Chapter Notes

Introduction

Every business, whether it's a small local restaurant or a large manufacturing company, needs money to start, run its daily operations, and grow. This money is called business finance, and it's often described as the "life blood" of any business. Just like a person can't live without blood, a business can't function without adequate funds.

This guide will explore where businesses get this money. We'll look at the different types of funding available, their advantages and disadvantages, and how a business owner decides which source is the right one for their specific needs.

Meaning, Nature and Significance of Business Finance

Business finance refers to the money required by a business to carry out its various activities, from producing goods and services to distributing them. An entrepreneur's initial investment is rarely enough to cover all expenses, so they must find other sources of funding.

A business needs funds for several reasons throughout its life cycle:

• Starting the business: Money is needed immediately to buy long-term assets.
• Day-to-day operations: Funds are required for daily expenses.
• Expansion and growth: As a business becomes successful, it needs more money to expand, upgrade technology, or build up inventory for busy seasons.

Financial Needs of a Business

The financial needs of a business can be broken down into two main categories:

Fixed capital requirements

This is the money needed to purchase fixed assets—things that will be used in the business for a long period of time.

• Examples: Land, buildings, plant and machinery, furniture.
• The amount of fixed capital needed depends on the type and size of the business. A large manufacturing plant will need far more fixed capital than a small trading shop.

Working capital requirements

This is the money needed for the day-to-day operations of the business. It keeps the business running smoothly.

• Working capital is used for holding current assets like inventory (stock of materials) and bills receivables.
• It's also used for meeting current expenses like salaries, wages, taxes, and rent.

Classification of Sources of Funds

There are many ways to get funding, and they can be classified based on three different criteria: the time period, who owns the funds, and where the funds come from.

Period Basis

This classification is based on how long the business needs the money.

• Long-term sources: These funds are needed for a period of more than five years. They are typically used to buy fixed assets like equipment or a new building.
  • Examples: Issuing shares and debentures, long-term loans from financial institutions.
• Medium-term sources: These funds are required for a period of more than one year but less than five years.
  • Examples: Borrowings from commercial banks, public deposits, lease financing.
• Short-term sources: These funds are needed for a period of up to one year. They are mainly used to finance working capital needs, like buying inventory or paying immediate expenses.
  • Examples: Trade credit, loans from commercial banks, commercial papers.

Ownership Basis

This classification depends on whether the funds are provided by the owners or borrowed from outsiders.

• Owner's funds: This is the money provided by the owners of the enterprise (a sole trader, partners, or shareholders). It includes the initial capital and any profits that are reinvested back into the business (retained earnings).
  • Key Feature: This capital remains with the business for its entire life and gives the owners control over management.
  • Examples: Issue of equity shares, retained earnings.
• Borrowed funds: This refers to funds raised through loans or borrowings. These funds are provided for a specific period and must be repaid with interest.
  • Key Feature: The business has to pay a fixed rate of interest, even if it is making a loss. Often, assets are pledged as security for these loans.
  • Examples: Loans from banks, issue of debentures, public deposits.

Source of Generation Basis

This classification is based on whether the funds are generated from inside or outside the business.

• Internal sources: These are funds generated from within the business itself. While useful, they can usually only fulfill limited financial needs.
  • Examples: Ploughing back profits (retained earnings), selling off surplus inventory.
• External sources: These include all sources of funding that are outside the organization. When a large amount of money is needed, businesses usually turn to external sources.
  • Examples: Issue of shares and debentures, loans from banks, public deposits.

Sources of Finance

Each source of finance has its own unique features, benefits, and drawbacks. A business must carefully evaluate them to choose the best option for its situation.

Retained Earnings

When a company makes a profit, it usually doesn't distribute all of it to the shareholders as dividends. A portion is kept or "retained" in the business for future use. This is known as retained earnings or ploughing back of profits. It's a form of internal or self-financing.

Merits

• It is a permanent source of funds for the organization.
• There are no explicit costs like interest or dividend payments.
• It provides greater operational freedom and flexibility since the funds are generated internally.
• It strengthens the business's ability to absorb unexpected losses.
• It can lead to an increase in the market price of the company's equity shares.

Limitations

• Keeping too much profit can cause dissatisfaction among shareholders, who might prefer higher dividends.
• It is an uncertain source because business profits can fluctuate from year to year.
• Many firms ignore the opportunity cost of these funds, which could lead to them being used inefficiently.

Trade Credit

Trade credit is the credit that one business (a supplier) extends to another (a buyer) for the purchase of goods and services. It allows the buyer to receive supplies now and pay for them later.

Merits

• It is a convenient and continuous source of funds.
• It is often readily available if the buyer has a good reputation.
• It helps a business increase its inventory to meet expected demand without immediate payment.
• It does not create any charge on the assets of the firm, meaning assets are free to be used as security for other loans.

Limitations

• Easy access to trade credit might tempt a firm into overtrading (buying more than it can sell), which increases risk.
• Only a limited amount of funds can be generated this way.
• It can be a costly source if the supplier charges a higher price to customers who buy on credit.

Factoring

Factoring is a financial service where a business sells its accounts receivables (bills owed by customers) to a third party, called a factor, at a discount. The factor then collects the debt from the customers.

There are two main types:

1. Recourse Factoring: The business is not protected from bad debts. If a customer fails to pay, the business must buy back the debt from the factor.
2. Non-recourse Factoring: The factor assumes the entire risk of bad debts. If a customer doesn't pay, the factor bears the loss.

Merits

• Obtaining funds through factoring can be cheaper than bank credit.
• It provides a quick inflow of cash, helping the business meet its liabilities on time.
• It is a flexible source of funds and provides security for a debt.
• It does not create any charge on the firm's assets.
• The business can focus on its core operations, as the factor handles credit control and debt collection.

Limitations

• It can be expensive if the invoices are numerous and for small amounts.
• The advance finance provided by the factor often comes at a higher interest cost.
• Customers may not feel comfortable dealing with a third party (the factor) for payments.

Lease Financing

A lease is a contract where the owner of an asset (the lessor) grants another party (the lessee) the right to use the asset in exchange for periodic payments, called lease rentals. It's essentially renting an asset for a specific period.

Merits

• It allows the lessee to acquire an asset with a lower initial investment.
• The documentation is simple, making it an easy way to finance assets.
• Lease payments are tax-deductible expenses.
• It provides finance without diluting ownership or control of the business.
• The risk of the asset becoming outdated (obsolescence) is borne by the lessor.

Limitations

• The lease agreement may have restrictions on how the asset can be used or modified.
• If the lease is not renewed, normal business operations could be affected.
• Terminating a lease agreement early can result in high payout obligations.
• The lessee never becomes the owner of the asset and loses out on its potential residual value.

Public Deposits

Public deposits are funds raised by organizations directly from the public. A company invites people to deposit their savings with it, usually for a period of up to three years.

Merits

• The procedure for obtaining deposits is simple and has fewer restrictive conditions than a bank loan.
• The cost is generally lower than borrowings from banks.
• It does not create a charge on the company's assets, leaving them free for other purposes.
• Since depositors have no voting rights, the control of the company is not diluted.

Limitations

• New companies find it difficult to raise funds this way as they lack a track record.
• It is an unreliable source, as the public may not respond when the company needs money most.
• Collecting a large amount of money can be difficult.

Commercial Paper

A Commercial Paper (CP) is an unsecured promissory note issued by large, highly-rated companies to raise short-term funds. It was introduced in India in 1990.

• Maturity: Can be issued for a period from a minimum of 7 days up to a maximum of one year.
• Investors: Individuals, banks, companies, and even Foreign Institutional Investors (FIIs) can invest in CPs.

Merits

• It is unsecured and does not have restrictive conditions.
• It is a freely transferable instrument, giving it high liquidity.
• The cost to the issuing company is generally lower than a commercial bank loan.
• It provides a continuous source of funds, as a maturing CP can be repaid by issuing a new one.

Limitations

• Only financially sound and highly-rated firms can issue CPs.
• The amount of money that can be raised is limited to the excess liquidity available in the market at that time.
• If a firm faces financial difficulty, it is not possible to extend the maturity of a CP.

Issue of Shares

The capital of a company is divided into small units called shares. The money raised by issuing these shares is known as share capital, and the people who hold them are shareholders. There are two main types of shares.

Equity Shares

Equity shares represent the ownership of a company. The capital raised from them is called ownership capital. Equity shareholders are the real owners and risk-bearers of the company.

• Dividends: They do not get a fixed dividend; their payment depends on the company's earnings. They are "residual owners" because they get paid only after all other claims are settled.
• Control: They have the right to vote and participate in the management of the company.

Merits

• Suitable for investors willing to take risks for higher returns.
• There is no compulsion to pay dividends, so there is no financial burden on the company.
• It is permanent capital, repaid only when the company is liquidated.
• It provides credit worthiness and boosts the confidence of lenders.
• It does not create any charge on the company's assets.

Limitations

• Not suitable for investors who want a steady income.
• The cost of issuing equity shares is generally higher than other sources.
• Issuing more equity shares dilutes the voting power and earnings of existing shareholders.
• The process involves many formalities and procedural delays.

Preference Shares

Preference shareholders have preferential rights over equity shareholders in two ways:

1. They receive a fixed rate of dividend before any dividend is paid to equity shareholders.
2. They receive their capital back before equity shareholders if the company is liquidated.

Merits

• Provide a steady income with relatively low risk.
• Does not affect the control of equity shareholders.
• Having a fixed dividend rate can allow for higher dividends for equity shareholders during profitable years.
• Does not create any charge on the company's assets.

Limitations

• Not suitable for investors seeking high returns.
• The rate of dividend is generally higher than the interest on debentures.
• There is no assured return, as dividends are only paid if the company makes a profit.
• The dividend paid is not tax-deductible, so there is no tax saving for the company.

Debentures

Debentures are an instrument for raising long-term debt capital. A debenture is an acknowledgment of debt, where the company promises to repay a certain amount of money at a future date with a fixed rate of interest. Debenture holders are creditors of the company, not owners.

Merits

• Preferred by investors who want a fixed income with lesser risk.
• They are fixed-charge funds, meaning debenture holders do not share in the company's profits.
• Financing through debentures is less costly because the interest paid is a tax-deductible expense.
• Debenture holders have no voting rights, so control is not diluted.

Limitations

• They create a permanent burden on the company's earnings, as interest must be paid regardless of profit or loss.
• The company must make provisions for repayment on a specific date, which can be difficult during financial trouble.
• Issuing debentures reduces the company's capacity to borrow further funds.

Commercial Banks

Commercial banks are a vital source of finance for businesses of all sizes. They provide funds for different purposes and time periods through various means like cash credits, overdrafts, and term loans.

Merits

• Banks provide timely assistance as and when funds are needed.
• Business secrecy is maintained, as information shared with the bank is kept confidential.
• It is an easier source of funds as it doesn't require formalities like issuing a prospectus.
• It is a flexible source, as the loan amount can be increased or repaid early as per business needs.

Limitations

• Funds are generally available for short periods, and renewal can be difficult.
• Banks conduct a detailed investigation and may require security (collateral), making the process difficult.
• Banks may impose difficult terms and conditions, such as restrictions on the sale of mortgaged goods.

Financial Institutions

The government has established several financial institutions (also called development banks) to provide finance to businesses, especially for long-term needs like expansion and modernization.

Merits

• They provide long-term finance, which commercial banks often do not.
• They also offer managerial and technical advice.
• Obtaining a loan from a financial institution increases the goodwill of the company, making it easier to raise funds from other sources.
• Repayment can be made in easy installments.
• Funds are often available even during periods of economic depression.

Limitations

• They follow rigid criteria for granting loans, and the process can be time-consuming and expensive.
• They often impose restrictions, such as on dividend payments.
• They may appoint their own nominees to the company's Board of Directors, thereby restricting the company's powers.

International Financing

As businesses go global, they can also tap into international sources for funding.

• Commercial Banks: International banks like Standard Chartered provide foreign currency loans to businesses worldwide.
• International Agencies and Development Banks: Bodies like the International Finance Corporation (IFC) provide long-term loans and grants to promote development in economically backward areas.
• International Capital Markets: Companies can raise funds through special instruments.
  • Global Depository Receipts (GDRs): An Indian company deposits its local shares with a foreign bank (depository bank), which then issues receipts denominated in US dollars. These GDRs can be traded on foreign stock exchanges. Holders get dividends and capital appreciation but usually have no voting rights.
  • American Depository Receipts (ADRs): These are similar to GDRs but are issued specifically to American citizens and traded on US stock exchanges.
  • Indian Depository Receipt (IDRs): This allows a foreign company to raise funds from the Indian market. The foreign company's shares are held by an Indian Depository, which issues receipts (IDRs) to Indian investors.
  • Foreign Currency Convertible Bonds (FCCBs): These are debt securities issued in a foreign currency. The holder has the option to either convert them into equity shares at a predetermined price or keep them as bonds. They carry a fixed interest rate, which is usually lower than that of non-convertible bonds.

Factors Affecting the Choice of the Source of Funds

Choosing the right mix of financing is a complex decision. A business must consider several factors:

1. Cost: This includes both the cost of obtaining the funds (e.g., advertisement costs for public issues) and the cost of using them (e.g., interest payments). The cheapest source is often preferred.
2. Financial Strength and Stability: A financially strong company can easily handle borrowed funds. However, if a company's earnings are unstable, it should be cautious about taking on debt with fixed interest payments.
3. Form of Organisation: The type of business determines the available options. For example, a partnership cannot issue equity shares; only a joint stock company can.
4. Purpose and Time Period: The source of funds should match the purpose. Long-term needs like expansion should be financed with long-term sources (shares, debentures), while short-term needs should be met with short-term sources (trade credit, bank overdraft).
5. Risk Profile: Every source has a different level of risk. Equity is the least risky for the company because dividends are not mandatory. A loan is riskier because interest must be paid no matter what.
6. Control: Business owners must decide how much control they are willing to give up. Issuing new equity shares dilutes the control of existing owners. Taking a loan from a financial institution might come with conditions that restrict the company's power.
7. Effect on Credit Worthiness: The company's choice of financing can affect its reputation. Relying heavily on secured loans might make unsecured creditors hesitant to lend more money.
8. Flexibility and Ease: Some sources are easier to obtain than others. Borrowing from banks can involve detailed investigations and restrictive conditions, which might make other options more attractive.
9. Tax Benefits: Different sources have different tax implications. Interest paid on debentures and loans is a tax-deductible expense, while dividends paid on shares are not. This makes debt financing more attractive from a tax perspective.