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Chapter 8 Sources of Business Finance - 1.6
Chapter 8 Sources of Business Finance - 1.6
Chapter 8 Sources of Business Finance - 1.6
1. Long Term Finance (Fixed capital) – It refers to the funds raised for a long period,
(minimum 5 Years) and it is used for investment in fixed assets which required for
permanent needs of the business. Usually, long term finance is raised from
shareholders, debenture holders, financial institutions, retained earnings etc.
2. Medium term finance – It is used for the modernization and expansion of business,
usually it is raised for a period of 1 to 5 years. It is also raised from the debenture
holders, financial institutions, commercial banks, public deposits etc.
3. Short term finance – It is raised for a period of less than a year and is used for meeting
the short term needs of the business such as investment in working capital. E.g.
purchase of materials, payment of wages and salaries, rent etc.
Features
a. Risk capital – all the risk with regard to the enterprise lies on the shoulders of the owners
and hence their capital bears all the risks.
b. It is a permanent source of capital to the business.
c. No security is required.
d. It provides the right to manage and control the business.
2. Borrowed Funds
It refers to the funds raised through loans or borrowings. It may be from the debenture holders,
or from public deposits, financial institutions, commercial banks etc.
Features
a. Raised for a fixed period.
b. Fixed interest rate to be paid even if there is loss.
c. Charge on assets.
d. No sharing of control in management.
Choice of Source of Finance – A business can raise funds from various sources by way of
issue of shares, retained earnings, issue of debentures, loans from financial institutions and
commercial banks, public deposits etc. Each of them are having its own merits and demerits,
the entrepreneurs have to take decisions regarding their choice based on their situation and
purpose.
Merits
1. It is more dependable than external sources.
2. No dividend is to be paid.
3. No cost of raising funds such as prospectus, advertisement etc.
4. No sharing of ownership and control.
5. No security is needed.
6. It makes companies financially strong.
Limitations
1. It may result in overcapitalization.
2. It may create dissatisfaction among the share holders.
3. Not dependable in the year of inadequate profit.
4. Ignores opportunity cost.
Trade Credit – It is the credit extended by one trader to another for the purchase of goods and
services. When creditors grant such a facility, they are in fact financing purchases for a short
period.
Merits
1. Convenient source of financing.
2. Readily available.
3. Increased sales.
4. Helps in maintaining higher inventory level.
5. No charge on the assets.
Limitations
1. Chances of overtrading – bulk trading than required.
2. Limited funds can only be generated.
3. Higher cost – by charging high price.
Debt collection and credit management is a tedious (difficult) process for the organization and it
will take a long period of time. In such a case this duty may be entrusted to an agency called
Factoring Organizations who are specialized in collection and administration of debts.
They extend financial assistance (advance) against book debts and provide full protection
against any bad debt. Factors do this service in return for a factoring commission and interest
on advance granted.
Lease Financing – Now a days it has been treated as an important source of long term
financing. It is an arrangement under which a company acquires the right to use an asset
without holding its title.
The owner of the asset is called lessor and the user is lessee. The lessee has to pay the
lease rent to the lessor for the use of the asset. At the end of the lease agreement the asset
reverts to the lessor, who is the legal owner of the asset.
Merits
1. It enables the lessee to acquire the assets with a very little investment.
2. Limited formalities only.
3. Lease rent is a charge against profit, hence the tax liability is reduced.
4. It provides finance without sharing the ownership.
5. The risk of obsolescence on the shoulders of the owner of the asset.
Limitations
1. Restrictions on the use of asset.
2. Normal business operations may be affected on non-renewal of agreement.
3. If the lease agreement is terminated before maturity, it results in heavy loss.
4. Lessee may not take much care on the asset as he never becomes the owner.
Public Deposits – It can also be treated as medium term finance, by which the companies may
try to invite deposits from public at a higher rate of interest than the commercial banks. They
are issued for a period up to 3 years. The acceptance of public deposits by companies is
regulated by the RBI.
Merits
1. Less formality.
2. No security is given by the company.
3. No sharing of control.
4. No charge on assets.
Limitations
1. Not easy for a new company – Only the company with proven track record will get good
response.
2. Unreliable source – Poor response from investors.
3. Limited funds – Raising large fund is not possible.
Merits
1. No restrictive conditions – Since it is unsecured it has no restrictive conditions.
2. High liquidity – Freely transferable.
3. Economical – Cost of raising fund is cheaper than a bank loan.
4. Continuous source – Repayment of a CP can be made by issuing new CPs.
5. Investment of excess funds – Companies can keep their excess funds in CPs to earn
more returns.
Limitations
1. Only sound firms can issue.
2. Limited funds can be raised.
3. Impersonal financing – Extension of maturity period is not possible in case of difficulties.
Issue of Shares
The capital of a company is divided into a large number of equal parts or units. Each such unit
is called a share. In other words share is the share in the share capital of a company. The
aggregate value of shares is known as share capital.
Those who subscribe to the share capital become the members of the company and are called
share holders and they are getting the status of owners in the company. Hence shares are also
described as ownership securities. Two types of shares are issued by companies to raise its
capital such as Equity shares and Preference Shares.
a. Equity Shares (Ordinary shares) – Equity shares are those shares which do not carry any
special or preferential rights in payment of dividend or repayment of capital. Equity share
holders are the risk bearers as well as the real owners as they are entitled to receive any
money only after the payment of all other debts. The amount raised by the issue of equity
shares is known as equity share capital.
Merits
1. Suitable for risk takers.
2. No obligation for dividend.
3. Permanent capital.
4. Provides creditworthiness to the company.
5. No charge against assets.
6. They have voting rights – Companies follow democratic management.
Limitations
1. Income is not steady – Fluctuation in dividend based on profit.
2. High cost – Cost of raising equity capital is very high.
3. Dilution in control for existing share holders when the company makes fresh issues.
4. Complex legal formalities – for the issue of shares.
Merits
1. Fixed rate of return is guaranteed.
2. Preference in repayment of capital on winding up
3. No dilution in control – they have only restricted voting rights.
4. Trading on equity – Equity shareholders enjoys more return in good times.
5. No charge over the assets.
6. Economical – Cost of raising preference share capital is cheaper than equity capital.
Demerits
1. Not suitable for high risk takers – The return on investment is fixed.
2. Dilutes claim on assets – The claim on assets in the company should be shared with
preference shareholders also.
3. High rate of dividend – Normally preference share capital bears high rate of dividend
than the interest rate of debentures.
4. It may not attract many investors – The return on investment is not assured, but it is paid
only if there is profit.
5. No tax benefits – Dividend on preference shares is not a charge against profit.
1. Cumulative Preference Shares – They have the right to enjoy unpaid dividend (in the
year of loss or inadequate profit) in future years.
2. Non-cumulative Preference shares – Unpaid dividend is not carried forward to the
subsequent years.
3. Participating Preference Shares – Usual dividend at fixed rate and share in surplus
profit of the company.
4. Non-participating Preference Shares – No right to share surplus profit, fixed dividend
only.
5. Convertible Preference Shares – These shares can be converted into equity shares
after a particular period.
6. Non-convertible Preference Shares – No right to be converted into equity shares.
Note: As per Indian Companies Act 2013, all preference shares issued by Indian Companies
must be redeemed within 20 years.
Issue of Debentures
Merits
1. Fixed income at lesser risk – Suitable to conservative investors who are not willing to
take much risk.
2. No participation in profit – Debentures are fixed interest bearing securities.
3. No dilution in control – Debenture holders have no voting rights.
4. Suitable during stable earnings – If the sales and profits are stable, it is better to raise
funds through issue of debentures.
5. Less costly – Debenture financing is relatively cheaper than other sources.
Limitations
1. Permanent burden - Interest is to be paid even if there is no profit.
2. Repayment difficulty – Company has to accumulate enough funds for the repayment
of debentures on redemption even if on financial difficulties.
3. Reduces borrowing capacity – As debenture itself is a debt for the company, they
cannot raise additional funds by borrowings.
Types of Debentures
Commercial Banks – Banks extend loans to firms in many ways like cash credit, overdraft,
term loans etc. Rate of interest depends on factors like nature of business, interest rate
prevailing in the country etc. Usually loans are allowed on the basis of securities and they are
repayable either in lump sum or by installments.
Merits
1. Timely assistance – Banks provide timely help by providing funds as and when needed.
2. Secrecy – Information furnished to the bank by the borrower is kept confidential.
3. Less formalities – Formalities like issue of prospectus etc. not required.
4. Flexible – The loan amount can be increased or decreased or even repaid whenever
required.
Limitations
1. Meeting short term needs only – Most of the bank loans are short period in nature. It’s
extension or renewal is uncertain.
Loans from Financial Institutions - A number of financial institutions have been set up by
government with the main object of promoting long tern industrial finance. As they aim at
promoting industrial development, they are also called “development banks”. They are not only
providing financial assistance, but conducting market surveys, providing technical and
managerial services etc.
Merits
1. Long term finance – They provide long term finance, which is not provided by
commercial banks.
2. Additional services – They are also conducting market surveys, providing managerial
and technical services etc.
3. Increases goodwill of the company – Obtaining funds from these financial institutions
often increased the reputation of the firm.
4. Easy repayments – It reduces burden for the business.
5. Reliable source – Funds are available even during depression, when other sources are
not available.
Limitations
1. Complicated formalities – Rigid formalities in obtaining loans makes the procedure time
consuming and expensive.
2. Imposing restrictions – Restrictions on dividend payments may be imposed.
3. Interference in management – Financial institutions may have their nominees in director
board of the company.
International Financing
Indian companies have an access to funds in global capital market. Various international
sources from where funds may be generated include:
1. Commercial Banks: CBs all over the world extend foreign currency loans for business
purposes. Eg: Standard Chartered Bank, City Bank etc.
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