Part: B

Finance &Trade

SOURCES OF
BUSINESS FINANCE
6.11

Earning Objectives

Meaning,
ear
Nature and Significance of Finance

TOes of Finance: Short-term, Medium-term, Long-term

Finance: Owner's fund, Borrowed fund
Sources of
Owner's Fund: Features
Borrowed Fund: Features
Public deposits, Retained Earnings:
Securities Issued: Shares, Debentures,
Features, Merits, Demerits

Trade Credit
Demerits
Public Deposits: Features, Merits,
Merits,
Shares: shares, Preference shares. Equity Shares: Features,
Equity
Demerits
Demerits Preference Shares: Features, Types, Merits,
Debentures: Features, Types, Merits, Demerits
Commercial Banks: Features, Merits, Demerits
InstitutionalFinance: Features, Merits, Demerits
nternational Sources of Finance
GDR
ADR
Loan from Commercial Banks

1.MEANING
funds invested in the business. Financing
Bus
CSs capital funds and credit
hnance refers to
Ikans
making money available when it is needed. all the money
Business finance may be defined as, planning, raising, managing and controlling
dWsed o business.
"pital funds of any kind used in connection with
218 Part: B Finance &Trade

Definitions of Finance by Different Authors

"Finance is that business activity which is concerned with the acquisition and co-
in meeting the financial needs and overall objectives of business enterprise"

"Business finance involves a set of administrative functions in an organisatio

nsevation ot capita
arrangement of cash and credit so that the organisation may have the means
means to
to
an
ce
carry
BOhe
which reliate
out its with
satisfactorily as possible"
Finance is a major function of any business enterprise. It deals with the -HowardobeancdthveUtise
am.

adequate amount of capital to achieve the objectives of the enterprise.

rangement
2. NATURE AND SIGNIFICANCE OF BUSINESS FINANCE
No one can start a business or run an enterprise without
adequate funds. Fver.
requires some money to start which is called initial capital. Ihe amount very bus
upon the nature and size of the business. pital require
of capital required deper
Business enterprise requires capital and finance for the following purposes:
1. While starting a business, finance is
required to procure fixed assets and also for
day-to-day expenses. meti.
2. To meet the
working capital requirement when production process is
3. To finance the
lengthy.
growth and expansion projects of the comnpany. We need fixed
capital
Adequate finance provides the following benefits to a business concern:
1. The firm can meet its liabilities on time.
2. The firm can carry on its business smoothly.
3. The firm can
adopt latest technology and new innovative
4. The firm
methods of production.
can make use of its business
5. The firm can face
opportunities.
competition more strongly.
6. The firm can replace its assets and
7. The firm can face
machinery whenever necessary.
recession and depression
period of trade cycle.
CONCLUSION
Abusiness enterprise needs
at the right time for financeofat every stage. It must be
smooth functioning an available in an adequate
blood of a business. enterprise. In amoun
short, we can say that finance is the Ire

3. SOURCES OF FINANCE ON THE BASIS OF

For every business enterprise, there are two sources
of business
OWNERSHIP
Owner's Fund finance. These are:
Borrowed Fund
 219
Business FinanCe
Chapter: 7 Sources of

3.1 Owner's Fund

Owner's fund rerers to the funds contributed by of

owners as well as the accumulated profit
as the
company. This
the company.
the runcd remai
inis fund remains
by owners
Duted
as
accumua
with the company and it has no liability to return u *

For example, equity shares, retained

earnings.
3.1A Main Features of wner's Fund

Source of Permanent
Capital: The owner's fitnd remains permanently invested in uic
business. it is not
refundable like loan
used for acquiring fixed borrowed fund. large part
or A
u of owners
assets. This tvpe of finance is available for all
the life of a business. purposes tnroug
2 ProvisiOn ot Kisk
Capital: The owner's fund is also known as the risk
as the return on this capital of the business,
capital depends upon the rate of earning of the company. In
company 1S ncurring loss then it is not Casc
loss continues owners compulsorv to pay any return on owner's fund. Ir
may be unable to recover even their original investment. In times or
prosperity high level of return is given on owner's fund. The
with the profht earning of the return on owner's fund varies
company, that is why it is called risky capital.
No Security
Required: Nosecurity has to be offered against ownership
4. Sources of Owner's capital.
Fund: The owner's fund comprises of share capital, retained
(accumulated profit). earnings
3.2 Borrowed Fund

Borrowed fund refers to the borrowing of the firm. It

includes all funds available
loans or credit. by way of
3.2A Features of Borrowed Fund Capital
1: Fixed Time: The borrowed fund is raised by business fhrms
for
funds may be raised for short-term, medium-term or specified periods. These
long-term.
2 Security: Generally firms can get borrOwea runds against the securities of assets Banke
nk and
financial institutions offer loans on diierent terms against the an
security of assets.
3.
Regular Payment of Interest: It is a legal compulsion on business firms to pay
amount of interest on borrowed rund. 1c regular a
p al amount also
has to be paid
within
fixed time períod. The payment of interest as well as principal amount ie thin a
a

company irrespective of its earnings

borrowed fund security holders not get the right to control and
do
4. Control: The
activities of the business firm. They nave tne rgnt to sue the firm in case t h u man

loan amount.
payment of interest
or repayment of

Sources of Borrowed
:
Fund: Sourcesotborrowed fund are debentures, loan from
S,loan frome
banks, loan from financial
institutions, public deposits, intercorporate commercial
etc.
deposits trade credit
 220Part. B Finance &Trate

Difference between Owners' Fund and Borrowed Fund

Owner fund
Borrowed fund
It refers to the funds contributed by owners It refers to the botee
deaning
as well as retained eanings includes all fund borrowing of
or credit available by waythe fud
2ime Perrod Owner fund is a source of permanent capital Borrowed fund is for fixed
a
period nf
3 Secunty No security is required with owner fund Generally firms get borrowed
the security of assets. fund
agan
4 Control Owner fund contributors control the company The borrowed fund security
the right to control. holder dodo not he
5. Sources The sources of owner fund are share capital, The sources of borrowed
Retained learning's GDR, ADR and 1DR. Debentures, Loans, Trade fund
deposits, etc. Credit
Public
6. Rightto Return Owner fund security holders have no right toBorrowed fund security holdere H
get regular return. right to get regular return. e leqal

7. Risk Bearer Owner fund security holders are Primary Risk Borrowed fund security holders bear ne a
bearer of the company. ORisk

4. SOURCES OF RAISING FINANCE

SOURCES OF RAISING FINANCE

On the Basis of Ownership

Owner's Fund Borrowed Fund

Equity share Debentures

Preference share Loan from financial banks

Loan from commercial banks

Retained earning

GDR (Global depository receipt) Public deposit

ADR (American depository receipt) Trade credit

IDR (Indian depository receipt) inter corporate deposit

(ICD)
 ra",,12a
Chaptor,7 Source; of

Shares (Owner's Fund, Long-term Source of Finance)

I Issue
divided. A share is
A Share
is
is divided.
Share iis the
smalest unit wnerscanital of
in which owner's capital of the
the company
company
of
money for the purpose
ofthe.
ofthe
erest of
shareholder in the
the shareholder the measured by a of sum
pany interest
a shareholder's
i n t e r e s t

the
Ihabilityand inte t. A share may also defined as a
be unit of ofmeasure

a the company

According to Companies Act, a public company can issue two types of snare

1. Equity Shares 2. Preference Shares.

,1A Equity Shares

pefinition of Shares: share means smallest unit in which share capital of a company
stock. Equity share is a or owners
includes
ivided and incl
videdand common security issued under permanent
faund capital. Equity shares are the most important source of raising long-term capital. The eqty
of annual
hares are those shares which do not carry any special or preferential rights in the payment
dividend or repayment of capital. At the time of winding up also capital of equity shareholders
is returned only
after every claim has been settled. Prior to the year 2000, the companies were
allowed to issue equity shares with equal rights only. In the year 2000, an amendment was made in
Companies Act permitting companies to issue two categories of equity shares:
(G) Equity shares with equal rights

(Gi) Equity shares with differential rights as to dividend.

4.18 Features of Equity Shares
1.Primary Risk Bearers: The equityshareholders are the primary risk bearers ofthe company. In
case the company suffers losses then equity shareholders have to bear the loss. The due payment
is given to creditors before paying the equity shareholders.
2. Claim over Residual Income: The equity shareholders have claim over the left- over income
of the company only. They get share in the income lett after satisfying the claims of al
shareholders.
creditors, outsiders and preference
3. Basis for Loans: Equity share capital is the basis on whicn loans can be raised. The amount

the credibility of the company.

Ihe amount of equity s
of equity share capital adds to

increases the confidence of

the creditors.
capital
have control over the activities of the company. The easit
4. Control:Equity shareholders shareholders cast vote to select the Board of
The equity
shareholders have voting rights.
the affairs of the company.
Directors who control and manage
debentureholders and
the rate dividend for prefar
of ce
for
Higher Profit: The rate interest of the
d e b e n t u r e h o l d e r s and preference shareh
areholders
fixed. At the time of profit
Shareholders are
shareholders enjoy
a higher profit.
but equity
get fixed income only rignt by the provisioneof
given pre-empuve
.

The equity shareholders are is planning to issue Dea

of
0,
Pre-emptive Right: whenever a company ty
to this right, hrst. If existing sharo
Companies Act. According existing
shareholders areholders
to the
shares, it must offer the shares
 222 a R rmane

refree to herr the new isere then only a compay shall offer these
these shares to
public This right prtecte the controiling right of equity shareholders the
he e
1C Merits Advantages of Equity Shares
From a company point of view, there are several merits of issuing eauitu
ong term finane Ihese are

Permanenttapital Equity shareholders provide the permanent funds of com a

fixed commitment to return the money or
pay fixed rate of dividend npany he
Is no a

Noharge on lixed Assets For issue of cquity shares, a company is not

mortgage its assets. The assets remain free for borrowing loans. not reqmrd
High redit Standing: The amount of equity shares in the capital
structure detern
creditworthiness of a company. A company with more
equity share capital rmines the
creditworthiness. eniove

Huge Funds: By issue of equity shares a company can raise a

huge amount
the denomination of equity share is very small. People trom all income of funds Decause
had

in cquity share groups can

capital. So a company can mobilise huge funds from investors e
different income groups. belonu
ngingto
4.10 Demerits/Disadvantages of Equity Shares
There are certain limitations of equity share
capital:
Risk of Fluctuating Return: Equity shareholders sink and swim with the
time of adversity company, At the
equity shareholders have to suffer loss and get no return or very low
reru
Inflexibility (cannot be returned): Equity share is a permanent source of capital. It cannotbe
returned even when it is lyingidle. When there is no of
expansion or growth then the
scope
equity share capital remains idle but it cannot be returned
during the lifetime of the company
3. Legal Formalities: A company has to complete too many legal formalities and has to take
many permissions before issue of equity shares to the general public.
Issue Depends on Market Conditions: The issue of equity share capital
depends upon
market conditions. Equity shares are risky securities so these are demanded during
boom
period only. During recession period people hesitate to invest in equity share capital.

4.2 Preference Shares (0wner's Fund-Long-term Finance)

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

4.2A Features of Preference Shares

The main features of preference shares are:

1. Fixed Rate of Dividend: Preferenceshareholders get a fixed rate of dividend before paying
dividend to equity shareholders.
 223
Chapter:7 Sources of Pusiness Finance
rify:Cornpaniesdo not offer any security against preference shares. The preferenc
is a part of the owner's fund
start
capital capital.
Rights Ihe preserence shareholders do not get voting rights under eneral
es. However, the preterence shareholders get voting rights if the dividends are not
two years or more.
paidfor
sberid Security:
sbrid Preference
Security: Pre shares are called hybrid securities, as these shares have the
ures oí equty Siares as well as features of debentures. Like equity shares, e
haresget dividend. only when company is earning profit and like debentures prerere
icetur
preference
stares get a fzed rate of return.

3Advantage:/Merits of Preference Shares

Help to Collect 1arge Amount of Funds: The preference shares help to collect a huge amount
fund because cautious investors and financial institutions prefer to invest in preference shares
ofa company. Preterence shares attract more public due to fixed rate of return.
No Fixed Liability: Dividend to preference shareholders is paid only when the company 1s
earning proíit. During loss period, there is no fixed liability to pay dividend as in the case ot
Ioans and borrowings.

Interference: The preference shareholders do not carry any voting rights. The presence
No

of preference shares does not diffuse the control of equity shareholders. With
preference
shares in capital structure also, the equity shareholders retain exclusive control over the
company.
No Charge on Assets: Preference shares are not issued against any security. The assets of the
Company remain free to be offered as security for loans andborrowings.

Variety: A company can issue differenttypes ofpreference shares according to the need of
the investors and interest of the company.
Equity: The rate of dividend on preference shares is fixed. Hence, in
.

Trading on vears of
prosperity and more profit equity shareholders enjoyhign rate of earnings with the presence

of preference shares in the capital structure.

Shares
.2 Demerits/Disadvantages of Preference
nere are certain limitations of this
source of finance. These are:

Low Return:The preterencesnarenolders get returnonly when .

. Fluctuating and
is
shares generally low and lesser ompany
is earning profit. The return on preference of
interest on loan. The preference shares do not attract many investors as there is no assured

return.
The dividend paid to prefe
anse: The
as an Expense:
dvidend
preterence
Dividend is Not Treated
It is not deducted from
from
shareholders
deducted shareholders
as an expense. the income of
is not treated the
by the company
income tax.
The company pays income
before calculating
Company shareholders.

which is distributed to
preference
 Part: B Finance&
Trade
224

3. No Voting Rights: The preference shareholders generally do not car-

TY Yoting rigts,.
shareholders have no say in the management. These shareholders getg r i g
holders get voting
any resolution regarding winding up of the company or repaymensng riph
capital. rreduction
eductigtsion or
4. Fixed Obligation: The rate ofdividend paid to preference shareholder
of low also a company has to pay a fixed rate of dividend to its
profit Dun
ixed. Dur
Emuployees' Stock Option means theoption given tothedirectors, oficere reference sharehia
a company or of its holding company or subsidiary company or compan
hcers or empkoye
gives such directors, officers or employees, the benefit or right to purchase,
for, the shares of the company at a fruture date at a pre-determined price.

Difference between Equity Shares and Preference Shares

Point of Difference Equity Shares

Preference Shares
1. Face Value The face value of equity share is generally The face value of
low.
preference share is
generally high.
2. Dividend The dividend is paid to equity Preference shareholders get a
shareholders after paying dividend to all dividend before equity fixedtats
tate of
shares. shareholders
3. Voting Rights Equity shareholders get all the voting No voting rights under normal
rights in a company. conditions
They get voting right when dividend is net
paid for two years.

4. Attraction The equity shares attract bold and The preference shares attract
adventurous investors. conservative investors. cautious and
5. Risk The equity shareholders are the The risk
primary involved in preference shares is
risk bearers of the company. relatively less.
Refund of At the time of winding up the equity At the time of
shareholders are refunded only after
winding up preference shares
capital get priority over equity shares for refund of
preference shares are paid. capital.

Redemption The equity shares are never redeemed Preference shares may be redeemed on ep
or paid back during the lifetime of the
of a fixed period of time or at the option of
company. company.

4.4 Retained Profits Earnings (Owner Fund-Long-term Finance)

Retained profits are also known as
or internal financing, reserves or
ploughing back of profit, retained earnings, sel-n04
surplus.
Retained
earning refers to undistributed profits after payment of dividend and
provides the basis of expansion and growth of t
sOurce of fhnance; since it is
companies. It is considered the most n
internally generated, this method of financing is know
financing
 225
Chapter: 7 Sources of Business Finance

Featreso f
af Retained Earnings
Retai

A urity: The retained

a s h i o no f S e c u r i t

pport in times of
earnings are considered cushion of security because
as a

the'r
rovide
ther sour
adversity, when a
company finds it difficult to arrang
from any

nuls tor
and
Innovative Projects: "The of
andsfor financing risky
and innovative retained earnings are a common source

projects. This fund is used for

generally used
generally tor researd
pansion projects etc.
w
i i a t and and Long term Finance:
of medium-and
Retained profit is considered as an ownership .
es the
purpose
long-term finance.
rsion into OwnershipP Fund: The
surplus retained
earnings can be converted nto
capital by issue or bonus shares. In issue of bonus shares, there is no outflow of cash.
too are efited by the issue of shares free
of cost.
i n v e s t o r s

Merits/Advantages of Retained Earnings

.S8
i source of finance has the following advantages:
fast Dependable Source: As an internal source, this is more dependable than the external
cQurce of finance. The external source depends upon the preference of investors, market
conditions etc.

No Cost: Raising of retained earnings and its use do not involve any cost to be incurred as
there are no expenses on prospectus, advertising etc.

No Fixed Liability: There is no fixed commitment to pay dividend or interest on this source
of fund as retained profits are a company's own money.
No Interference: With retained earning there is no increase in the number ofshareholders.
Retained earnings involve no risk of dilution of control.
assets. The company is free
No Security: Unlike debentures, no charge is created againstthe
to use its assets for raising loans in future.
financial strength and improved credibility of the
Goodwill: Retained earnings add to

company. With large reserves companies

can easily meet all types of untoreseen contingencies
and any other crisis.
Profits
3 Demerits/Disadvantages of Retained
drawbacks:
se etained earnings may result in the following
available easily at no cost. The management of the
dreless use: The retained earnings are interest of the shareholders.
earnings in the best
not always the retained
use investment proposals.
pany may or
undesirable
investing in unprofitable
Lay misuse them by may cause dissatisfaction
retained earnings
Large
Diss ifalarge
Shareholders: amount
dividend
a i s t a c t i o n among
do not receive high rate of
shareholders, as they
gthe equity
in the form ofreserves.
Surplus profit is kept aside
 Part: B Finance
& Trade
226
earnings result in issue of
Large
amount of retained bonus sha
ult in
may result
of
overcapitalis
Over-capitalisation: reserves o
3. capitalisation ar
equity
shareholders.

Imbalanced
Growth:
Frequent
When surplus profits
are not

its
ted
distributed
her growth
further
in
in
growth and.
thecali
the form ofof dividene sao
divit.
4. industry for
results in use

the surplus profit

of profits by
is
the
distributed in the
same

form dividend
of
then the shareholaPansion
of all the comnanay in.
pansion.
resulting in balanced growth ies. ves
companies
money in other
Fund-Long-term)
(0wner
4.4 Global Depository Receipt (GDR),
against issue equity shares in the
of .
Global Depository Receipts
are issued
The equity shares
issued against GDR a ln
GDR are held global m
These are indirect equity offerings. dividend notices, reportsedb
depository. Companies issue etc.
international bank called regat
These shares are called
shares. The
depository holdersof
a bank only.
these
do shares to
not get voting rights. The capital contributed by these shares is in dollars. That is why the

called dollar-denominated instruments. The global depoSitory receipts were introduced

introd by
Citibank in 1990.
Main features of GDR are:
is in foreign currency.
i) Capital collected from the issue of GDR
(i) The issue price of GDR is fixed on the basis of investors' response.

ii) No voting rights are given to holders of GDR.

(iv) GDRs are easily transferable at the stock exchange.
(v) The first Indian company to issue GDRs was Reliance Industries. It sold $150 million w
of GDRs in 1992.

4.5 American Depository Receipt (ADR), (Owner Fund-Long-term)

An ADR is just like a GDR except that it can be issued to a citizen of USA only and itg
be listed in the US stock
exchange.
Shares issued by the company are held
by an internatiom
bank called depository, which receives dividend notices and
reports. ADRs are subject to ma
stricter disclosure
requirements than GDRs because regulations of US stock
exchange are v=
strict. Annual legal and
accounting cost of maintaining an ADR are much higher than GDR
An ADR is an American
dollar-denominated instrument. Any Anmerican bank
as a
depository can issue ADR. functio
4.6 IDR, (0wner Fund-Long-term)
An IDR is also like
GDR except that it is
issued to citizen of India. fores
companies raise funds from Indian market. Through i
The foreign company IDRs will
issues receipts deposit shares
to an Indian ository. The
1ne depo
to
investors in India Depository.
global company to file for an issue ofagainst these shares. Standard Chartered Bank was their
IDR in India.
 Finance
227
Chapter 7 Sources ofBusiness

of Companies
to Issue IDRs
ity
/ l i j g i d i l i t y

The issuing com; mpany must be listed in prohibited to issue

its home country and is not
securities byaany regulatory authority.
as net tangible assets of at least three crores in three years continuously.

) t st have net worth of t one crore in each preceding three years.

ervationsin IDR Issues

the is to be 30% of the issue
lcast 50% ot allocated
issue
At to qualified institutional buyers,
retail individual
the retal individu, investors and balance 20% of the issue to non-institutional investors and

CaseStudies
Anshuman has been successfully running a financial consultancy firm for past five
years. His company has become popular and enjoy good reputation. It has sufficient
reserves of profit accumulated from last five years. He plans now to start branches
in Bangalore and Mumbai also. For expanding business does not want any additional

liability. In the above context:

I. Suggest the source of finance suitable to Anshumaan for expansion.
II Give any two merits and Demerits of thatsource
Ans. I. "Retained Earnings."
Il. Merits and Demerits. (Refer to Page No. 225)

Ping Pong Ltd. is planning to float an issue of equity shares in the market in next
six months. The directors of the company are also ofthe opinion that the company
should raise some portion of funds from International Capital market through
equity.
In context of above case.

(a) State any three merits of raising funds through equity shares.
from International market
(6) Explain the sources through with it can raise funds
through equity.
Ans. (a) Merits of equity shares
Refer to page No. 222.
6) International sources of funds through equity are:
I. GDR
II. ADR
Q.3 has invested in long term investment
ABCLtd. is not having good liquidity position. It
It is not in a position to bear
projects and will get smooth cash flow after five years.
risk of fixed burden of paying interest.
228 Part B Finance & Irade

suitable for this comn.

source of finance is any.
(a) Suggest which are to be kept in mind.
that
risk factors
(b) Suggest other
Share (i) Retained Earning
Ans.(a) (i) Equity
(b) Referto page No. 236

5. BORROWED FUND
Fund-Short-term Finance
5.1 Trade Credit (Borrowed
a
Trade credit refers to an
arrangement whereby manutacturer is gran
etc. Ihe suppliers allow their.
their customerscredit fr
supplier of raw materials, inputs, spare parts to pay
credit Generally the duration of trader
period.
outstanding balance within a credit is thre,
months and thus it is a short-term financing facility.
of tradeecroth
ity of
The availability
credi
(b) Size of the firm dependk
(a) Nature of the firm

(c) Status or creditworthiness of the firm.

5.1A Merits of Trade Credit

1. Readily Available: Trade credit is available without any special efforts on.

manufacturer or trader. part

2. Flexible: There are no rigid rules and regulations involved in trade credit. It Cank
adjusted with the changing needs of purchases as time of payment is generall ad.
view of past dealings.
adjustei
3. No Floatation Cost: No floatation cost is involved in arranging trade credit.

5.18 Limitations ofTrade Credit

1. Increase in Prices: Sometimes, the supplier may increase the price of commodity or
material supplied if he is selling goods on credit.
Legal Action: In trade credit, the buyer generally issues a promissory note and in cae
fails to meet his commitment, the supplier can take legal action.

5.2 Public Deposits (Borrowed Fund-Medium-term Finance)

Public deposits refers to unsecured deposits invited from the
public. A companywihi
invite public deposits places an advertisement in newspapers. Any memberofthe publik an
up the prescribed form and deposit money with the company.

5.2A Features/Characteristics of Public Deposits

1. Unsecured: n gen
Companies mortgage no assets against the public deposits raise
public.
 Chapter: 7 Sources of Business nce2229
rking Capital: The amount raised
from public deposits is generally
tor nmeeting the requirements of ue
shunt
tt term
term tina
nance but
working capital. Though they are a pria
by renewing these can be used for medium-term also.
ither i o
d: Public deposits can be invited by companies for a period of six months to

uiltge'rucdure
l u r e to Raise: Public deposits are simple to raise. A company simply nas io
A Yh e r r
in the
vertisement newspaper. Any member of the public can money
the conyn
any by tilling a prescribed form. The company issues deposit
a deposit receipt in
i the reverse ot the receipt the terms and
conditions
of the deposits are printed.
ment: Acompany which has public deposits is required to set aside 10 per cent of the
Nits aturing by the end ot the year. The amount so set aside can be used for repaying
i e p o s i t s .

. " s
Advantages of Public Deposits
Procedure: lhe procedure for obtaining public deposits is much simpler than equity
ighenture issue. For obtaining public deposits companies do not take permission from
ntroller of capital and there is no need to get listed in any stock exchange market.
conon
omical: Obtaining public deposits involves very less cost. Companies don't need to
end orn prospectus and underwriters commission. There are very few administrative costs

valed in obtaining public deposits. The interest paid on public deposits is less than the
interest paid on debentures and loan.
o Security: Public deposits are unsecured so the assets ofthecompany are free to be used
28mortgage in tuture.

Reduetion in Tax Liability: Interest paid on public deposits is deducted from the total
income of the company. Hence it helps in bringing down the tax liability.
Flevibility: Public deposits can be repaid when they are not required. Therefore public
eposits introduce flexibility in the financial structure of the company.
NoDilution of Control: Public depositors have no voting rights. They cannot influence the
Isions of the company. There is no dilution of shareholders control.

Damerits Disadvantages of Public Deposits

.ISing tinance through public deposits suffers from the following limitations:
i mited Amount: The amount of funds that can be raised by way of public deposits is
C , because of
legal restrictions. Public deposits cannot exceed 25 per cent of share
Capital and free reserves.
ncertainty: Public deposits is an uncertain and unreliable source of hnance. During
depression
has eriod the depositors may not respond. Also, deposits may be withdrawn
ver the financial position of the company is not stable.
 Suitable tor Short term Finance: Aconnpany cannot dlepend ua
ong term requirement as the maturity perlod of
financing
ublie
months to three years
Hindrance te Growth of Capital Market: P'ubic deposits hamper t.
market in the country Widespread use of publ
the pruwilh
apital ublic deposits
Teates a *A
industrial securities.
Not Suitable for New Concerns: New companies do not have enoua
market. The advertisenments given by new companies do not attract n
tract many people yunlwl
money in their public deposits.
. Suitable tor Conservative Investors only: Public deposits doho
do not
atventurous investors who want capital gains. Only cautious and atlract
nd con
conservalivebobull
preter to invest in public deposits.
wwwt
5.3 Debentures Bonds (Borrowed Fund Long-term Source of Finance)

Detinition of a Debenture includes debenture stock, bonds or any oth

company evidencing a debt, whether constituting a charge on the assets of the com
instr
Debentures are common securities issued under borrowed fund
instruments for raising long-term debt capital. Debentures are calle
capital. Deber
lled creditorship ures ar
because debenture holders are called creditors of a company. securiti-
A debenture can
be defined as "a document or a certihcate issued by a
companw s
seal as an
acknowledgement of its debt. Holder of debenture certiicate is called under
debentid
sholler
5.3A Features/Characteristies of Debentures

1. Borrowed Fund: Debentures are fund as

part of borrowed capital debenture- holder s-
considered as the creditors of the company.
Fixed Rate of Interest: The interest on debentures is paid at a fixed rate. The
rate of inter=
is decided in the annual general meting of the company.
Compulsory Payment of lnterest: Payment of regular and fixed rate of interest isal
obligation ofthe company. Company has to pay interest to its debenture-holders irespotr
of its profit-earning capacity.
Security: Most of the time debentures are issued against the charge
ofsomefixed asete
the company.
Redeemable: Debentures are always redeemed or paid back on expiry ofa fixed period oftima
6. No Voting Rights: Debentureholders have no say in the management as they are ntt

granted voting rights in the company.

Appointent of Trustee: When a large number of debentures are sold to thegener puia
n
then usually a trustee is appointed. Trustee can be a bank or a financial insttu
ons
trustee is appointed to ensure that the borrowing firm fulfils its contractual oblg
 Chapter.7 Gores of F
231
,antagesofbebentures

ery common ana popular securities issued by the company due t i

the

cost of raising debentures is less than the cost of raising preference shares
cOst of
:
lhe
cheaper source of finance
I t is aa chean
H 1s
yshatS

u i o ofl C Control: Debenture holders do not

get any voting rights. Ihey are i
atticipate in ecision-makingso debenture
financing does not result in dilution
dio shareholders,
cquity
tiolof
ge
LargeNumber
Number of Investors: The company offers a fixedrate ofinterest on debentures

efurn appeals and attracts many investors to invest in debentures. Hence the company
ixedretur

large amount
of funds by issue of debentures.
oilect a

Treated as an Expense: The interest paid to debentureholders is considered as an

,enseofth
afthe company. Interestis deducted from the total income of the company betore
income
tax. So the liability of tax reduces.
ulating
much is
Interest: The earning rate of the company by utilising debenture fund
Rateof
Lr than the rate of interest offered to debentureholders. As a result, equity shareholders
more
with the presence of debentures in the capital structure.
arn

the funds raised debentures when it does not

ihility: A company can repay through
of debentures
auire
aquire
it any more. The danger overcapitalisation gets minimised because
redeemed out of profit.
rn be

merits/Disadvantages of Debentures

are:
nitations of debentures
whether it
Fived Obligation: Payment of interest is a fixed commitment ofthe organisation of interest
s earning profit or not. Sometimes companies
have to borrow fund for payment
to debenture-holders.

in
hesitate to lend funds in the
Peduction Credibility: Financial institutions and lenders
credit-worthiness of a company which has
oImpanies having more of debentures. The
aed a large number of debentures is low.
on
securities of fixed assets. During
rge Assets: Usually debentures are issued against
e of depression,if a company is unable to pay the regular
amount ofinterest and finds
ne debenture-holders can have claim over
to repay the anmount, in this situation the
Clt
hie assets
of the
company.
allowed to vote in the management of
he
ng Rights: The debenture-holders are not are taken by the equity
All the decisions regarding interest rate for debentures
any.
1olders only. Therefore, they remain at the mercy of equity shareholders.
 232 Part: B Finance & Trade

Shares and Debentures

between
Difference

Point of Difference
Shares Debentures
considered as
a part of owner's
pebentures are part of
borrowet
Shares are
Nature
fund find
a r e known
as owners of the Debentureholders are known.
SharehoBders of the company.
Known as/status
Companv.
crocto
rights Debenturehold do not get
get voting
Voting rights
Sharehoders
voting rn
The control of the
company
lies in the Debentureholders
the affairs of the
have no
control
Contro
hands of equity
shareholders
company.
Right to return Equity
shareholders have n o right to get Debentureholders have legal right
regular amount of interest even t
in c a s e of loss.
regular return
company is not earning profit when
mortgaged
company a r e
Company has to mortgage some of
No assets of the
Security issue of shares. its assets as a security against
as security against
the the
debentures.

redeemable preference shares no Debentures are generally redeemed

Redemption Except expiry ofa fixed period of time. n
other shares a r e redeemable. They are paid
back at the time of winding up only, after
claimants.
settlingthe claim of all the

There is minimum risk in case of

8. Risk Shareholders are the primary risk bearers
debentures.
of the company.

5.4 Commercial Banks (Borrowed Fund-Short & Medium-term Finance)

Commercial banks occupy a very important position as they provide funds for differe
purposes and different periods. Firms of all sizes can approach commercial banks. Generaly
commercial banks provide short-term and medium-term loans but nowadays they have started
giving long-term loans against security

5.4A Merits of Commercial Banks

1. Banks provide funds to firms as and when required.
2. The banks keep the information of borrower confidential and the business can maintain its
secrecy.
3. No formalities of issue of prospectus etc. are required. So it is very easy and economical
source of funds.
4. It is a very flexible source as loan amount can be increased as well as decreased.

5.4B Limitations of Commercial Banks

1. Funds are generally available for a short period.
2. Banks make detailed
issue of loan.
investigation of the company's affairs and financial structure before
3. In some cases, banks may put restrictions and difficult terms and conditions.
 Chapter: 7 Sources of Business Finance3

Difference between Public Deposits and Loan from Commercial Banks

Public Deposits Loan from Commercial Banks

B a s i s

No security required. Bank loans generally require security.

S e c u r i t y

Public deposits are governed by the Bank loans are governed by rules and
Governedby
provisions of Companies Act. regulations of RBI.

Rate of interest of public deposits is Rate of interest of loans from commercial

Rate of
comparatively low. bank is comparatively higher.
I n t e r e s t

Public deposits are available for a period of Bank deposits are available for short and
Period

upto 3 years. medium term.

Suitable source of finance for companies Suitable for all enterprises

Suitability
5 with good reputation and financial
standing.
maintained.
There is no secrecy. Secrecy about bank loan can be
Secrecy

Financial institutions (Borrowed Fund-Long-term)

5 an from
banks or
institutions are referred to as lending institutions, development
Public financial realised that for economic
institutions. After Independence, the government of India
ancial
hnand must be financial
are not sufficient. There
of a country only commercial banks
development industries and business enterprises.
financial assistance and guidance to
institutions to provide
financial institutions was felt due to the following
reasons:

The need for public

Institutions
5.5A Merits of Financial finance.
I.Long-term
Finance: Financialinstitutions providelong-term advice on
as well as financial
Financial institutions provide managerial
Managerial Advice:

various matters.

Finance: Public financial

institutions provide medium and long-
Medium and Long-term
at a reasonable rate of interest.
term finance to industrial enterprise
institutions often
subscribe to theshares and debentures
4.Subscrilbers ofSecurities:Financial

of companies. issue of shares and debentures

.Underwriters: Financial institutions
underwrite thepublic

by companies. guarantees to
industrial units from
Financial institutions provide loan
6. Guarantee Loan:
institutions.
and financial
other banks foreign currency to import
in
Financialinstitutions proVide loan
Loan in Foreign Currency: also for purchase of capital goods from
institutions provide guarantee
machinery. These
foreign countries.
234 Part: B Finance& Trade
5.58 Limitations of Financial Institutions
1. Too many formalities have to be fulfilled for taking loans from
from financial
financial :institutions
2. They may put certain restrictions such as restrictions on dividend pay
3. Sometimes financial institutions appoint their nominees as Board of
of Direcs. yment etc.
Directors to
powers of a company.
estid
5.6 Inter-corporate Deposits (ICD) (Borrowed Fund-Short-term Source of Finaneo
ance
It is the deposits made by one company with another company. This option
is available to all public companies whether having share capital or not. It includec using finan
1. When a company acquires security ofanother company
2. When a company gives loan to another company
3. When a company gives guarantee to any person or institution who provides loant.
to a
company. In general, we can say when companies arrange funds from another com
other company it
known as Inter-corporate Deposits.
There are three types of Inter-corporate Deposits:
1. Three Months' Deposits: This is the most common deposits to overcome the
finance problem. The annual rate of interest given for three months' deposits isshort-ter
2% p.
2. Six Months' Deposits: These are made with fhirst class borrowers. The annualinte
rate is 15%.
intere-
3. Call Deposits: This can be withdrawm by lender by giving one-day notice. The rae
interest is 10%.
The biggest advantage of ICD is that transactions are free from legal and bureaucrat
hassles.
Merits of ICD
1. Secrecy: The broker in this market never reveal their list of lenders and borrowers.
2. These deposits are suitable for borrowing company to solve their short term fund
problems immediately.
3. Free from Bureaucratic and legal problems.
Demerits
1. Not suitable for Long Term.
2. High Risk as ICD are unsecured deposits.
3. High rate of Interest than Bank.
 Chapter:7 Sources of Business Finance 2
Sudies edaa small sweet shop in Delhi under the name 'Mithai Wala. Over the |
smal
started
H i n a husiness grew
er business grewmanifold by the word of month. Recently she procured a big|
yea det, Although the exporter has promised to make some advance payments, |
esawill still need some more funds to meet the working capital requirement.
e x p o
butHina will
Suggest
any t
two source through which Hina can raise funds to meet working|
I. capital requirement.
Give two
merits of eachof suggested source.
sources suggested are
Two
1. Trade Credit
from commercial bank
2. Loan
of Trade Credit.
II. Merits
228.
Refer to Page No.
Commercial Banks
Merits of
Refer to Page No. 232.
view the
is a popular film entertainment company. Keeping in
a2. Enjoy Entertainment its owners have decided to make some changes in the
growing culture of multiplex, effective sound system etc. The|
area, installing more
interiors like creatingalounge than one year but less
raise the required fund fora period of more
companywants to
than five years.
In context of above
case.
the types of funds company seek
to raise on the basis of
I. Identify and explain
Time period.
and demerits of that source.
II. Give any two merits
Ans. I. Public Deposits
II. Merits of Public Deposits (Refer to Page No. 229)
Demerits of Public Deposits. (Refer
to Page No. 229)
of
and also state one merit for each
in the following cases
Q.3. Identify sources of finance
the following:
source of capital.
(a) It is a permanent
without making immediate payment.
(b) It facilitates purchase of goods
irrespective
()This source puts permanent
obligation on the company topayinterest
of profits. have the status of owners.
Their holders do not enjoy voting
rights though they
(d) (b) Trade Credit.
Ans. (a) Equity Capital.
(d) Preference Shares.
(c) Debenture.
236 Part: B Finance & Trade

6. FACTORS KEPT IN MIND BEFORE SELECTING A SUITABLE SOU

OF BUSINESS FINANCE
from imitations so we car
is free cannot say
No source
of business finance nnance to meet fin-
source or
deciding the nancial requiwhichremejs
Source of finance. Before tactors:

must
mind the following
Dusinessman keep in
source ot hnance, thecomDar
Involved: Betore finalising any n
find o
I Cost cost using the funde
of funds and invoved ooh the
involved in procurement using that sourceoffunde
benetit which they get by
be less than the
is
fhinancially it sound then
Firm:
Financial
of the Dav
Capacity borrowed can easily
lfthehrm fund andd can
easily pay ththe may preter bo
to repay
the interesta
fund as it will be able must depend upon the owner s fund sec amou
stable then it
if the firm is not financially
firm
rm and
and partner
Sole proprietorship partnership t
Business Organisation: have to depend uno
3. Form of d e b e n t u r e s . They upon
raise fund issue ofshares or factoring te
by stock companies prefer issue sharee
es aand
trade credit etc. whereas joint debenhe
loan,
raise funds.
the source
factor which heips in deciding offunds is thed duratio
Time Period: Another trade credit, factoring, short
as for a short period
which the firm requires funds suitable, for a nu
shares, debentures are
a long-term medium
etc. are suitable whereas for
are suitable.
public deposits, loans
risk whereas borrowed fiud
fund securities involve no
Owners Stcur
5. Risk Involved:
business firm can bear
the risk then only it should eo fork
are risky
securities. If a
owners fund securities.
fund otherwise it should prefer
real owners ast
are considered as the of the business he
6. Control: Equity shareholders shareholders do not want to l
the business. If existing equity
complete control over shares to reuse additional capital as t
more equity
control, then they must not issue
result in dilution of control.
financial institutions which provide long-term debt to comu
7. Flexibility: Sometimes the
on the companies which
restricts the flexibility of the compa
put certain restrictions
firms don't prefer loans from financial instiuti
if other options are easily available then
and banks which put restrictions.
8. Claim over the Assets: Some sources of finance mortgage the assets of the firms and r.
suit-
its creditworthiness. For example, debentures, secured loan. Whereas some sources
shares, unsecured loan etc. do not put claim over the assets, hence result in no reductora
creditworthiness.
9. Tax Benefits: Interest on debentures, loan is deducted from the total income ofthecomi
dedut
before calculating income tax whereas dividend paid to equity shareholders is not ac
iebentura

from the total income. So if a firm wants to get tax benefit it should issue dr

preference shares, loans, public deposits etc.