Chapter 8

Sources of Business Finance

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

• state the meaning, nature and importance of business finance;

• classify the various sources of business finance;

• evaluate merits and limitations of various sources of finance;

• identify the international sources of finance; and

• examine the factors that affect the choice of an appropriate source

of finance.

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 SOURCES OF BUSINESS FINANCE 173

Mr. Anil Singh has been running a restaurant for the last two years. The excellent
quality of food has made the restaurant popular in no time. Motivated by the success
of his business, Mr. Singh is now contemplating the idea of opening a chain of
similar restaurants at different places. However, the money available with him from
his personal sources is not sufficient to meet the expansion requirements of his
business. His father told him that he can enter into a partnership with the owner of
another restaurant, who will bring in more funds but it would also require sharing
of profits and control of business. He is also thinking of getting a bank loan. He
is worried and confused, as he has no idea as to how and from where he should
obtain additional funds. He discusses the problem with his friend Ramesh, who
tells him about some other methods like issue of shares and debentures, which
are available only to a company form of organisation. He further cautions him that
each method has its own advantages and limitations and his final choice should
be based on factors like the purpose and period for which funds are required. He
wants to learn about these methods.

8.1 Introduction needs of society. For carrying out

various activities, business requires
This chapter provides an overview of
money. Finance, therefore, is called the
the various sources from where funds
life blood of any business. The
can be procured for starting as also for
requirements of funds by business to
running a business. It also discusses
carry out its various activities is called
the advantages and limitations of
business finance.
various sources and points out the
A business cannot function unless
factors that determine the choice of a
adequate funds are made available to
suitable source of business finance.
it. The initial capital contributed by the
It is important for any person who
entrepreneur is not always sufficient to
wants to start a business to know
take care of all financial requirements
about the different sources from
of the business. A business person,
where money can be raised. It is also
therefore, has to look for different other
important to know the relative merits
sources from where the need for funds
and demerits of different sources so
can be met. A clear assessment of the
that choice of an appropriate source
financial needs and the identification
can be made.
of various sources of finance, therefore,
is a significant aspect of running a
8.2 Meaning, Nature and Significance
business organisation.
of Business Finance
The need for funds arises from the
Business is concerned with the stage when an entrepreneur makes
production and distribution of goods a decision to start a business. Some
and services for the satisfaction of funds are needed immediately say for

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 174 BUSINESS  STUDIES

the purchase of plant and machinery, stock of material, bills receivables

furniture, and other fixed assets. and for meeting current expenses
Similarly, some funds are required like salaries, wages, taxes, and
for day-to-day operations, say to rent.
purchase raw materials, pay salaries to The amount of working capital
employees, etc. Also when the business required varies from one business
expands, it needs funds. concern to another depending on
The financial needs of a business various factors. A business unit selling
can be categorised as follows: goods on credit, or having a slow sales
( a) Fixed capital requirements: In turnover, for example, would require
order to start business, funds more working capital as compared to a
are required to purchase fixed concern selling its goods and services
assets like land and building, plant on cash basis or having a speedier
and machinery, and furniture turnover.
and fixtures. This is known as The requirement for fixed and
fixed capital requirements of the working capital increases with the
enterprise. The funds required in growth and expansion of business. At
fixed assets remain invested in times additional funds are required for
the business for a long period of upgrading the technology employed
time. Different business units need so that the cost of production or
varying amount of fixed capital operations can be reduced. Similarly,
depending on various factors such larger funds may be required for
as the nature of business, etc. A building higher inventories for the
trading concern for example, may festive season or to meet current debts
or expand the business or to shift to a
require small amount of fixed capital
new location. It is, therefore, important
as compared to a manufacturing
to evaluate the different sources from
concern. Likewise, the need for
where funds can be raised.
fixed capital investment would
be greater for a large enterprise,
8.3 Classification of Sources of
as compared to that of a small
enterprise. Funds
(b) Working capital requirements: In case of proprietary and partnership
The financial requirements of concerns, the funds may be raised either
an enterprise do not end with from personal sources or borrowings
the procurement of fixed assets. from banks, friends etc. In case of
No matter how small or large a company form of organisation, the
business is, it needs funds for different sources of business finance
its day-to-day operations. This which are available may be categorised
is known as working capital of as given in Table 8.1
an enterprise, which is used for As shown in the table, the sources
holding current assets such as of funds can be categorised using

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 SOURCES OF BUSINESS FINANCE 175
Classification of Sources of Funds
Table 8.1

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 176 BUSINESS  STUDIES

different basis viz., on the basis of often need short-term financing for
the period, source of generation and the interim period between seasons.
the ownership. A brief explanation of Wholesalers and manufacturers with
these classifications and the sources a major portion of their assets tied
is provided as follows: up in inventories or receivables also
require large amount of funds for a
8.3.1 Period Basis short period.
On the basis of period, the different
sources of funds can be categorised 8.3.2 Ownership Basis
into three parts. These are long-term On the basis of ownership, the sources
sources, medium-term sources and can be classified into ‘owner’s funds’
short-term sources. and ‘borrowed funds’. Owner’s funds
The long-term sources fulfil the means funds that are provided by the
financial requirements of an enterprise owners of an enterprise, which may
for a period exceeding 5 years and be a sole trader or partners or
include sources such as shares and shareholders of a company. Apart
debentures, long-term borrowings and from capital, it also includes profits
loans from financial institutions. Such
reinvested in the business. The
financing is generally required for the
owner’s capital remains invested in
acquisition of fixed assets such as
the business for a longer duration
equipment, plant, etc.
and is not required to be refunded
Where the funds are required for a
period of more than one year but less during the life period of the business.
than five years, medium-term sources Such capital forms the basis on which
of finance are used. These sources owners acquire their right of control of
include borrowings from commercial management. Issue of equity shares
banks, public deposits, lease financing and retained earnings are the two
and loans from financial institutions. important sources from where owner’s
Short-term funds are those which funds can be obtained.
are required for a period not exceeding ‘Borrowed funds’ on the other
one year. Trade credit, loans from hand, refer to the funds raised through
commercial banks and commercial loans or borrowings. The sources
papers are some of the examples of the for raising borrowed funds include
sources that provide funds for short loans from commercial banks, loans
duration. from financial institutions, issue of
Short-term financing is most debentures, public deposits and trade
common for financing of current credit. Such sources provide funds for
assets such as accounts receivable a specified period, on certain terms
and inventories. Seasonal businesses and conditions and have to be repaid
that must build inventories in after the expiry of that period. A fixed
anticipation of selling requirements rate of interest is paid by the borrowers

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 SOURCES OF BUSINESS FINANCE 177

on such funds. At times it puts a lot 8.4 Sources of Finance

of burden on the business as payment
A business can raise funds from
of interest is to be made even when
various sources. Each of the source has
the earnings are low or when loss is
unique characteristics, which must be
incurred. Generally, borrowed funds
properly understood so that the best
are provided on the security of some
available source of raising funds can
fixed assets. be identified. There is not a single best
source of funds for all organisations.
8.3.3 Source of Generation Basis
Depending on the situation, purpose,
Another basis of categorising the cost and associated risk, a choice may
sources of funds can be whether the be made about the source to be used.
funds are generated from within the For example, if a business wants to
organisation or from external sources. raise funds for meeting fixed capital
Internal sources of funds are those requirements, long term funds may
that are generated from within the be required which can be raised in
business. A business, for example, the form of owned funds or borrowed
can generate funds internally by funds. Similarly, if the purpose is to
accelerating collection of receivables, meet the day-to-day requirements of
disposing of surplus inventories and business, the short term sources may
ploughing back its profit. The internal be tapped. A brief description of various
sources of funds can fulfill only limited sources, along with their advantages
needs of the business. and limitations is given below.
External sources of funds include
8.4.1 Retained Earnings
those sources that lie outside an
organisation, such as suppliers, A company generally does not
lenders, and investors. When large distribute all its earnings amongst the
amount of money is required to be shareholders as dividends. A portion
raised, it is generally done through of the net earnings may be retained
the use of external sources. External in the business for use in the future.
funds may be costly as compared to This is known as retained earnings. It
those raised through internal sources. is a source of internal financing or self-
In some cases, business is required to financing or ‘ploughing back of profits’.
mortgage its assets as security while The profit available for ploughing back
obtaining funds from external sources. in an organisation depends on many
Issue of debentures, borrowing from factors like net profits, dividend policy
commercial banks and financial and age of the organisation.
institutions and accepting public
Merits
deposits are some of the examples of
external sources of funds commonly The merits of retained earning as a
used by business organisations. source of finance are as follows:

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 178 BUSINESS  STUDIES

(i) Retained earnings is a permanent creditors’ or ‘accounts payable’. Trade

source of funds available to an credit is commonly used by business
organisation; organisations as a source of short-
(ii) It does not involve any explicit cost term financing. It is granted to those
in the form of interest, dividend or customers who have reasonable
floatation cost; amount of financial standing and
(iii) As the funds are generated
goodwill. The volume and period of
internally, there is a greater
credit extended depends on factors
degree of operational freedom and
flexibility; such as reputation of the purchasing
(iv) It enhances the capacity of the firm, financial position of the seller,
business to absorb unexpected volume of purchases, past record of
losses; payment and degree of competition in
(v) It may lead to increase in the the market. Terms of trade credit may
market price of the equity shares vary from one industry to another and
of a company. from one person to another. A firm
may also offer different credit terms to
Limitations different customers.
Retained earning as a source of funds
has the following limitations: Merits
(i) Excessive ploughing back may The important merits of trade credit
cause dissatisfaction amongst the are as follows:
shareholders as they would get (i) Trade credit is a convenient and
lower dividends;
continuous source of funds;
(ii) It is an uncertain source of funds
(ii) Trade credit may be readily
as the profits of business are
available in case the credit
fluctuating;
(iii) The opportunity cost associated worthiness of the customers is
with these funds is not recognised known to the seller;
by many firms. This may lead to (iii) Trade credit needs to promote the
sub-optimal use of the funds. sales of an organisation;
(iv) If an organisation wants to
8.4.2 Trade Credit increase its inventory level in
Trade credit is the credit extended order to meet expected rise in the
by one trader to another for the sales volume in the near future,
purchase of goods and services. Trade it may use trade credit to, finance
credit facilitates the purchase of the same;
supplies without immediate payment. (v) It does not create any charge
Such credit appears in the records on the assets of the firm while
of the buyer of goods as ‘sundry providing funds.

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 SOURCES OF BUSINESS FINANCE 179

Limitations (b) Providing information about credit

worthiness of prospective client’s
Trade credit as a source of funds has
etc., Factors hold large amounts
certain limitations, which are given
of information about the trading
as follows:
histories of the firms. This can
(i) Availability of easy and flexible
be valuable to those who are
trade credit facilities may induce
using factoring services and can
a firm to indulge in overtrading,
thereby avoid doing business with
which may add to the risks of the
customers having poor payment
firm;
record. Factors may also offer
(ii) Only limited amount of funds can
relevant consultancy services in the
be generated through trade credit;
areas of finance, marketing, etc.
(iii) It is generally a costly source of
The factor charges fees for
funds as compared to most other
the services rendered. Factoring
sources of raising money.
appeared on the Indian financial
scene only in the early nineties
8.4.3 Factoring
as a result of RBI initiatives. The
Factoring is a financial service under organisations that provides such
which the ‘factor’ renders various services include SBI Factors and
services which includes: Commercial Services Ltd., Canbank
(a) Discounting of bills (with or without Factors Ltd., Foremost Factors Ltd.,
recourse) and collection of the State Bank of India, Canara Bank,
client’s debts. Under this, the Punjab National Bank, Allahabad
receivables on account of sale of Bank. In addition, many non-
goods or services are sold to the banking finance companies and
factor at a certain discount. The other agencies provide factoring
factor becomes responsible for all service.
credit control and debt collection
from the buyer and provides Merits
protection against any bad debt The merits of factoring as a source of
losses to the firm. There are two finance are as follows:
methods of factoring — recourse (i) Obtaining funds through factoring
and non-recourse. Under recourse is cheaper than financing through
factoring, the client is not protected other means such as bank credit;
against the risk of bad debts. On (ii) With cash flow accelerated by
the other hand, the factor assumes factoring, the client is able to meet
the entire credit risk under non- his/her liabilities promptly as and
recourse factoring i.e., full amount when these arise;
of invoice is paid to the client in the (iii) Factoring as a source of funds
event of the debt becoming bad. is flexible and ensures a definite

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 180 BUSINESS  STUDIES

pattern of cash inflows from credit arrangements are given in the lease
sales. It provides security for a contract. At the end of the lease period,
debt that a firm might otherwise the asset goes back to the lessor. Lease
be unable to obtain; finance provides an important means
(iv) It does not create any charge on of modernisation and diversification to
the assets of the firm; the firm. Such type of financing is more
(v) The client can concentrate on prevalent in the acquisition of such
other functional areas of business assets as computers and electronic
as the responsibility of credit equipment which become obsolete
control is shouldered by the quicker because of the fast changing
factor. technological developments. While
making the leasing decision, the cost
Limitations of leasing an asset must be compared
with the cost of owning the same.
The limitations of factoring as a source
of finance are as follows: Merits
(i) This source is expensive when
the invoices are numerous and The important merits of lease financing
smaller in amount; are as follows:
(ii) The advance finance provided (i) It enables the lessee to acquire the
by the factor firm is generally asset with a lower investment;
available at a higher interest cost (ii) Simple documentation makes it
than the usual rate of interest; easier to finance assets;
(iii) Lease rentals paid by the lessee
(iii) The factor is a third party to
are deductible for computing
the customer who may not feel
taxable profits;
comfortable while dealing with it. (iv) It provides finance without
diluting the ownership or control
8.4.4 Lease Financing of business;
A lease is a contractual agreement (v) The lease agreement does not
whereby one party i.e., the owner of an affect the debt raising capacity of
asset grants the other party the right an enterprise;
to use the asset in return for a periodic (vi) The risk of obsolescence is borne
payment. In other words it is a renting by the lesser. This allows greater
flexibility to the lessee to replace
of an asset for some specified period.
the asset.
The owner of the assets is called the
‘lessor’ while the party that uses the
Limitations
assets is known as the ‘lessee’ (see
Box A). The lessee pays a fixed periodic The limitations of lease financing are
amount called lease rental to the lessor given as below:
for the use of the asset. The terms (i) A lease arrangement may impose
and conditions regulating the lease certain restrictions on the use

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 SOURCES OF BUSINESS FINANCE 181

of assets. For example, it may (iii) It may result in higher payout

not allow the lessee to make any obligation in case the equipment
alteration or modification in the is not found useful and the lessee
opts for premature termination of
asset;
the lease agreement; and
(ii) The normal business operations (iv) The lessee never becomes the
may be affected in case the lease owner of the asset. It deprives him
is not renewed; of the residual value of the asset.

Box A
The Lessors
1. Specialised leasing companies: There are about 400-odd large companies
which have an organisational focus on leasing, and hence, are known as
leasing companies.
2. Banks and bank-subsidiaries: In February 1994, the RBI allowed banks
to directly enter leasing. Till then, only bank subsidiaries were allowed to
engage in leasing operations, which was regarded by the RBI as a non-banking
activity.
3. Specialised financial institutions: A number of financial institutions, at
the Central as well as the State level in India, use the lease instrument along
with traditional financing instruments. Significantly, the ICICI is one of the
pioneers in Indian leasing.
4. Manufacturer-lessors: As competition forces the manufacturer to add value
to his sales, he finds the best way to sell the product on lease. Vendor leasing
is gaining increasing importance. Presently, vendors of automobiles, consumer
durables, etc., have alliances or joint ventures with leasing companies to offer
lease finance against their products.
The Lessees
1. Public sector undertakings: This market has witnessed a good rate of growth
in the past. There is an increasing number of both centrally as well as State-
owned entities which have resorted to lease financing.
2. Mid-market companies: The mid-market companies (i.e., companies with
reasonably good creditworthiness but with lower public profile) have resorted
to lease financing basically as an alternative to bank/institutional financing.
3. Consumers: Recent bad experience with corporate financing has focussed
attention towards retail funding of consumer durables. For instance, car
leasing is a big market in India today.
4. Government deptts. and authorities: One of the latest entrants in
leasing markets is the government itself. Recently the Department of
Telecommunications of the central government took the lead by floating
tenders for lease finance worth about ` 1000 crores.

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 182 BUSINESS  STUDIES

8.4.5 Public Deposits (iv) As the depositors do not have

The deposits that are raised by voting rights, the control of the
organisations directly from the public company is not diluted.
are known as public deposits. Rates
of interest offered on public deposits Limitations
are usually higher than that offered The major limitation of public deposits
on bank deposits. Any person who is are as follows:
interested in depositing money in an (i) New companies generally find it
organisation can do so by filling up difficult to raise funds through
a prescribed form. The organisation public deposits;
in return issues a deposit receipt as (ii) It is an unreliable source of finance
acknowledgment of the debt. Public as the public may not respond
deposits can take care of both medium when the company needs money;
and short-term financial requirements (iii) Collection of public deposits may
of a business. The deposits are prove difficult, particularly when
beneficial to both the depositor as the size of deposits required is
well as to the organisation. While the large.
depositors get higher interest rate
than that offered by banks, the cost of 8.4.6 Commercial Paper
deposits to the company is less than
the cost of borrowings from banks. Commercial Paper (CP) is an unsecured
Companies generally invite public money market instrument issued in
deposits for a period upto three years. the form of a promissory note. It was
The acceptance of public deposits is introduced in India in 1990 for enabling
regulated by the Reserve Bank of India. highly rated corporate borrowers to
diversify their sources of short-term
Merits borrowings and to provide an additional
instrument to investors. Subsequently,
The merits of public deposits are: primary dealers and all-India financial
(i) The procedure of obtaining institutions were also permitted to
deposits is simple and does not
issue CP to enable them to meet their
contain restrictive conditions
short-term funding requirements for
as are generally there in a loan
agreement; their operations. Individuals, banking
(ii) C o s t o f p u b l i c d e p o s i t s i s companies, other corporate bodies
generally lower than the cost (registered or incorporated in India)
of borrowings from banks and and unincorporated bodies, Non-
financial institutions; Resident Indians (NRIs) and Foreign
(iii) Public deposits do not usually Institutional Investors (FIIs) etc. can
create any charge on the assets of invest in CPs. CP can be issued for
the company. The assets can be maturities between a minimum of 7
used as security for raising loans days and a maximum of up to one year
from other sources; from the date of issue in denominations

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 SOURCES OF BUSINESS FINANCE 183

of Rs.5 lakh or multiples thereof. (iii) C o m m e r c i a l p a p e r i s a n

However, the maturity date of the CP impersonal method of financing.
should not go beyond the date up to As such if a firm is not in a
which the credit rating of the issuer position to redeem its paper
is valid. due to financial difficulties,
extending the maturity of a CP is
Merits not possible.
(i) A commercial paper is sold on 8.4.7 Issue of Shares
an unsecured basis and does not
contain any restrictive conditions; The capital obtained by issue of shares
(ii) As it is a freely transferable is known as share capital. The capital
instrument, it has high liquidity; of a company is divided into small
(iii) It provides more funds compared units called shares. Each share has
to other sources. Generally, the its nominal value. For example, a
cost of CP to the issuing firm is company can issue 1,00,000 shares
lower than the cost of commercial of Rs. 10 each for a total value of
bank loans; Rs. 10,00,000. The person holding
(iv) A commercial paper provides a the share is known as shareholder.
continuous source of funds. This There are two types of shares normally
is because their maturity can be issued by a company. These are
tailored to suit the requirements equity shares and preference shares.
of the issuing firm. Further, The money raised by issue of equity
maturing commercial paper shares is called equity share capital,
can be repaid by selling new while the money raised by issue of
commercial paper; preference shares is called preference
(v) Companies can park their excess share capital.
funds in commercial paper (a) Equity Shares
thereby earning some good return E q u i t y s h a r e s i s t h e m o s t
on the same. important source of raising long
term capital by a company. Equity
Limitations shares represent the ownership of
(i) Only financially sound and highly a company and thus the capital
rated firms can raise money raised by issue of such shares
through commercial papers. New is known as ownership capital
and moderately rated firms are or owner’s funds. Equity share
not in a position to raise funds by capital is a prerequisite to the
this method; creation of a company. Equity
(ii) The size of money that can be shareholders do not get a fixed
raised through commercial paper dividend but are paid on the
is limited to the excess liquidity basis of earnings by the company.
available with the suppliers of They are referred to as ‘residual
funds at a particular time; owners’ since they receive what

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 184 BUSINESS  STUDIES

is left after all other claims on (vi) D e m o c r a t i c c o n t r o l o v e r

the company’s income and assets management of the company is
have been settled. They enjoy assured due to voting rights of
the reward as well as bear the equity shareholders.
risk of ownership. Their liability,
however, is limited to the extent of Limitations
capital contributed by them in the
The major limitations of raising funds
company. Further, through their
through issue of equity shares are as
right to vote, these shareholders
have a right to participate in the follows:
management of the company. (i) Investors who want steady income
may not prefer equity shares
Merits as equity shares get fluctuating
The important merits of raising funds returns;
through issuing equity shares are (ii) The cost of equity shares is
given as below: generally more as compared to
(i) Equity shares are suitable for the cost of raising funds through
investors who are willing to other sources;
assume risk for higher returns; (iii) Issue of additional equity shares
(ii) Payment of dividend to the equity dilutes the voting power, and
shareholders is not compulsory. earnings of existing equity
Therefore, there is no burden on shareholders;
the company in this respect; (iv) More formalities and procedural
(iii) Equity capital serves as permanent delays are involved while raising
capital as it is to be repaid only funds through issue of equity
at the time of liquidation of a share.
company. As it stands last in (b) Preference Shares
the list of claims, it provides a The capital raised by issue
cushion for creditors, in the event of preference shares is called
of winding up of a company; preference share capital. The
(iv) Equity capital provides credit preference shareholders enjoy
worthiness to the company and a preferential position over
confidence to prospective loan equity shareholders in two ways:
providers; (i) receiving a fixed rate of dividend,
(v) Funds can be raised through out of the net profits of the
equity issue without creating company, before any dividend is
any charge on the assets of declared for equity shareholders;
the company. The assets of a and (ii) receiving their capital
company are, therefore, free to after the claims of the company’s
be mortgaged for the purpose of creditors have been settled, at
borrowings, if the need be; the time of liquidation. In other

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 SOURCES OF BUSINESS FINANCE 185

words, as compared to the equity (v) Preference shareholders have a

shareholders, the preference preferential right of repayment
shareholders have a preferential over equity shareholders in the
claim over dividend and repayment event of liquidation of a company;
of capital. Preference shares (vi) Preference capital does not create
resemble debentures as they any sort of charge against the
bear fixed rate of return. Also assets of a company.
as the dividend is payable only
at the discretion of the directors Limitations
and only out of profit after tax, to The major limitations of preference
that extent, these resemble equity shares as source of business finance
shares. Thus, preference shares are as follows:
have some characteristics of both (i) Preference shares are not suitable
equity shares and debentures. for those investors who are willing
Preference shareholders generally to take risk and are interested in
do not enjoy any voting rights. A higher returns;
company can issue different types (ii) Preference capital dilutes the
of preference shares (see Box B). claims of equity shareholders over
assets of the company;
Merits (iii) The rate of dividend on preference
shares is generally higher than
The merits of preference shares are the rate of interest on debentures;
given as follows: (iv) As the dividend on these shares is
(i) P r e f e r e n c e s h a r e s p r o v i d e to be paid only when the company
reasonably steady income in the earns profit, there is no assured
form of fixed rate of return and return for the investors. Thus,
safety of investment; these shares may not be very
(ii) Preference shares are useful for attractive to the investors;
those investors who want fixed (v) The dividend paid is not deductible
rate of return with comparatively from profits as expense. Thus,
low risk; there is no tax saving as in the
(iii) It does not affect the control case of interest on loans.
of equity shareholders over
the management as preference 8.4.8 Debentures
shareholders don’t have voting Debentures are an important
rights; instrument for raising long term debt
(iv) Payment of fixed rate of dividend capital. A company can raise funds
to preference shares may enable through issue of debentures, which
a company to declare higher bear a fixed rate of interest. The
rates of dividend for the equity debenture issued by a company is an
shareholders in good times; acknowledgment that the company

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 186 BUSINESS  STUDIES

has borrowed a certain amount of Merits

money, which it promises to repay at
The merits of raising funds through
a future date. Debenture holders are,
therefore, termed as creditors of the debentures are given as follows:
company. Debenture holders are paid (i) It is preferred by investors who
a fixed stated amount of interest at want fixed income at lesser risk;
specified intervals say six months or (ii) Debentures are fixed charge funds
one year. Public issue of debentures and do not participate in profits
requires that the issue be rated by a of the company;
credit rating agency like CRISIL (Credit (iii) The issue of debentures is suitable
Rating and Information Services of in the situation when the sales
India Ltd.) on aspects like track record and earnings are relatively stable;
of the company, its profitability, debt (iv) As debentures do not carry
servicing capacity, credit worthiness voting rights, financing through
and the perceived risk of lending. A
debentures does not dilute
company can issue different types of
control of equity shareholders on
debentures (see Box C and D). Issue of
Zero Interest Debentures (ZID) which management;
do not carry any explicit rate of interest (v) Financing through debentures is
has also become popular in recent less costly as compared to cost of
years. The difference between the face preference or equity capital as the
value of the debenture and its purchase interest payment on debentures is
price is the return to the investor. tax deductible.

Box B
Types of Preference Shares
1. Cumulative and Non-Cumulative: The preference shares which enjoy the
right to accumulate unpaid dividends in the future years, in case the same
is not paid during a year are known as cumulative preference shares. On
the other hand, on non-cumulative shares, dividend is not accumulated if
it is not paid in a particular year.
2. Participating and Non-Participating: Preference shares which have a
right to participate in the further surplus of a company shares which
after dividend at a certain rate has been paid on equity shares are called
participating preference shares. The non-participating preference are such
which do not enjoy such rights of participation in the profits of the company.
3. Convertible and Non-Convertible: Preference shares that can be converted
into equity shares within a specified period of time are known as convertible
preference shares. On the other hand, non-convertible shares are such that
cannot be converted into equity shares.

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Limitations 8.4.9 Commercial Banks

Debentures as source of funds has Commercial banks occupy a vital
certain limitations. These are given position as they provide funds for
as follows: different purposes as well as for
(i) As fixed charge instruments, different time periods. Banks extend
debentures put a permanent loans to firms of all sizes and in many
burden on the earnings of a ways, like, cash credits, overdrafts, term
company. There is a greater risk loans, purchase/discounting of bills,
when earnings of the company
and issue of letter of credit. The rate
fluctuate;
of interest charged by banks depends
(ii) In case of redeemable debentures,
on various factors such as the
the company has to make
provisions for repayment on characteristics of the firm and the
the specified date, even during level of interest rates in the economy.
periods of financial difficulty; The loan is repaid either in lump sum
(iii) E a c h c o m p a n y h a s c e r t a i n or in installments.
borrowing capacity. With the Bank credit is not a permanent
issue of debentures, the capacity source of funds. Though banks have
of a company to further borrow started extending loans for longer
funds reduces. periods, generally such loans are

Box C
Types of Debentures
1. Secured and Unsecured: Secured debentures are such which create a charge
on the assets of the company, thereby mortgaging the assets of the company.
Unsecured debentures on the other hand do not carry any charge or security
on the assets of the company.
2. Registered and Bearer: Registered debentures are those which are duly
recorded in the register of debenture holders maintained by the company.
These can be transferred only through a regular instrument of transfer. In
contrast, the debentures which are transferable by mere delivery are called
bearer debentures.
3. Convertible and Non-Convertible: Convertible debentures are those
debentures that can be converted into equity shares after the expiry of a
specified period. On the other hand, non-convertible debentures are those
which cannot be converted into equity shares.
4. First and Second: Debentures that are repaid before other debentures are
repaid are known as first debentures. The second debentures are those which
are paid after the first debentures have been paid back.

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 188 BUSINESS  STUDIES

used for medium to short periods. of obtaining funds slightly

The borrower is required to provide difficult;
some security or create a charge on (iii) In some cases, difficult terms and
the assets of the firm before a loan is conditions are imposed by banks.
sanctioned by a commercial bank. for the grant of loan. For example,
restrictions may be imposed on
Merits the sale of mortgaged goods, thus
The merits of raising funds from a making normal business working
commercial bank are as follows: difficult.
(i) Banks provide timely assistance
to business by providing funds as 8.4.10 Financial Institutions
and when needed by it. The government has established
(ii) Secrecy of business can be a number of financial institutions
maintained as the information all over the country to provide
supplied to the bank by the finance to business organisations
borrowers is kept confidential; (see Box E). These institutions are
(iii) Formalities such as issue of established by the central as well as
prospectus and underwriting are state governments. They provide both
not required for raising loans
owned capital and loan capital for long
from a bank. This, therefore, is
and medium term requirements and
an easier source of funds;
supplement the traditional financial
(iv) Loan from a bank is a flexible
agencies like commercial banks. As
source of finance as the loan
these institutions aim at promoting the
amount can be increased
according to business needs and industrial development of a country,
can be repaid in advance when these are also called ‘development
funds are not needed. banks’. In addition to providing
financial assistance, these institutions
Limitations also conduct market surveys and
provide technical assistance and
The major limitations of commercial managerial services to people who
banks as a source of finance are as run the enterprises. This source of
follows: financing is considered suitable when
(i) Funds are generally available for large funds for longer duration are
short periods and its extension or required for expansion, reorganisation
renewal is uncertain and difficult; and modernisation of an enterprise.
(ii) Banks make detailed investigation
of the company’s affairs, financial Merits
structure etc., and may also ask
for security of assets and personal The merits of raising funds through
sureties. This makes the procedure financial institutions are as follows:

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BOX D
Inter Corporate Deposits (ICD)
Inter Corporate Deposits are unsecured short-term deposits made by a company
with another company. ICD market is used for short-term cash management of a
large corporate. As per the RBI guidelines, the minimum period of ICDs is 7 days
which can be extended to one year.
The three types of Inter Corporate Deposits are:
(i) Three months deposits;
(ii) Six months deposits;
(iii) Call deposits.
Interest rate on ICDs may remain fixed or may be floating. The rate of interest on
these deposits is higher than that of banks. These deposits are usually considered
by the borrower company to solve problems of short-term funds insufficiency.

(i) Financial institutions provide (i) Financial institutions follow

long-term finance, which are not rigid criteria for grant of loans.
provided by commercial banks; Too many formalities make the
(ii) Besides providing funds, many procedure time consuming and
of these institutions provide
expensive;
financial, managerial and
technical advice and consultancy (ii) Certain restrictions such as
to business firms; restriction on dividend payment
(iii) Obtaining loan from financial are imposed on the powers of
institutions increases the goodwill the borrowing company by the
of the borrowing company in the financial institutions;
capital market. Consequently, (iii) Financial institutions may have
such a company can raise funds their nominees on the Board
easily from other sources as well; of Directors of the borrowing
(iv) As repayment of loan can be made
company thereby restricting the
in easy instalments, it does not
prove to be much of a burden on powers of the company.
the business;
(v) The funds are made available 8.5 International Financing
even during periods of depression, In addition to the sources discussed
when other sources of finance are above, there are various avenues
not available. for organisations to raise funds
internationally. With the opening up
Limitations
of an economy and the operations of
The major limitations of raising funds the business organisations becoming
from financial institutions are as given global, Indian companies have an
below: access to funds in global capital

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 190 BUSINESS  STUDIES

market. Various international sources of a company are delivered to the

from where funds may be generated depository bank. The depository
include: bank issues depository receipts
(i)  Commercial Banks: Commercial against these shares. Such
banks all over the world extend foreign depository receipts denominated
currency loans for business purposes. in US dollars are known as Global
They are an important source of Depository Receipts (GDR). GDR is
financing non-trade international a negotiable instrument and can be
operations. The types of loans and traded freely like any other security.
services provided by banks vary from In the Indian context, a GDR is an
country to country. For example, instrument issued abroad by an
Standard Chartered emerged as a Indian company to raise funds
major source of foreign currency loans in some foreign currency and is
to the Indian industry. listed and traded on a foreign
stock exchange. A holder of GDR
(ii) International Agencies and can at any time convert it into the
Development Banks: A number number of shares it represents. The
of international agencies and holders of GDRs do not carry any
development banks have emerged over voting rights but only dividends
the years to finance international trade and capital appreciation. Many
and business. These bodies provide Indian companies such as Infosys,
long and medium term loans and Reliance, Wipro and ICICI have
grants to promote the development of raised money through issue of
economically backward areas in the GDRs (see Box F).
world. These bodies were set up by the (b) American Depository Receipts

Governments of developed countries (ADRs): The depository receipts
of the world at national, regional and issued by a company in the USA
international levels for funding various are known as American Depository
projects. The more notable among Receipts. ADRs are bought and sold
them include International Finance in American markets, like regular
Corporation (IFC), EXIM Bank and stocks. It is similar to a GDR
Asian Development Bank. except that it can be issued only to
(iii) International Capital Markets: American citizens and can be listed
Modern organisations including and traded on a stock exchange
multinational companies depend of USA.
upon sizeable borrowings in rupees as (c)  Indian Depository Receipt (IDRs):
well as in foreign currency. Prominent An Indian Depository Receipt is a
financial instruments used for this financial instrument denominated
purpose are: in Indian Rupees in the form of a
( a) Global Depository Receipts
Depository Receipt. It is created
(GDR’s): The local currency shares by an Indian Depository to enable

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 SOURCES OF BUSINESS FINANCE 191

Box E
Companies rush to float GDR issues
It’s not the IPO (initial public offer) market alone which is humming with activity.
Companies — mostly small and medium-sized — are rushing to the overseas
market to raise funds through Global Depository Receipts (GDRs). Five firms
have already raised $464 million (around ` 2,040 crore) from the international
markets through GDR offerings this year. This is almost double of $228.6 mn
raised by nine companies in 2004 and $63.09 mn mobilised by four companies
in 2003. Nearly 20 companies are waiting in the wings to launch GDR issues
worth over $1 bn in the coming months. On the other hand, though the number
of companies going for FCCB (Foreign Currency Convertible Bonds) issues
has come down, several companies are still in the FCCB race, thanks to lax
rules and disclosure norms. For example, Aarti Drugs Ltd. has decided to raise
$12 mn by issuing FCCBs.
Significantly, small and medium companies are now taking the GDR route to raise
funds this time even for a small amount. For example, Opto Circuits has decided to
go for a GDR issue of $20 mn with a green-shoe option of $5 mn. The share price
of this company shot up by 370 per cent from ` 34 on May 17, 2004 to around `
160 on the BSE recently. Videocon Industries, Lyka Labs, Indian Overseas Bank,
Jubilant Organosys, Maharashtra Seamless, Moschip Semiconductors, and Crew
BOS are planning GDR issues. Two banks — UTI Bank ($240 million) and Centurion
Bank ($70 million) — raised funds from the GDR market recently. Companies now
prefer GDR over FCCB issues in view of the rise in interest rates abroad.

a foreign company to raise funds issued. The issuer company makes

from the Indian securities market. a public offer in India, and residents
The IDR is a specific Indian version can bid in exactly the same format and
of the similar global depository method as they bid for Indian shares.
receipts. ‘Standard Chartered PLC’ was
The foreign company issuing the first company that issued Indian
IDR deposits shares to an Indian Depository Receipt in Indian securities
Depository (custodian of securities market in June 2010.
registered with the Securities and (d) Foreign Currency Convertible
Exchange Board of India). In turn, the Bonds (FCCBs): Foreign currency
depository issues receipts to investors convertible bonds are equity linked
in India against these shares. The debt securities that are to be
benefits of the underlying shares (like converted into equity or depository
bonus, dividends, etc.) accrue to the receipts after a specific period.
IDR holders in India. Thus, a holder of FCCB has the
According to SEBI guidelines, option of either converting them into
IDRs are issued to Indian residents in equity shares at a predetermined
the same way as domestic shares are price or exchange rate, or retaining

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 192 BUSINESS  STUDIES

the bonds. The FCCB’s are issued (ii) Financial strength and stability
in a foreign currency and carry a of operations: The financial
fixed interest rate which is lower strength of a business is also a
than the rate of any other similar key determinant. In the choice of
non-convertible debt instrument. source of funds business should
FCCB’s are listed and traded in be in a sound financial position
foreign stock exchanges. FCCB’s so as to be able to repay the
are very similar to the convertible principal amount and interest on
debentures issued in India. the borrowed amount. When the
earnings of the organisation are
8.6 Factors Affecting the Choice not stable, fixed charged funds like
of the Source of Funds preference shares and debentures
should be carefully selected as
Financial needs of a business are of these add to the financial burden
different types — long term, short of the organisation.
term, fixed and fluctuating. Therefore, (iii) Form of organisation and legal
business firms resort to different types status: The form of business
of sources for raising funds. Short- organisation and status influences
term borrowings offer the benefit of the choice of a source for raising
reduced cost due to reduction of idle money. A partnership firm, for
capital, but long – term borrowings example, cannot raise money by
are considered a necessity on many issue of equity shares as these
grounds. Similarly equity capital has can be issued only by a joint stock
a role to play in the scheme for raising company.
funds in the corporate sector. (iv) P u r po s e a n d t i m e pe r i o d:
As no source of funds is devoid Business should plan according
of limitations, it is advisable to use to the time period for which the
a combination of sources, instead funds are required. A short-term
of relying only on a single source. A need for example can be met
number of factors affect the choice through borrowing funds at low
of this combination, making it a very rate of interest through trade
complex decision for the business. The credit, commercial paper, etc. For
factors that affect the choice of source long term finance, sources such
of finance are briefly discussed below: as issue of shares and debentures
(i) Cost: There are two types of cost are more appropriate. Similarly,
viz., the cost of procurement of the purpose for which funds are
funds and cost of utilising the required need to be considered so
funds. Both these costs should be that the source is matched with
taken into account while deciding the use. For example, a long-
about the source of funds that will term business expansion plan
be used by an organisation. should not be financed by a bank

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 SOURCES OF BUSINESS FINANCE 193

overdraft which will be required to (vii) Effect on credit worthiness:

be repaid in the short term. The dependence of business on
(v) Risk profile: Business should certain sources may affect its
evaluate each of the source credit worthiness in the market.
of finance in terms of the risk For example, issue of secured
involved. For example, there is a debentures may affect the interest
least risk in equity as the share of unsecured creditors of the
capital has to be repaid only at the company and may adversely
time of winding up and dividends affect their willingness to extend
need not be paid if no profits are further loans as credit to the
available. A loan on the other company.
hand, has a repayment schedule (viii) Flexibility and ease: Another

for both the principal and the aspect affecting the choice of a
interest. The interest is required source of finance is the flexibility
to be paid irrespective of the firm and ease of obtaining funds.
earning a profit or incurring a Restrictive provisions, detailed
loss. investigation and documentation
in case of borrowings from banks
(vi) Control: A particular source
and financial institutions for
of fund may affect the control
example may be the reason that
and power of the owners on the
a business organisations may
management of a firm. Issue of
not prefer it, if other options are
equity shares may mean dilution
readily available.
of the control. For example, as
(ix) Tax benefits: Various sources
equity share holders enjoy voting may also be weighed in terms of
rights, financial institutions may their tax benefits. For example,
take control of the assets or while the dividend on preference
impose conditions as part of the shares is not tax deductible,
loan agreement. Thus, business interest paid on debentures
firm should choose a source and loan is tax deductible and
keeping in mind the extent to may, therefore, be preferred
which they are willing to share by organisations seeking tax
their control over business. advantage.

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 194 BUSINESS  STUDIES

Key Terms

Finance Owned capital Fixed capital

Working capital Borrowed capital Short term sources
Restrictive conditions Long term sources Charge on assets
Voting power Fixed charge funds Accounts receivable
Bill discounting Factoring GDRs
FCCBs ADRs 1CD
1DR

SUMMARY

Meaning and significance of business finance: Finance required by business

to establish and run its operations is known as business finance. No business
can function without adequate amount of funds for undertaking various
activities. The funds are required for purchasing fixed assets (fixed capital
requirement), for running day-to-day operations (working capital requirement),
and for undertaking growth and expansion plans in a business organisation.
Classification of sources of funds: Various sources of funds available to
a business can be classified according to three major basis, which are
(i) time period (long, medium and short term), (ii) ownership (owner’s funds
and borrowed funds), and (iii) source of generation (internal sources and
external sources).
Long, medium and short-term sources of funds: The sources that provide
funds for a period exceeding 5 years are called long-term sources. The sources
that fulfill the financial requirements for the period of more than one year but
not exceeding 5 years are called medium term sources and the sources that
provide funds for a period not exceeding one year are termed as short term
sources.
Owner’s funds and borrowed funds: Owner’s funds refer to the funds that
are provided by the owners of an enterprise. Borrowed capital, on the other
hand, refers to the funds that are generated through loans or borrowings from
other individuals or institutions.
Internal and external sources: Internal sources of capital are those sources
that are generated within the business say through ploughing back of profits.
External sources of capital, on the other hand are those that are outside the
business such as finance provided by suppliers, lenders, and investors.

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 SOURCES OF BUSINESS FINANCE 195

Sources of business finance: The sources of funds available to a business

include retained earnings, trade credit, factoring, lease financing, public
deposits, commercial paper, issue of shares and debentures, loans from
commercial banks, financial institutions and international sources of finance.
Retained earnings: The portion of the net earnings of the company that is
not distributed as dividends is known as retained earnings. The amount of
retained earnings available depends on the dividend policy of the company. It
is generally used for growth and expansion of the company.
Trade credit: The credit extended by one trader to another for purchasing
goods or services is known as trade credit. Trade credit facilitates the purchase
of supplies on credit. The terms of trade credit vary from one industry to
another and are specified on the invoice. Small and new firms are usually
more dependent on trade credit, as they find it relatively difficult to obtain
funds from other sources.
Factoring: Factoring has emerged as a popular source of short-term funds in
recent years. It is a financial service whereby the factor is responsible for all
credit control and debt collection from the buyer and provides protection against
any bad-debt losses to the firm. There are two methods of factoring — recourse
and non-recourse factoring.
Lease financing: A lease is a contractual agreement whereby the owner of an
asset (lessor) grants the right to use the asset to the other party (lessee). The
lessor charges a periodic payment for renting of an asset for some specified
period called lease rent.
Public deposits: A company can raise funds by inviting the public to deposit
their savings with their company. Pubic deposits may take care of both long
and short-term financial requirements of business. Rate of interest on deposits
is usually higher than that offered by banks and other financial institutions.
Commercial paper (CP): It is an unsecured promissory note issued by a firm
to raise funds for a short period The maturity period of commercial paper
usually ranges from 90 days to 364 days. Being unsecured, only firms having
good credit rating can issue the CP and its regulation comes under the purview
of the Reserve Bank of India.
Issue of equity shares: Equity shares represents the ownership capital of a
company. Due to their fluctuating earnings, equity shareholders are called
risk bearers of the company. These shareholders enjoy higher returns during
prosperity and have a say in the management of a company, through exercising
their voting rights.
Issue of preference shares: These shares provide a preferential right to
the shareholders with respect to payment of earnings and the repayment of

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 196 BUSINESS  STUDIES

capital. Investors who prefer steady income without undertaking higher risks
prefer these shares. A company can issue different types of preference shares.
Issue of debentures: Debenture represents the loan capital of a company and
the holders of debentures are the creditors. These are the fixed charged funds
that carry a fixed rate of interest. The issue of debentures is suitable in the
situation when the sales and earnings of the company are relatively stable.
Commercial banks: Banks provide short and medium-term loans to firms of
all sizes. The loan is repaid either in lump sum or in instalments. The rate of
interest charged by a bank depends upon factors including the characteristics
of the borrowing firm and the level of interest rates in the economy.
Financial institutions: Both central and state governments have established
a number of financial institutions all over the country to provide industrial
finance to companies engaged in business. They are also called development
banks. This source of financing is considered suitable when large funds are
required for expansion, reorganisation and modernisation of the enterprise.

EXERCISES

Short Answer Questions

1. What is business finance? Why do businesses need funds? Explain.
2. List sources of raising long-term and short-term finance.
3. What is the difference between internal and external sources of raising
funds? Explain.
4. What preferential rights are enjoyed by preference shareholders. Explain.
5. Name any three special financial institutions and state their objectives.
6. What is the difference between GDR and ADR? Explain.

Long Answer Questions

1. Explain trade credit and bank credit as sources of short-term finance for
business enterprises.
2. Discuss the sources from which a large industrial enterprise can raise
capital for financing modernisation and expansion.
3. What advantages does issue of debentures provide over the issue of equity
shares?
4. State the merits and demerits of public deposits and retained earnings as
methods of business finance.

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 SOURCES OF BUSINESS FINANCE 197

Projects/Assignment
1. Collect information about the companies that have issued debentures in
recent years. Give suggestions to make debentures more popular.
2. Institutional financing has gained importance in recent years. In a scrapbook
paste detailed information about various financial institutions that provide
financial assistance to Indian companies.
3. On the basis of the sources discussed in the chapter, suggest suitable
options to solve the financial problem of the restaurant owner.
4. Prepare a comparative chart of all the sources of finance.

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