Business Studies: Class 11 — Chapter 8: Sources of Business Finance

Introduction & Conceptual Framework

Every business enterprise requires funds to establish its operations, run day-to-day activities, and undertake expansion or modernization. Finance is widely regarded as the life blood of business.

Business Case Title: Expansion of Anil Singh's Restaurant Business
Corporate Context/Problem: Mr. Anil Singh has been running a highly successful restaurant for two years. Motivated by this success, he contemplates opening a chain of similar restaurants. However, his personal savings are insufficient to meet the expansion requirements. He is confused about whether to enter a partnership (which requires sharing profits and control) or take a bank loan, and is unaware of other corporate financing methods.
Strategic Action Taken: He consults his friend Ramesh, who introduces him to corporate methods like issuing shares and debentures, advising him that the final choice must be based on the purpose, cost, and period for which funds are required.
Managerial Inference: No single source of finance is perfect; a business must carefully evaluate the cost, risk, control, and duration of each source to select the most appropriate financing mix.

Classification of Capital Requirements

Financial needs of a business can be broadly categorized into two types:

Fixed Capital Requirements: Funds needed to purchase fixed assets like land, buildings, plant, machinery, and furniture. These funds remain invested in the business for a long period.
Working Capital Requirements: Funds needed for day-to-day operations, such as purchasing raw materials, paying salaries, wages, taxes, and rent.

The basic relationship for working capital is represented as:

$$\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}$$

Classification of Sources of Funds

Sources of business finance can be classified on three distinct bases: Period, Ownership, and Source of Generation.

Basis of Classification	Categories	Key Sources
Period Basis	Long-term Medium-term Short-term	Equity shares, Debentures, Term loans, Financial institutions Public deposits, Lease financing, Bank loans Trade credit, Factoring, Commercial paper
Ownership Basis	Owner's Funds Borrowed Funds	Equity shares, Retained earnings Debentures, Bank loans, Public deposits, Trade credit
Source of Generation	Internal Sources External Sources	Retained earnings, Disposal of surplus inventory Issue of shares, Debentures, Financial institutions, Commercial banks

Comparison: Owner's Funds vs. Borrowed Funds

Basis	Owner's Funds	Borrowed Funds
Source	Provided by the owners/shareholders.	Raised through loans, debentures, or public deposits.
Permanence	Permanent capital; not refunded during the life of the business.	Raised for a specified period; must be repaid.
Security	No security or charge on assets is required.	Generally requires mortgaging assets as security.
Control	Dilutes control as shareholders get voting rights.	Does not dilute control; creditors have no voting rights.
Return	Fluctuating return (dividends paid only out of profits).	Fixed rate of interest paid regardless of profits/losses.

Sources of Finance: Merits & Limitations

1. Retained Earnings

Retained Earnings (or ploughing back of profits) refers to the portion of net earnings not distributed as dividends but kept for future reinvestment.

Merits: Permanent source of funds; No explicit cost (interest/dividend); Operational freedom and flexibility; Enhances capacity to absorb unexpected losses.
Limitations: Excessive retention may cause dissatisfaction among shareholders; Uncertain source as profits fluctuate; High opportunity cost.

2. Trade Credit

Trade Credit is the credit extended by one trader to another for the purchase of goods and services without immediate payment.

Merits: Convenient and continuous; Readily available to creditworthy customers; Promotes sales; No charge on assets.
Limitations: May induce overtrading; Limited amount of funds can be raised; Generally a costly source of finance.

3. Factoring

Factoring is a financial service where a 'factor' discounts bills, collects receivables, and provides protection against bad debts.

Merits: Cheaper than bank credit; Accelerates cash flow; Flexible; No charge on assets; Outsources credit control.
Limitations: Expensive if invoices are numerous and small; Higher interest cost on advances; Third-party interference may affect customer relations.

4. Lease Financing

Lease Financing is a contractual agreement where the owner of an asset (lessor) grants the right to use the asset to another party (lessee) for periodic payments (lease rentals).

Merits: Lower initial investment; Simple documentation; Tax-deductible lease rentals; No dilution of ownership; Risk of obsolescence borne by lessor.
Limitations: Imposes restrictions on asset modification; Operations affected if lease is not renewed; High payout if terminated prematurely; Lessee never becomes the owner.

5. Public Deposits

Public Deposits are deposits raised directly from the public by organizations, offering higher interest rates than bank deposits.

Merits: Simple procedure; Lower cost than bank loans; No charge on assets; No dilution of control.
Limitations: Difficult for new companies to raise; Unreliable source; Collection is difficult for very large sums.

6. Commercial Paper (CP)

Commercial Paper is an unsecured, short-term money market instrument issued in the form of a promissory note with a maturity of 7 days to 1 year.

Merits: Unsecured (no restrictive conditions); Highly liquid and freely transferable; Lower cost than bank loans; Continuous source of funds.
Limitations: Only highly rated, financially sound firms can issue; Size of funds is limited to excess market liquidity; Cannot be easily extended or rescheduled.

7. Issue of Shares

The capital of a company is divided into small units called Shares. The two main types are:

Equity Shares: Represent ownership capital. They carry voting rights and receive fluctuating dividends based on profits.
Preference Shares: Enjoy preferential rights to receive a fixed dividend before equity shares and repayment of capital during liquidation.

Feature	Equity Shares	Preference Shares
Dividend Rate	Fluctuating (based on profits)	Fixed
Voting Rights	Full voting rights	No voting rights (generally)
Risk	High risk (residual owners)	Low risk

8. Debentures

Debentures are long-term debt instruments representing loan capital, carrying a fixed rate of interest.

Merits: Preferred by risk-averse investors; Fixed charge (does not dilute profits); No dilution of control; Interest is tax-deductible.
Limitations: Permanent financial burden; Repayment obligation even during financial distress; Reduces future borrowing capacity.

International Financing

With globalization, Indian companies can access global capital markets through various international instruments:

Global Depository Receipts (GDRs): Local currency shares of a company delivered to a depository bank, which issues dollar-denominated receipts traded on foreign stock exchanges.
American Depository Receipts (ADRs): Depository receipts issued by a company in the USA, traded on American stock exchanges, and available only to US citizens.
Indian Depository Receipts (IDRs): Denominated in Indian Rupees, enabling foreign companies to raise funds from the Indian securities market.
Foreign Currency Convertible Bonds (FCCBs): Debt securities issued in foreign currency, carrying a fixed interest rate, with an option to convert into equity shares after a specified period.

Factors Affecting the Choice of Source of Funds

A business must evaluate several factors before choosing an appropriate source of finance:

Cost: Includes the cost of procurement and the cost of utilizing the funds.
Financial Strength and Stability: Sound financial position is required to support fixed-charge instruments like debentures.
Form of Organisation and Legal Status: Partnership firms cannot issue equity shares; only joint-stock companies can.
Purpose and Time Period: Short-term needs should be met by short-term sources (e.g., trade credit), while expansion requires long-term sources.
Risk Profile: Equity has the least risk of repayment, whereas loans carry high default risk.
Control: Issue of equity shares dilutes control, whereas debt does not.
Effect on Credit Worthiness: Securing loans on assets may reduce the willingness of unsecured creditors to extend credit.
Flexibility and Ease: Restrictive provisions in bank loans may reduce operational flexibility.
Tax Benefits: Interest on debentures and loans is tax-deductible, whereas dividends on shares are not.