THE NEW INDIAN SCHOOL W.L.

L
KINGDOM OF BAHRAIN
CLASS: XI BUSINESS STUDIES
CHAPTER 8 – SOURCES OF BUSINESS FINANCE
NOTES
The funds required by Business to carry out its various activities is called Business finance.
Learning objective
 Understand the meaning of finance with its significance
 Financial requirements of business
 Classification of sources of finance
 On the basis of duration
 On the basis of ownership
 On the basis of source of generation
 Sources of funds with its merits and limitation
 International sources of fund

Finance is an essential factor of business, as it is needed for systematic operation of production process in
any company. Finance not only makes production possible but it also has an important place in the
distribution process that facilitates consumption. Every process of business is related to finance in some
or the other way. Availability of finance decides the form and size of business.

Importance of Business finance

 Finance is called the lifeblood of any business
 The need for funds arise from the point when an entrepreneur decides to start a business
 Some funds are also required for meeting day to day business operations like purchasing raw
materials paying salaries to employee’s bills and so on.
 Moreover funds are needed for the expansion and diversification of business

Types of financial needs of business

Fixed capital requirement:
Fixed capital means a capital that is invested in purchasing of those fixed assets which are used for a
longer period in business eg. building and plant and machinery furniture etc.

Working capital requirement :

Funds required for day-to-day operations of business is called working capital. It is used for holding
current assets like stock, cash, bills receivable and for meeting expenses like salaries, wages etc. The
amount of working capital required in a business depends on the nature of business, scale of operation,
production cycle, terms of buying etc.

Classification sources of finance (Diagram –Refer text book)

I. Duration basis
On the basis of period for which finance is raised it can be classified into long term sources medium term
sources and short term sources
Long term sources
Finance raised from long-term source is available for more than 5 years in a business enterprise.
It can raised by issuing equity shares, preference shares, loans from financial institutions, retained
earnings etc.
Medium term sources
When finance is raised for more than one year but less than five years, it is called medium term sources of
finance. The sources include public deposits, loans from banks etc.
Short term sources
Finance raised for less than one year to meet day-to-day operations of business is known as short-term
sources of finance. It can be raised from overdraft, cash credit, trade credit etc.

II. Ownership basis

On the basis of ownership business finance can be classified as owners fund and borrowed funds.
Owners fund
It is invested by the owners of business. In case of companies, it represents equity shares and retained or
undistributed profit of previous years belonging to the owners. Owners fund remain invested in business
for longer periods and hence it is utilised for acquiring fixed assets.
Borrowed funds
It represents that part of capital which is borrowed from outsiders. Debentures, loans from financial
institutions, public deposits are the various sources through which funds can be borrowed.
III. Generation basis
Business finance can also be classified on the basis of source of generation
Internal sources
A business may generate funds internally by accelerating collection of receivables, disposing of surplus
and accumulated profits in the form of retained earnings. The sources can fulfill only limited needs of the
business.
External sources
It includes those sources which lie outside the organisations such as suppliers, lenders and investors.
External funds are normally costlier as compared to funds which are internally generated. Issue of
debentures, term loans from financial institutions, public deposits are some of the examples of external
sources of funds commonly available to a business organisation

TYPES OF SOURCES OF BUSINESS FINANCE

1.Retained earnings
A portion of net profits which is not distributed among the shareholders but retained as reserves or re-
investment is known as retained earnings. It is a source of internal financing and also known as self-
financing or ploughing back of profit
2.Trade credit
The credit extended by one trader to another in order to facilitate the purchase of goods and services is
known as trade credit. It facilitates the buyer to purchase goods on credit for which they can make
payment on some future date. Period of trade credit differs from person to person and depends on the
reputation of the purchasing firm, financial position of the seller, past records of payments, frequency of
buying and volume of purchase etc.
3.Public deposits
Public deposits are considered to be an important source of finance to fulfill the requirement of short-term
and medium term capital needs. Under this method, public is invited to deposit their savings with the
company. The company at the time of accepting deposits issues a receipt specifying amount of loan
received, rate of interest, date of payment etc. The company offers higher rates of interest on public
deposits in comparison to that offered on bank deposits to attract the investor's.

4.Issue of shares
The part of capital raised from the owners of the company is known as share capital and hence owners are
known as shareholders. Share capital is divided into smaller units called shares.
Company can issue two types of shares Equity shares and Preference shares. The funds raised by issue of
equity shares is known as equity share capital and the funds raised by issue of preference shares is known
as preference share capital.
Equity shares
Equity shares is the most important source of finance in case of company form of business. Funds raised
through issue of equity shares is known as equity share capital. It represents the owner’s capital. Equity
shareholders are the real owners of the company. Return on equity shareholders is known as dividend and
it varies with the earning of the company. Equity shareholders are also known as residual owners as they
get dividend only after interest is paid on loans and tax is paid to government. Equity shareholders enjoy
voting rights through which they participate in the management. Liability of equity shareholders is limited
to the extent of capital contributed by them in the company.

Preference shares
Preference shares is another important source of business finance. Capital raised through issue of
preference shares is known as preference share capital. Preference shareholders have preferential rights
over equity shareholders.
 They get preference over equity shareholders at the time of distribution of dividend.
 Preference share capital is paid back before equity share capital at the time of liquidation of
company.
Preference shares have features of both equity shares as well as debentures. They resemble debentures as
they get fixed rate of return like them. As dividend is paid only at the discretion of directors and only out
of profit these shares resemble equity shares. Unlike equity shares preference shareholders normally do
not enjoy any voting rights.
5.Debentures
Debentures is defined as an acknowledgement of debt by a company i.e. company acknowledges that it
has borrowed a certain sum of money which is to be repaid after specified period along with the periodical
interest payment. Debentures are also known as creditorship securities as the debenture holders are the
creditors of the company. Debentures are one of the main instruments of a company for raising long-term
debt capital. Debentures carry a fixed rate of interest regardless of the profits of the company.
6.Commercial banks
Commercial banks are considered an important source of finance because they provide funds for different
purposes as well as time periods. The business firms raise funds in many ways like cash credit, overdraft,
term loans, purchase or discounting of bills issue of letter of credit etc. Normally commercial banks offer
funds for short or medium term. Usually a loan is sanctioned by a commercial bank against the security of
assets. Enterprise have an option to repay the loan in lump sum or in instalments.

7.Financial Institutions
Financial institutions have been set up by the government all over the country to provide finance to
business enterprise. These institutions are established by the central or state governments. They are also
known as Development Banks as they aim at promoting the industrial development of a country.
Financial institutions also conduct market survey and provide technical assistance and managerial services
to the enterprise besides providing financial assistance to them. These institutions are considered to be
most suitable for meeting expansion, reorganisation and modernisation needs of an enterprise.

8.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

Difference between owners fund & borrowed fund

Basis Owners fund Borrowed fund

Concept Funds provided by owners of an Funds raised through
enterprise loans or borrowings
Duration Remains invested in business for a Have to be repaid after
longer period. expiry of certain period.
Control in Remains in the hands of owners Lenders do not have
management voting rights in business.
Stability of Returns fluctuate with earnings of the Return is fixed & do not
earnings company fluctuate with earnings of
the company
Tax Returns on owners fund is not tax Return on borrowed is tax
deductible deductible deductible
Obligation Not compulsory to pay return on Fixed interest is paid
owners fund