Please refer to Sources of Business Finance Class 11 Business Studies notes and questions with solutions below. These revision notes and important examination questions have been prepared based on the latest Business Studies books for Class 11. You can go through the questions and solutions below which will help you to get better marks in your examinations.
Class 11 Business Studies Sources of Business Finance Notes and Questions
Sources of Business Finance
Business finance refers to the money and credit invested or employed in the business firm. It is concerned with the acquisition and utilization of capital in meeting the financial needs and overall objectives of a business enterprise. Finance is very important to the business as it is the lifeblood of an organization. Without adequate amount of finance an enterprise cannot function smoothly.
Nature of Business Finance
1. It includes capital and borrowed funds.
2. It requires in all types of organization – big, small, production, trading etc.
3. Differs depending on the nature and size of business.
4. Requirement of fund vary from time to time – boom period and depression.
5. It requires on a continuous basis.
Significance of Business Finance
1. It requires to start a business.
2. To meet day-to-day expense.
3. To modernize, expand and diversify business.
4. To buy fixed assets.
Financial Needs of Business
1. Fixed capital requirements – Purchase of land, buildings, plant, machinery etc.
2. Working capital requirements – It may be used for holding current assets like stock, bills receivable and for meeting current expenses such as salary, rent, taxes etc.
Classification of sources of funds:
On the Basis of Period
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.
On the Basis of Ownership
1. Owners’ funds or Ownership capital – It is the amount of capital contributed by the owner, partners or the share holders as the case may be. Issue of shares and retained earnings are the two important sources of company finance.
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.
On the Basis of Sources of Generation
1. Internal sources – It refers to the funds that are generated within the organization. Eg: Equity shares, disposing of surplus stock , retained earnings etc.
2. External sources – It refers to those funds that are raised outside the business. Eg: Issue of debentures, banks loans, public deposits etc.
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.
Retained Earnings or Ploughing Back of Profits – Usually a part of the profits is transferred to the reserves every year and it can be retained or reinvested in the business for its modernization, expansion etc. Reinvestment of undistributed profits is a very good source of business finance.
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.
Factoring – A factoring organization is a financial service provider which specializes in collection and administration of debts. A factor may be an individual or an institution.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.
Services rendered by Factors:
1. Discounting of bills and collection of the client’s debt – Here the accounts
receivable (bill receivable) are sold to the factors at a discount with or without recourse and they assumes all the risks on it. Eg: SBI Factors, Commercial Services Ltd.,Canbank Factors Ltd. and some financial institutions are also providing factoring services.
a. Recourse factoring – No protection is offered to the client on bad debt.
b. Non-recourse factoring – Factor assumes the entire risk.
2. Providing information – Factors provide information about the creditworthiness of the firms.
Merits
1. Cheaper fund than other means.
2. Instant cash flow enables the client to settle his liabilities in time.
3. It provides security for debt.
4. No charge on assets of the company.
5. The client can concentrate on core-areas.
Limitations
1. Expensive on invoices of small amounts.
2. Interest charged by factors on advance may be higher.
3. Customers may not feel comfortable while dealing with a third party factor.
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.
Commercial Paper (CP) – It is an unsecured promissory note issued to the public with a fixed maturity period ranging from 90 days to 1 year. Issuing commercial paper in India as a money market instrument took place in 1989-90. Since it is being unsecured, this is issued by highly reputed corporate entities. Commercial banks, Companies and mutual funds contribute towards this kind of instruments. It is also regulated by RBI.
Merits
1. No restrictive conditions – Since it is unsecured it has not 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.
b. Preference Shares – A preference share is one which carries certain preferential rights with regard to the payment of dividend at a fixed rate during the continuance of the company and repayment of capital on the winding up of the company. The capital raised by issue of preference shares is called preference share capital.
Privileges of a Preference Shareholder
i. Right to get the dividend first at a fixed rate, before it is given to the equity shareholders.
ii. Right to get the repayment of capital on winding up, before it is paid to the equity shareholders.
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.
Types of Preference Shares
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
In simple meaning debenture is a written document of debt. In other words, it is a written acknowledgement of debt by a company which contains the provisions regarding payment of
interest and repayment of principal amount.
A company can issue debentures, if permitted by its Memorandum of Association and Articles of Association to invite the general public to contribute to its loan capital in the same manner as it invites the share capital. A person who holds the debenture is called Debenture holder and he has the status of a creditor of the company.
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 not 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
1. Secured or Mortgage Debentures – Issued with a charge on assets of the company.
2. Simple or Naked or Unsecured Debentures – Issued without any charge (security) on assets.
3. Registered Debentures – Names of debenture holders are entered in the ‘Register of Debenture holders’.
4. Bearer Debentures – Issued without the name of the owner. They are transferable by mere delivery.
5. Convertible Debentures (CD) – Issued with an option to convert them into equity shares after a particular period.
6. Non – Convertible Debentures (NCD) – It will not be converted into equity shares.
7. First Debentures – They are repayable before other debentures are repaid.
8. Second Debentures – Repayable after the first debentures have been paid back.
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.
2. Detailed investigation – Banks may conduct detailed investigation about company’s affairs, financial structure and also ask for securities. All these make the procedure difficult.
3. Too many restrictions – Banks may impose difficult terms for granting loans, which may affect the smooth functioning of the business. Eg: Restriction on the sale of mortgaged asset.
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.
Special Financial Institutions / Development Banks
a. Industrial Development Bank of India (IDBI).
b. Industrial Finance Corporation of India (IFCI).
c. Industrial Credit and Investment Corporation of India (ICICI).
d. Industrial Reconstruction Bank of India (IRBI)
e. Unit Trust of India (UTI).
f. Life Insurance Corporation of India (LIC).
g. State Financial Corporation (SFCs)
h. State Industrial Development Corporation (SIDC)
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.
2. International Agencies and Development Banks: A number of international agencies and development banks have emerged over the years to finance international trade and business. Eg. IFC (International Finance Corporation), EXIM Bank and ADB (Asian Development Bank) etc.
3. International Capital Markets: The major instruments used in international capital markets are:
a. GDRs (Global Depository Receipts): It is an instrument issued abroad by an Indian company through an Overseas Depository Bank (ODB) to raise funds from foreign countries and is listed and traded on a foreign stock exchange. It does not carry any voting right but only dividends and capital appreciation. It is usually seen in European Union.
How GDR works – An Indian (domestic) company enters into an agreement with ODB to issue GDR – ODB then enters into a custodian agreement with a domestic custodian to hold the shares of that company – On the instruction of the domestic custodian, the ODB issues shares to foreign investors.
b. ADRs (American Depository Receipts): ADRs are bought and sold in American markets like other stocks. It is similar to GDR except that it can be traded only on a stock exchange of USA.
c. IDRs (Indian Depository Receipts): It is a financial instrument denominated in Indian Rupees in the form of Depository Receipt. It is created by an Indian Depository to enable a foreign company to raise funds from Indian securities market.
‘Standard Chartered PLC’ was the first foreign company that issued IDR in Indian securities market in June 2010.
d. FCCBs (Foreign Currency Convertible Bonds): These are the securities that are to be converted into equity after a specified period of time. They are issued in a foreign currency and carry a fixed interest rate. These are listed and traded in foreign stock exchanges. It is very similar to convertible debentures issued in India.
Factors affecting the choice of the Source of Funds
a) Cost (cost of procurement and cost of utilizing the fund).
b) Financial strength and stability of operation of the business – if the firm is in a sound financial position it can resort to more borrowed funds.
c) Form of business and legal status – only a joint stock company can issue shares and debentures, but a partnership firm cannot do so.
d) Purpose of the fund and time period – Commercial paper, trade credit etc. is suitable for short term fund while shares, debentures etc. are better for long term.
e) Risk profile of each source – risk is least in case of equity shares compared to loans.
f) Control – Extent to which they are willing to share their control over the business.
g) Effect on creditworthiness – For example, issuing secured debentures may affect the interest of unsecured creditors.
h) Flexibility and ease of obtaining funds – bank loans are bound to detailed investigations and documentation, which will take very much time to obtain funds.
i) Tax benefits – interest on debentures is a deductible expense where as dividend is not so.
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