Chapter sources-of-business-finance: Sources of Business Finance | Summary

The various sources of business finance can be classified on three bases: (i) Period basis — long-term (exceeding 5 years), medium-term (1–5 years), and short-term (up to 1 year); (ii) Ownership basis — owner's funds (equity shares, retained earnings) and borrowed funds (loans, debentures, trade credit); (iii) Source of generation basis — internal sources (retained earnings, surplus inventory disposal) and external sources (banks, debentures, public deposits).

Each classification helps a business choose the right source according to its specific needs. Long-term sources are suited for fixed capital investments, while short-term sources are appropriate for working capital requirements. Owner's funds provide stability and control, while borrowed funds come with repayment obligations and interest costs.

Retained earnings refer to the portion of a company's net profit that is not distributed as dividends but is reinvested in the business. Also known as ploughing back of profits or self-financing, it is an internal source of funds that does not involve any explicit cost in the form of interest or floatation charges.

The merits include permanent availability, no dilution of control, no charge on assets, and enhanced capacity to absorb losses. However, excessive retention may dissatisfy shareholders, the source is uncertain as profits fluctuate, and the opportunity cost of retained funds is often ignored, leading to sub-optimal use.

Trade credit is the credit extended by one trader to another for the purchase of goods and services, recorded as sundry creditors or accounts payable in the buyer's books. It is a convenient and continuous short-term source of finance that requires no formal documentation and does not create a charge on assets.

Factoring is a financial service where receivables (bills arising from credit sales) are sold to a factor at a discount. The factor collects debts and bears the risk of bad debts (in non-recourse factoring). It accelerates cash inflows, is flexible, and frees the client from credit control functions, though it can be expensive for small invoices and may affect customer relationships.

Lease financing is a contractual arrangement where the owner of an asset (lessor) grants another party (lessee) the right to use it for a specified period in exchange for periodic lease rentals. It enables asset acquisition with lower capital investment, provides tax benefits on lease rentals, does not dilute ownership, and allows flexibility to replace obsolete assets. Its limitations include restrictions on asset modification and the lessee never gaining ownership.

Public deposits are funds raised directly from the public by companies offering interest rates higher than banks. They are regulated by the RBI and generally raised for up to three years. While they are relatively simple to obtain and do not create charge on assets, they are unreliable as the public may not respond, and new or financially weak companies find it difficult to mobilise public deposits.

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note by highly rated corporate borrowers. Introduced in India in 1990, it allows companies to raise short-term funds directly from investors, bypassing banks. CP can be issued for maturities between 7 days and up to one year, in denominations of Rs. 5 lakh or multiples thereof.

Being freely transferable, it has high liquidity, lower cost than bank loans, and provides a continuous source of funds as maturing CPs can be replaced by new ones. However, only financially sound companies with good credit ratings can issue CP, the amount that can be raised is limited by available liquidity with investors, and it is an impersonal instrument that cannot be easily extended in times of financial difficulty.

A company raises long-term capital by issuing two types of shares — equity shares and preference shares. Equity shares represent ownership capital; equity shareholders are residual owners who receive variable dividends, enjoy voting rights, and bear the risk of ownership. The merits include permanent capital, no mandatory dividend, no charge on assets, and democratic control. The limitations include high cost, dilution of control upon new issue, and investor preference for stable income may reduce demand.

Preference shares offer a preferential right to a fixed rate of dividend before equity dividends are paid and to capital repayment before equity shareholders in the event of winding up. They combine features of both equity and debentures. Preference shareholders generally do not have voting rights, making them attractive to companies that do not wish to dilute control. However, dividend is not tax-deductible, and preference capital dilutes equity shareholders' claims on assets.

Debentures are instruments used to raise long-term debt capital from the public. They carry a fixed rate of interest payable regardless of profits and represent a creditor relationship between the holder and the company. Public issues of debentures must be rated by agencies like CRISIL. Types of debentures include secured/unsecured, registered/bearer, convertible/non-convertible, and first/second debentures.

The merits of debentures include tax-deductible interest, no dilution of management control, and suitability for companies with stable earnings. Limitations include fixed financial burden, obligation to repay on the specified date, and reduction in the company's future borrowing capacity. Zero Interest Debentures (ZIDs), which earn return through the difference between issue price and face value, have also become popular.

Commercial banks provide short-to-medium-term finance through cash credits, overdrafts, term loans, bill discounting, and letters of credit. They are accessible, maintain confidentiality, and require no prospectus or underwriting. However, loans are generally short-term, renewal is uncertain, documentation is detailed, and banks may impose restrictive conditions like restrictions on sale of mortgaged goods.

Financial institutions (also called development banks) are set up by central and state governments to provide long-term industrial finance for expansion, modernisation, and reorganisation. They supplement commercial banks, provide managerial and technical advice, and their loans help build the borrower's market credibility. Limitations include rigid procedures, restrictions on dividends, and their nominees may be appointed on the board of the borrowing company.

With globalisation, Indian companies can access funds from international sources. These include commercial banks abroad providing foreign currency loans, international agencies and development banks like IFC, EXIM Bank, and Asian Development Bank, and international capital markets through instruments such as GDRs, ADRs, IDRs, and FCCBs.

Global Depository Receipts (GDRs) are instruments issued by Indian companies abroad, denominated in US dollars and traded on foreign exchanges. American Depository Receipts (ADRs) are similar but issued only to US citizens and traded in the USA. Indian Depository Receipts (IDRs) allow foreign companies to raise funds from Indian markets. Foreign Currency Convertible Bonds (FCCBs) are equity-linked debt securities that can be converted into equity at a predetermined price after a specified period.

No single source of finance is suitable for all situations. Businesses must consider multiple factors when choosing a source: cost (both procurement and utilisation), financial strength and stability, form of organisation (e.g., a partnership cannot issue shares), purpose and time period of fund requirement, and risk profile of each source.

Other important factors include the impact on ownership control (equity dilutes control), effect on credit worthiness (secured debentures may affect unsecured creditors), flexibility and ease of access, and tax benefits (interest on debentures is tax-deductible whereas dividend on preference shares is not). A judicious combination of various sources is generally advisable to reduce risk and optimise cost.

Chapter 8 provides a comprehensive understanding of the various sources from which a business can raise funds to meet its short-term, medium-term, and long-term financial requirements. It covers internal and external sources, owner's funds and borrowed funds, and both domestic and international avenues. Each source has its distinct merits and limitations, making it essential for a business to evaluate all options carefully before making a financing decision. The choice of source must align with the purpose, cost, risk, control implications, and time horizon of the financial need.

From an examination perspective, this chapter is highly important for CBSE Class 11 students as questions on the merits and limitations of each source, the types of shares and debentures, differences between GDR and ADR, factors affecting choice of finance, and application-based scenarios are frequently asked. A clear grasp of the characteristics, advantages, and disadvantages of each source of finance, along with the ability to apply concepts to real business situations, is essential for scoring well in board examinations.