CBSE Class 10 Elements of Business Unit II: Sources of Business Finance

Unit II: Sources of Business Finance

(a) Owned and Borrowed funds

Meaning and nature of Business Finance:
Business is concerned with the production of goods and services to satisfy the needs of the society. To fulfil this task business requires money or finance. A business cannot function unless adequate funds are made available to it. So, finance is called the life-blood of any business.

The initial funds required by a business is often invested by the entrepreneur himself. But as business grows more capital infusion becomes necessary and the promoter is not always able to do so. Thus, a business person has to explore other sources from which the requirement of fund can be met. A clear assessment of the financial needs and the identification of various sources of finance is a crucial aspect of running a business establishment. There are three different stages of business for which funds have to be arranged. These are categorised below:

Fixed Capital Requirements:

At the time of starting a business, investment is needed to acquire fixed assets like land and building, plant and machinery and furniture and fixtures. This is categorised as fixed capital requirement of the business. This is a long -term investment and funds used to acquire fixed assets are known as block capital. A company reaps benefit out of this investment over a prolonged period. The requirement of fixed capital varies from business to business. A manufacturing industry may need heavy investment in plant and machinery and factory building. Comparatively, a trading concern may require small capital investment in fixed capital.

Working Capital Requirements:

After investment in fixed assets, a company needs to employ funds in working capital to utilise those assets which actually sets the ball of business rolling. Working capital is needed for day-to-day operations of the business such as for holding stock of raw-material and finished goods, meeting current expenses like salaries, wages, taxes and rent. The amount of working capital need varies from business to business depending on various factors. A business selling goods on credit will require more working capital than a business selling goods for cash.

Capital for Expansion of Business:

The requirements of fixed capital and working capital increases with the growth and expansion of business. At times additional funds are required for upgrading technology employed to economise on cost of production or operations. Similarly, larger funds may be required to meet higher seasonal demands. Additional funds may also be required to meet current debts or for shifting to a new location. It is, therefore important to evaluate the different sources from where the funds can be raised.

Sources of Business funds:

In the case of proprietary or partnership concerns, the funds may be raised either from personal sources or borrowings from banks, friends etc. But the requirement for fixed and working capital increases with the growth and expansion of business which eventually branch out as private or public limited companies requiring large and long-term sources of funds. So, we can categorise fund sourcing on the basis of the following factors:
(a) Period Basis
(b) Ownership Basis
(c) Generation Basis

Period Basis: On the basis of period, different sources of funds may be categorised into three parts:
(i) Long term sources
(ii) Medium term sources
(iii) Short term sources

The Long-Term sources fulfil the financial requirements of an enterprise for a period exceeding five years and such financing is generally required for the acquisition of fixed assets such as plant and machinery etc. The usual fund sources are:
(a) Shares and Debentures
(b) Long term borrowings from financial institutions

Medium Term finance is required for a term spanning one to five years. The sources include
(c) Borrowings from Commercial Banks
(b) Public Deposits
(c) Lease financing
(d) Loans from financial Institutions

Short Term funds are required for a period of less than one year. This is most common for financing current assets such as bills receivable and building inventories in anticipation of sales. These funds are managed through
(e)Trade Credit
(f) Loans from commercial banks
(g) Commercial papers

Ownership Basis:

On the basis of ownership, the sources of funds can be classified into two parts:

(i) Ownership funds
Ownership fund means funds which are provided by the owners of an enterprise who may be a sole trader, partners or shareholders of a company. Apart from ownership capital it includes profits reinvested in business. Ownership funds may be classified into two parts:
(a) Retained earnings
(b) Equity Shares

(ii) Borrowed funds:
Borrowed funds are funds raised through loans and borrowings. Generally borrowed funds are provided on the security of some fixed assets. The sources for raising borrowed funds include:
(c) Loans from commercial banks
(d) Loans from financial Institutions
(e) Public Deposits
(f) Issue of debentures
(g)Trade Credit

Generation Basis:
Another basis of categorising the sources of funds is self-generation of funds within the business. A business can generate funds internally by accelerating collection of receivables, disposing of excess inventories or ploughing back its profits.

The classification of business funds can be shown as follows:

Sources of Business Funds
Period Basis			Ownership Basis
Long term	Medium term	Short term	Owner’s funds	Borrowed fund
1. Equity Shares	1. Loan from Banks	1. Trade credit	1. Equity shares	1. Debentures
2. Retained earnings	2. Public deposit	2. Factoring	2. Retained earnings (ploughing back of profit)	2. Loan from Banks
3. Preference shares	3. Loan from financial institution	3. Loan from Banks		3. Loan from financial institutions
4. Debentures	4. Lease Finance	4. Commercial Papers		4. Lease finance
5. Loan from Banks				5. Public Deposits
6. Loan from financial institutions				6. Commercial Papers

Difference between Owner’s funds and Borrowed funds:

1. Source: Owner’s funds are internally generated while borrowed funds are outsourced from outside. So, owner’s funds are capital invested in the business while borrowed funds are loans.

2. Control: Owner’s fund gives the owners full control of the business while borrowed funds come with conditions which are periodically monitored.

3. Risk: Owner’s funds are not burdened with interest. Borrowed funds carry stipulated rate of interest and if the company defaults, loans are called back.

4. Security: Owner’s fund is an investment and is not backed by asset security. Loans or borrowed funds are usually covered with adequate security.

Owned Funds:

Equity Shares:
Equity shares is the most important source of raising long term capital. Equity shares represent ownership of a company and the capital raised through equity shares is known as owner’s capital.
Equity shares is a prerequisite to the formation of a company. Equity shareholders get dividends out of profits earned by the company. They have a right to participate in the management of the company through voting rights.

Merits:
(i) Equity capital serves the purpose of long -term capital needs of the company and is the bedrock of capital structure.
(ii) Payment of dividend to the equity shareholders is not compulsory. Therefore, there is less burden on the company.
(iii) Equity shares provide credit worthiness of the company.
(iv) Funds can be raised without creating any charge on the assets of the company.
(v) Democratic control of company affairs is ensured through voting rights of shareholders.

Retained Earnings:
A company does not generally distribute all its earnings or profits as shareholder dividends. A part of the net earnings may be retained for company’s own use. This is known as retained earnings. It is a source of internal financing or self- financing and is also known as ploughing back of profit.

Merits:
(i) It is a permanent source of funds which does not involve any explicit cost.
(ii) Internally generated funds offer greater flexibility and operational freedom.
(iii) It enhances the capacity of the business to absorb unexpected losses.
(iv) It may increase the market price of equity shares of a company.

Limitations:
(i) Excessive ploughing back will affect dividend payout causing dissatisfaction among shareholders
(ii) Profits keep fluctuating, so this is an uncertain source of funds.
(iii) Does not give steady income to shareholders
(iv) Issue of additional equity shares dilutes the earnings of existing shareholders.

Preference Shares:

The capital raised through issue of preference shares is called preference share capital. This is so called because preference shareholders have preferential right of repayment over equity shareholders in the event of liquidation of the company. Preference shareholders get fixed rate of dividend with preferential treatment over equity shareholders.

Merits:
(i) Preference Shares give reasonably steady income and is safe as an investment.
(ii) It does not interfere with the controlling rights of equity shareholders.
(iii) Preference shareholders are given priority over equity shareholders when it comes to returning the amount of share capital if the company goes into liquidation.
(iv) Preference shareholders do not create any charge against the assets of the company.

Limitations:
(i) Preference shares are not those investors who want to take risk for higher returns.
(ii) Preference shares dilute the claims of equity shareholders.
(iii) Cost of preference share is higher as dividend declared on such share is higher than debentures.

Borrowed Funds:

Debentures:
Debentures are an important instrument for raising long term capital. A company can raise funds through issue of debentures which bear a fixed rate of interest. The debenture issued by a company is an acknowledgement that the company has borrowed a certain amount of money which it promises to repay at a future date. Debenture holders are therefore termed as creditors of the company. Issue of debenture requires that the issue is rated by a credit rating company like CRISIL that record credit worthiness and perceived risk of lending.

Merits:
(i) It is preferred by investors who want fixed income and lesser risk.
(ii) Debentures are fixed charge funds and do not participate in profits of the company.
(iii) Debentures do not carry voting rights and hence do not interfere in the management.
(iv) Financing through debentures is less costly than preference shares.

Limitations:
(i) As fixed charge instruments, debentures are a permanent burden on a company.
(ii) Redeemable debentures due for repayment can be a headache at the time of financial difficulty.
(iii) Every company has limited borrowing capacity. With the issue of debentures, other options become difficult to choose.

Loan from Commercial Banks:
Commercial Banks occupy a vital position as they provide funds for different purposes as well as for different time frames. Banks offer loans in the form of cash credits, overdrafts, term loans, discounting of bills and issue of letter of credit. Rate of interest varies from bank to bank. The loan can be repaid on a one time basis or in instalments.

Merits:
(i) Banks provide timely finance to businesses to tide over crises.
(ii) Secrecy of the business can be maintained.
(iii) It is an easier source of funds as documentation is minimum.

Limitations:
(i) Funds are generally available for short periods.
(ii) Banks make detailed investigation about the company’ affairs and may ask for security of assets or personal guarantee.
(iii) In some cases difficult terms and conditions may be imposed.

Loan from Financial Institutions:
The government sponsored financial institutions all over the country provide finance to business organisations. They provide both owned capital and loan capital for long- and medium-term requirements and supplement traditional financial agencies like commercial banks. Thus, if the bank provides working capital the state financial corporations can offer long term loans. These institutions also conduct technical feasibility studies market surveys.

Merits:
(i) Financial Institutions provide long-term finance.
(ii) These institutions also provide financial, managerial and technical advice.
(iii) Repayment of the loan can be made in instalments
(iv) Funds are even made available in crisis situation.

Limitations:
(i) Financial institutions have rigid criteria for granting loans.
(ii) Financial Institutions may have their nominees in the board of directors.
(iii) Certain restrictions like dividend payment may sometimes be imposed.

Trade Credit:
Trade credit is the credit extended by one trader to another for purchase of goods and services. Such credit appears in the books as ‘Sundry Creditors’. Trade credit is commonly used by business organisations as a source of short-term financing.

Merits:
(i) Trade credit is a convenient and continuous source of funds.
(ii) If the credit worthiness of the buyer is established, trade credit is readily available.
(iii) Can help stock build-up in anticipation of increased sales.
(iv) It does not create any charge on the assets of a company.

Limitations:
(i) Availability of easy trade credit may provoke companies into overtrading.
(ii) Limited amount of funds can be generated
(iii) This could be costly source of fund as the seller would mark-up the price accordingly

Lease Financing:
A lease is a contractual agreement whereby one party who is the owner of an asset grants the other party the right to use the asset in return for a periodic payment called lease rentals. It is like renting of an asset particularly machineries and is often used for modernisation and diversification. Here, the owner of the asset is known as ‘lessor’ while the user is called the ‘lessee’. The terms and conditions of the lease agreement are given in the lease contract which is executed for a specific time frame. This type of agreement is often prevalent in the acquisition of electronics items where technological changes occur rapidly. But, while opting for such lease financing the cost of leasing must be compared with the cost of owning the same.

Merits:
(i) Assets can be acquired at lower investment
(ii) Simple documentation leads to easier finance.
(iii) Lease rentals are deductible from taxable profits.
(iv) It is a kind of finance that does not dilute control of the business neither does it affect debt raising from other sources.
(v)The risk of obsolescence is borne by the lessor offering greater flexibility to the lessee to replace the asset.

Limitations:
(i) A lease agreement may impose certain restrictions on the use of assets.
(ii) Normal business may be affected if the lease agreement is not renewed.
(iii) Comparative cost of acquirement is higher.
(iv)Lessee never becomes owner. Thus, he is not entitled to any residual value.

Public Deposits:
The deposits that are raised by organisations directly from the public are known as public deposits. Rates offered in such deposits are usually higher than that offered on bank deposits. Persons opting for such deposits are issued a deposit receipt as an acknowledgement of the debt. Companies generally invite public deposits for a period of three years and they can take care of the short-term and medium- term financial requirements. The acceptance of public deposits is regulated by the Reserve Bank of India.

Merits:
The merits of public deposits are:
(i) The procedure of obtaining deposits is simple.
(ii) Cost of public deposits is generally lower than the cost of borrowings from banks.
(iii) Public deposits do not create charge on the assets of the company.
(iv) The depositors do not have voting rights, so control of the company is not compromised.

Demerits:
(i) Deposits can be availed only by reputed companies.
(ii) Public response is not always certain.
(iii) Large fund target is difficult to meet.

Commercial Paper:
Commercial Paper is an unsecured promissory note issued by a firm to raise short term fund. It is issued by one firm to other business firms, insurance companies, pension funds and banks. The amount raised by commercial paper is generally very large.

Merits:
(i) A commercial paper is sold on an unsecured basis and does not contain any restrictive condition.
(ii) It is freely transferable instrument.
(iii) It provides more funds than other sources.
(iv)The maturity of the commercial paper can be tailored to suit requirements of the issuing firm.

Limitations:
(i) Only financially sound and highly rated firms can raise money through commercial papers.
(ii) Raising money through commercial paper depends upon excess liquidity available with the suppliers of funds.
(iii) Extending the maturity of the paper is not possible.

Factoring:
Factoring is a financial service and the organisations that provide such services are called factors.
Factoring services include the following:
(a) Discounting of bills and collection of the clients debts. Under this the receivables on account of sale of goods or services are sold to the factor at a certain discount. The factor becomes responsible for all credit control and debt collection from the buyer and provides protection against any bad debt i.e. the factor assumes all the credit risk.
(b) Providing information about the credit worthiness of the buyer
The organisations that provide factoring services include SBI Factors and Commercial Services Ltd..
Canbank Factors Ltd. apart from non-banking financial companies.

Merits:
(i) Obtaining funds through factoring is cheaper than bank credits.
(ii) With the help of factors, cash flow is accelerated.
(iii) It does not create any charge on assets.
(iv) The client can concentrate on other functional areas.

Limitations:
(i) This source is expensive when invoices are numerous
(ii) The advance finance available from the factors is generally available at higher interest rate
(iii) Factors being third parties, some customers may not be interested to work with them.

CBSE Class 10 Elements of Business Unit II: Sources of Business Finance – Completed

The following topics have been completed in Unit II: Sources of Business Finance:

(a) Owned and Borrowed funds