Sources of Business Finance – Complete Guide For Class 11 Business Studies Chapter 8

Our learning resources for Class 11th Business Studies Chapter 8 – Sources of Business Finance are designed to ensure that you grasp this concept with clarity and perfection. Whether you’re studying for an upcoming exam or strengthening your concepts, our engaging animated videos, practice questions and notes offer you the best of integrated learning with interesting explanations and examples. 

With our meticulously crafted materials for Class 11th Business Studies Chapter 8 – Sources of Business Finance, you can confidently navigate through complex topics such as equity shares, debentures, loans, and other sources of finance. The iPrep Learning Super App provides interactive simulations and real-life case studies to deepen your understanding and application of these financial concepts. By integrating theoretical knowledge with practical insights, we aim to make learning not just informative but also enjoyable and impactful. Dive into our comprehensive resources and master the essentials of business finance effortlessly. So let’s start with understanding what exactly is business finance.

When starting your own business or expanding an existing one, funds or finances will likely be needed. Thus, finance is called the lifeblood of any business.

Meaning of Business Finance

Business finance refers to the requirement of funds by business units to carry on various activities. According to B.O. Wheeler, “Finance is that business activity which is concerned with the acquisition and conservation of capital fund in meeting the financial needs and overall objectives of a business enterprise.”

Significance of Business Finance

Business finance is essential to:

• Procure fixed assets.
• Meet daily expenses.
• Meet working capital requirements.
• Finance growth and expansion projects of the company.

Categories of Financial Needs

Businesses generally need finance to meet the following requirements:

Classification of Sources of Finance

Based on Period

Long-term Sources of Finance:

• Fulfill the requirements of an enterprise for more than 5 years.
• Used for acquiring fixed assets like land, buildings, machinery, furniture, etc.
• Include shares, debentures, long-term borrowings, etc.

Medium-term Sources of Finance:

• Required for more than one year but less than five years.
• Including borrowings from commercial banks, public deposits, lease financing, and loans from financial institutions.

Short-term Sources of Finance:

• Required for less than one year.
• Including trade credit, loans from commercial banks, commercial papers, etc.
• A common source of financing current assets such as inventories, cash, etc.

Based on Ownership

Owner’s Funds

• Provided by owners of an enterprise like a sole trader or partners or shareholders of a company.
• Invested in the business for a longer duration.
• Include profits reinvested in the business.
• Not refundable during the life period of the business.

Borrowed Funds

• Fixed rate of interest.
• Raised for a specific period and have to be repaid after the expiry of that period.
• Include loans from commercial banks, loans from financial institutions, debentures, etc.

Based on Source of Generation

Internal Sources of Funds:

• Generated from within the business.
• Fulfills only limited needs of the business.
• Including the collection of receivables, plowing back of profits, etc.

External Sources of Funds:

• Raised when a large amount of money is required.
• May be costly compared to internal sources of funds.
• Including debentures, borrowing from commercial banks, public deposits, etc.

Sources of Finance

Retained Earnings

• Include undistributed profits after payment of dividends and taxes.
• Basis of expansion and growth of companies.
• Part of ownership funds.
• Serve the purpose of medium and long-term finance.

Merits:

• A permanent source of funds.
• Provides support in times of adversity.
• Does not involve any cost in the form of interest, dividend, or floatation cost.
• A greater degree of operational freedom and flexibility.

Demerits:

• Large retained earnings may cause dissatisfaction amongst shareholders as they would get lower dividends.
• Uncertain source of funds.
• Management may misuse these funds by investing in unprofitable investment proposals.

Trade Credit

• Credit extended by one trader to another for the purchase of goods and services.
• Facilitates the purchase of supplies without immediate payment.
• Source of short-term financing generally for the period of 3 to 6 months.

Merits:

• Convenient and continuous source of funds.
• Readily available in case the creditworthiness of the customers is known to the seller.
• Does not create any charge on the assets of the firm.
• Involves no floatation cost.

Demerits:

• Supplier may increase the price of the commodity or raw material supplied if he is selling goods on credit.
• A limited amount of funds can be generated.
• Costly source of funds as compared to most other sources.
• This may induce a firm to indulge in overtrading.

Factoring

Factoring is a financial service under which the ‘factor’ renders various services including:

• Discounting of bills of exchange: The supplier generally draws bills of exchange upon customers in case of credit sales. Customers are required to accept the bill. Instead of holding the bill with himself, the supplier gets it encashed before the maturity date from the bank (factor). The factor becomes responsible for all credit control and debt collection from the buyers.
• Provides information about the creditworthiness of prospective clients. Factors hold large amounts of information about the trading history of the firms. This information can be used by the financier for lending money to these firms. Factors offer relevant consultancy services in the areas of finance, marketing, etc. They charge fees for the services rendered.

Merits:

• Cheaper than any other source of finance like bank credit.
• Clients can meet their financial commitments on time.
• No claim over the assets of the company.
• Provides security for a debt that a firm might otherwise be unable to obtain.

Demerits:

• Expensive when the invoices are numerous and smaller in amount.
• Factors generally charge a higher rate of interest.
• The factor is a third party between the customer and the company; the customer may not like it.

Lease Financing

Lease: Contract between lessor and lessee. The lessor is the owner of the assets and the lessee hires the assets by paying rent. The lessee can use the assets without investing a high amount of funds to buy them. The asset goes back to the lessor at the end of the lease period.

Merits:

• Enables the lessee to acquire the asset with a lower investment.
• Not much of legal formalities are required.
• Lease rent is deducted from the income of the lessee for computing taxable profits.
• Provides finance without diluting the ownership of the business.

Demerits:

• The lessor may put certain restrictions on the use of the assets.
• The lessee never becomes the owner of the assets.
• Business operations may get affected if the lessor terminates the agreement before the maturity date.

Public Deposits

• Unsecured credit invited from the public.
• Interest rates offered on public deposits are usually higher than those offered on bank deposits.
• Suitable for both short-term and long-term financial requirements of a company.
• Taken by a company for a period of 6 months to 3 years.

Merits:

• Obtaining procedure is simpler than equity and debenture issues.
• No requirement of security.
• Lower cost compared to borrowings from banks.
• Control of the company is not diluted.

Demerits:

• New companies face difficulty in raising money through it.
• Unreliable source of finance as the public may not respond when the company needs money.
• Creates limitations on the amount of money as it should not exceed 25% of share capital and free reserves.

Commercial Paper (CP)

• Introduced in 1990.
• Issued by one firm to other firms, insurance companies, pension funds, and banks.
• Unsecured promissory note to raise funds for a short period.
• The fixed maturity period varies from 3 to 12 months.

Merits:

• Sold on an unsecured basis and does not contain any restrictive conditions.
• Freely transferable instrument with high liquidity.
• A continuous source of funds.
• Unsecured, so no asset of the company is mortgaged.
• The cost of the issue is lower than the cost of taking a loan.

Demerits:

• Only financially sound and highly rated firms can raise money through it.
• The amount of money raised is limited.
• Impersonal method of financing.

Shares

Shares: Small units of capital of a company. Share capital: Capital obtained by issuing shares. Shareholder: A person holding a share of a company. Normally, companies issue two types of shares: Equity shares and Preference shares.

Equity Shares:

• An important source of raising long-term capital.
• Represent the ownership of a company and thus known as owner’s funds.
• Shareholders do not get a fixed dividend but are paid based on earnings by the company.
• Due to voting rights, shareholders can participate in the management of the company.

Merits:

• Permanent capital as it is to be repaid at the time of liquidation of a company.
• Suitable for investors who are willing to assume risk for higher returns.
• As payment of dividends is not compulsory, there is no burden on the company.
• Equity capital forms the basis for further borrowing. Higher equity capital increases the creditworthiness of the company.

Demerits:

• Investors who want steady income may not prefer equity shares.
• The cost of equity shares is generally more as compared to the cost of raising funds through other sources.
• The issue of additional equity shares dilutes the voting power and earnings of existing equity shareholders.
• More formalities and procedural delays are involved while raising funds through the issue of equity share capital.

Preference Shares

• Part of ownership of the company but do not enjoy normal voting rights.
• Preferential rights over equity shares in payment of dividends and return of capital.
• The rate of dividend is fixed.

Merits:

• Provides reasonably steady income in the form of a fixed rate of return and safety of investment.
• Useful for investors who want a fixed rate of return with comparatively low risk.
• Do not affect the control of equity shareholders.
• No obligation to pay dividends in case of no profit.

Demerits:

• Fixed obligation to pay dividends irrespective of earnings.
• Not suitable for investors who are willing to take risks.
• Preference in payment of dividends over equity shareholders affects the interest of equity shareholders.
• Lower return compared to equity shares.

Debentures

Debentures are a debt instrument used by companies to raise capital with an assurance of repayment at a later date. Debenture holders are creditors to the company and earn interest on the debentures they hold.

Merits:

• Provide funds for long-term requirements.
• As the interest is tax-deductible, the real cost of raising funds through debentures is low.
• Investors who want fixed income at low risk prefer them.
• Do not dilute control of equity shareholders over the company.

Demerits:

• As fixed charge instruments, debentures put a permanent burden on the earnings of a company.
• In the case of redeemable debentures, the company should arrange funds for repayment on the specified date.
• Debenture holders do not have any voting rights and cannot participate in the management of the company.

Commercial Banks

Commercial banks are an important source of financing business operations. Banks extend loans to firms of all sizes. Banks also provide credit in other ways, such as cash credit, overdraft, and discounting bills of exchange.

Merits:

• Provide timely assistance to businesses.
• Secrecy is maintained about the operations of the business.
• Flexible source of finance.
• A loan from a bank is generally easier to obtain without any restrictive conditions.

Demerits:

• Banks make a detailed investigation of the company’s affairs, financial structure, etc. which makes the procedure time-consuming.
• In some cases, difficult terms and conditions are imposed by banks.
• Loans from banks are generally for a short period and their extension or renewal is uncertain and difficult.
• There are restrictions on the dividend payment imposed by banks on the borrower.

Conclusion

Business finance is essential for a company’s growth and operation. A thorough understanding of the various sources of finance, along with their merits and demerits, can help businesses make informed decisions and ensure long-term sustainability and success.