y It is an uncertain source of fund as the profits are fluctuating.

y The opportunity cost associated with it when not recognized may lead to sub-optimal use of the funds. 2-Trade Credit It is the credit extended by one trader to another for the purchase of goods and services. It is a short-term source of finance. It facilitates he purchase of supplies without immediate payment. Factors affecting the provision of trade credit
b. Reputation of the purchasing firm c. Financial position of the seller d. Volume of purchases e. Past record of payment f. Degree of competition in the market. Merits g. It is a convenient and continuous source of finance. h. It may be readily available if the seller knows the credit worthiness of the customer. i. It promotes the sales of an organization j. It does not create any charge on the assets of the firm. k. It increases the inventory level of the firm in order to meet expected rise in the sales volume. Demerits l. It may induce a firm to indulge in overtrading which may add to the risks of the firm. m. Only limited amount of funds can be generated through trade credit. n. It is generally a costly source of fund, compared to other sources of raising funds. 3-Factoring

It is a financial service under which the factor renders the following services: a) iscounting the bills and collection of the client s debts. The factor becomes responsible for all credit control and debt collection from the buyer and provides protection against any bad losses to the firm. b) Providing information about the credit worthiness of prospective clients. Factors may also offer relevant consultancy services in the areas of finance, marketing etc.
Methods of factoring a- Under recourse factoring, the client is not protected against the risks of bad debts. b- The factor assumes the entire credit risk under non-recourse factoring i.e., full amount of the bill is paid to the client in the event of bad debt. Merits y Obtaining funds through factoring is cheaper than financing through other means such as bank credit.

y y y y

With the acceleration of cash flow, the client is able to meet his/her liabilities promptly as and when these arise. It is a flexible source of fund and ensures a definite pattern of cash inflows from credit sales. It does not create any charge on the assets of the firm. The client can concentrate on other business functions as the responsibility of credit control is shouldered by the factor.

Demerits y This source is expensive when the invoice are numerous and smaller in amount. y y The advance provided by the firm is generally available at a higher interest rate than the usual rate of interest. The factor is a third party to the customer who may feel uncomfortable when dealing with it.

4-Lease Financing A lease is a contractual agreement whereby one party i.e., the owner of the asset grants the other party the right to use the asset in return for a periodic payment called lease rental. The owner of the asset is called the lesser while the party that uses the asst is known as the lessee. Merits y y y y y y It enables the lessee to acquire the asset with a lower investment. Simple documentation makes it easier to finance the assets. Lease rentals are deductible for computing taxable profits. It provides finance without diluting the ownership or control of the business. The lease agreement does not affect the debt raising capacity of an enterprise. The risk of obsolescence is borne by the lesser. This allows greater flexibility to the lessee to replace the asset.

Demerits y A lease agreement may impose certain restrictions on the use of assets. y y y The normal business operations may be affected in case the lease is not renewed. It may result in higher payout obligation in case the equipment is not found useful and the lessee opts for premature termination f the lease agreement. The lessee never becomes the owner of the asset. It deprives him of the residual value of the asset.

5-Public Deposits The deposits hat are raised by the organization directly from the public are known as public deposits. These can take care of both medium term and short-term financial requirements of a business. The deposits are beneficial to both the depositors as well as the organization. While the depositors get higher rate of interest than that offered by the banks, the cost of deposits to the company is less than the cost of borrowings from the banks.

Merits y y y y The procedure of obtaining deposits is simple and does not contain any restrictive conditions Cost of public deposits is generally lower than the cost of borrowings from banks and financial institutions. They do not create any charge on the assets of the company. As the depositors do not have any voting rights, the control of the company is

not diluted. Demerits y y y New companies generally find it difficult to raise funds through public deposits. It is an unreliable source of finance, as the public may not respond when the company needs money. Collection of public deposits may prove difficult, particularly when the size of

deposits required is large. 6-Commercial Paper (CP) It is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. Its regulation comes under the Reserve Bank Of India. Merits y It is sold on an unsecured basis and does not contain any restrictive conditions. y y y y It is a freely transferrable instrument and has high liquidity. The cost of CP to the issuing firm is lower than the cost of commercial bank loans. It provides a continuous source of fund as its maturity can be changed according to the requirements of the company. Companies can park their excess funds in commercial paper thereby earning

some good return on the same. Demerits y y y Only financially sound and highly rated firms can raise money through commercial papers. The size of money that can be raise through CP is limited to the excess liquidity available with the suppliers of funds at a particular time. If a firm is not in a position to redeem its paper due to financial difficulties, extending the maturity of a CP is not possible.

7-Issue of Shares The capital obtained by issue of shares is known as share capital. The capital of a company is divided into small units called shares. Types of shares a) Equity Shares The equity shares are those shares, which do not carry any special or preferential rights in the payment of annual dividend or repayment of capital. These shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owners fund or equity share capital. Equity shareholders do not get a fixed dividend but

are paid on the basis of earnings by the company. They are referred to as residual owners, since they are paid only after every claim has been settled. Features  Primary risk bearers- The equity shareholders are the primary risk bearers of the company. In case the company suffers losses then equity shareholders have to bear the loss.  Claim over residual income- The equity shareholders get share in the income left after satisfying the claims of all creditors, outsiders and preference shareholders and are thus referred to as residual owners.  Basis for loans- Equity share capital adds to the creditability of the company and thus is the basis on which loans can be raised.  Control- The equity shareholders have voting rights and can cast a vote to select the Board of directors.  Higher profit- At the time of profit, the debenture holders and preference shareholders get fixed income but equity shareholders enjoy a higher profit. Merits y y y y y y Equity shares are suitable for investors who are willing to assume risk for higher returns. There is no burden on the company as the payment of dividend to equity shareholders is not compulsory. Equity capital serves as permanent capital as it is to be repaid only at the time of winding up of a company. Equity capital provides credit worthiness to the company and confidence to the prospective loan providers. Funds can be raised through equity issue without creating any charge on the assets of the company. Voting rights of the equity shareholders ensures democratic control over the management of the company.

Demerits y Equity shares get fluctuating returns. y y y The cost of equity shares is more as compared to the cost of raising funds through other sources. Issue of additional equity shares dilutes the voting powers and earnings of existing equity shareholders. More formalities and procedural delays are involved while raising funds through issue of equity shares.

b) Preference Shares Preference shares are those shares which get preference over equity shares in respect to: - The payment of dividend - The repayment of investment amount during winding up.

The preference shareholders enjoys a preferential position over equity shareholders in two ways: - Receiving a fixed rate of dividend before the equity shareholders. Receiving their capital after the claims of the companys creditors have been settled.

Features y Fixed rate of dividend- Preference shareholders get a fixed rate of y y y dividend before paying dividend to equity shareholders. No security- Companies do not offer any security against preference shares. The preference share capital is a part of owners fund capital. Voting rights- The preference shareholders do not get voting rights under general conditions. Hybrid security- Preference shares are called hybrid securities, as these

have the features of equity shares as well as features of debentures. Types of preference shares i. Cumulative preference shares ii. Non-cumulative preference shares iii. Participating preference shares iv. Non-participating preference shares v. Redeemable preference shares vi. Irredeemable preference shares vii. Convertible preference shares viii. Non-convertible preference shares Merits y y y y y y Preference shares provide steady income in the form of fixed rate of return and safety of investment. Investors get fixed rate of return with comparatively low risk. It does not effect the control of equity shareholders over management, as preference shareholders do not have voting rights. Payment of fixed rate of dividend to preference shares may enable a company to declare higher rates of dividend to equity shareholders. Preference shareholders have a preferential right of repayment over equity shareholders at the time of winding up of the company. Preference capital does not create any charge on the assets of the company.

Demerits y These shares are not suitable for the investors who are not willing to take risk y y and are interested in higher returns. It dilutes the claims of the equity shareholders over the assets of the company. The rate of dividend on preference shares is generally higher than on debentures.

y y

There are no assured returns for the investors as dividend on these shares is to be paid only when the company earns profit. There is no tax saving as the dividend paid is not deductible from profits as expense.

8-Debentures Debentures are an important instrument for raising long-term debt capital. The debenture issued by a company is an acknowledgement that the company has borrowed a certain amount of money, which it promises to pay at a future date. Debenture holders are also known as creditors of the company. Features  The interest on debenture is paid at a fixed rate.  These are always paid back on expiry of a fixed period of time.  Debenture holders are paid a fixed amount of interest at specified intervals. Merits y y y y y Investors get fixed income at lesser risk. Debentures are fixed charge funds and do not participate in the profits of the company. The issue of debentures is suitable when the sales and earnings are stable. Debentures do not carry voting rights and thus, does not dilute the control of equity shareholders on the management. Financing through debentures is cheaper as compared to preference or equity capital.

Demerits y There is a greater risk when the earnings of the company fluctuate. y y y The company has to make provisions for repayment on the specified date, even during crucial times. The capacity of the company to borrow further funds reduces. The debenture holders are not allowed to vote in the management of the company. 9-Commercial Banks These banks provides funds for different purposes and different periods. Firms of all sizes can approach these banks. Merits y It provides funds to the firm as and when required. y y y Secrecy of the business can be maintained, as the information provided to the bank by the borrower is kept confidential. Formalities such as issue of prospectus and underwriting are not required to raise loans from these banks. It is a very flexible source as loan amount can be increased as well as decreased.

Demerits

y y y

Funds are generally available for a short period. Banks make detailed investigation of the companys affairs and financial structure before issue of loans. In some cases, the banks impose difficult terms and conditions.

10-Financial Institutions Public financial institutions are referred to as lending institutions, development banks or financial institutions. These institutions aim at promoting the industrial development of a country. Central as well as state governments establish these institutions. They provide both owned and loan capital for long and medium term requirements and supplement the traditional financial agencies like commercial banks. They also conduct market surveys and provide technical assistance and managerial services. Merits y y y y y They provide long-term finance. They provide financial as well as managerial advice on various matters. It increases the goodwill of the borrowing firm in the capital market. Repayment of loan can be made in installments and so avoids burden on the business. The funds are made available even during periods of depression.

Demerits y Many formalities have to be fulfilled for taking loans from financial institutions. y y They may put certain restrictions such as on payment of dividend. They may have their nominees in the Board of Directors of the borrowing firm.

11-International Sources Of Finance Commercial Banks These banks all over the world extend foreign currency loans for business purposes. They are an important source of financing nontrade international operations. The types of loans and services provided b banks vary from country to country. The rate of interest of loans is generally fixed by the Reserve Bank Of India. International Agencies and Development Banks A number of international agencies and development banks have been setup by the governments of developed countries of the world at national, regional and international levels for funding various projects and to finance international trade and business. These bodies provide long and medium term loans and promotes the development of economically backward areas. Example- EXIM Bank, Asian Development Bank. International Capital Market Global Depository Receipts The local currency shares of a company are

delivered to the depository bank. The depository bank issues depository receipt against these shares. Such depository receipts denominated in US Dollars are known as Global Depository Receipts. GDR is a negotiable instrument and can be

traded freely like other securities. A holder of GDR can at any time convert it into the number of shares it represents. The holders of GDRs do not carry any voting rights but only dividends and capital appreciation. Many Indian companies such as Infosys, Reliance, Wipro has raised funds through issue of GDRs. - American Depository Receipts The depository receipts issued by a company in the USA are known as American Depository Receipts. ADRs are bought and sold in the American markets like regular stocks. It can be issued only to American citizens and can be listed and traded on a stock exchange of USA. Foreign Currency Convertible Bonds These are equity linked debt securities that are to be converted into equity or depository receipts after a specified period. Thus, the holder of the FCCB has the option of either converting them into equity shares at a predetermined price or retaining the bonds. These are issued in a foreign currency only and carry a fixed interest rate, which is lower than rate of any other similar non-convertible debt instrument.

Factors Affecting the Choice of the Source of Funds


 Cost- The cost of procurement of funds and cost of utilizing the funds should be taken into account while deciding the source of fund to be used by the organization.  Financial Strength And Stability Of The Operations- If the firm is financially sound then it may prefer borrowed funds. But if the firm is not financially stable then it must depend upon the owners fund securities. Form of Organization and Legal Status- The for of the business organization and status influences the choice of a source for raising money. Purpose and Time Period- Business should plan according to the time period for which the funds are required. Similarly, the purpose for which the funds are required needs to be considered so that the source is matched with the use.      Risk Profile- Business should evaluate each of the source of finance in terms of the risk involved. Control- A particular source of fund may affect the control and powers of the owners on the management of the firm. Effect on Credit Worthiness- the dependence of business on certain sources may affect its credit worthiness in the market. Flexibility and Ease- Another aspect affecting the choice of a source of finance is the flexibility and the ease of obtaining funds. Tax Benefits Various sources may also be weighed in terms of the tax benefits.