Business Studies Chapter 8 Notes NCERT Class 11th – Sources of Business Finance

8.1 Introduction

This chapter covers various funding sources for businesses, their pros and cons, and factors for choosing appropriate finance. Understanding these is crucial for entrepreneurs.

8.2 Meaning, Nature, and Significance of Business Finance

• Meaning: Funds required for business activities; “life blood of any business.”
• Need for Funds: From startup (fixed assets, daily operations) to expansion.
• Financial Needs Categories:
  • Fixed Capital: For long-term assets (land, machinery). Amount varies by business type and size.
  • Working Capital: For day-to-day operations (raw materials, salaries, current assets). Amount varies by credit sales, sales turnover.
• Additional funds needed for growth, tech upgrades, inventory, debt, relocation.

8.3 Classification of Sources of Funds

Sources for companies classified by:

1. Period
2. Ownership
3. Source of Generation

8.3.1 Period Basis

• Long-term (Exceeds 5 years): Shares, debentures, long-term loans from financial institutions. Used for fixed assets.
• Medium-term (1-5 years): Commercial bank borrowings, public deposits, lease financing.
• Short-term (Up to 1 year): Trade credit, commercial bank loans, commercial papers. Common for current assets, seasonal businesses.

8.3.2 Ownership Basis

• Owner’s Funds: Provided by owners (capital, retained profits). Long-duration, provides control. Sources: Equity shares, retained earnings.
• Borrowed Funds: Raised via loans/borrowings. Specified period, fixed interest, must be repaid. Sources: Commercial banks, financial institutions, debentures, public deposits, trade credit. Often secured by assets.

8.3.3 Source of Generation Basis

• Internal Sources: Generated within business (e.g., collecting receivables, selling surplus inventory, ploughing back profits). Limited funding capacity.
• External Sources: From outside (suppliers, lenders, investors). For large needs. Can be costly, may require asset security. Sources: Debentures, bank loans, financial institution loans, public deposits.

8.4 Sources of Finance

Choice depends on “situation, purpose, cost and associated risk.”

8.4.1 Retained Earnings

• Meaning: Portion of net earnings “retained in the business for use in the future.” Also internal/self-financing or ‘ploughing back of profits’.
• Merits: Permanent, no explicit cost, operational freedom, absorbs losses, may increase share price.
• Limitations: Shareholder dissatisfaction (lower dividends), uncertain source (profit fluctuations), potential for sub-optimal fund use (opportunity cost ignored).

8.4.2 Trade Credit

• Meaning: Credit “extended by one trader to another for the purchase of goods and services.” Short-term financing, appears as ‘sundry creditors’. Based on financial standing.
• Merits: Convenient, readily available, promotes sales, useful for inventory, no charge on assets.
• Limitations: May lead to overtrading, limited funds, generally costly.

8.4.3 Factoring

• Meaning: Factor provides services like discounting bills, debt collection, creditworthiness info. Selling receivables to factor at a discount.
• Merits: Cheaper, faster cash flow, flexible, no charge on assets, client focuses on core business.
• Limitations: Expensive for small invoices, higher interest on advances, third-party involvement may displease customers.

8.4.4 Lease Financing

• Meaning: Contract to use an asset from owner (lessor) for periodic payment by user (lessee). Essential “renting” an asset.
• Merits: Lower investment for asset acquisition, simple, rentals are tax-deductible, no ownership dilution, no impact on debt capacity, lessor bears obsolescence risk.
• Limitations: Restrictions on asset use, potential operational impact if not renewed, high payout if prematurely terminated, lessee never owns asset.

8.4.5 Public Deposits

• Meaning: Deposits directly from public, usually higher interest than banks. Up to three years. Regulated by RBI.
• Merits: Simple, lower cost than bank loans, no asset charge, no dilution of control.
• Limitations: Difficult for new companies, unreliable, collection difficult for large amounts.

8.4.6 Commercial Paper (CP)

• Meaning: Unsecured promissory note, money market instrument. Short-term funding (7 days to 1 year).
• Merits: Unsecured, no conditions, high liquidity, lower cost than bank loans, continuous source, good for parking excess funds.
• Limitations: Only for highly-rated firms, limited by available liquidity, impersonal method.

8.4.7 Issue of Shares

• Meaning: Company’s capital divided into shares. Two types: equity and preference.
• (a) Equity Shares: Most important long-term source. Represents ownership. Variable dividends, residual owners, bear risk, voting rights.
  • Merits: Suitable for risk-takers, no compulsory dividend burden, permanent capital, enhances creditworthiness, no asset charge, democratic control.
  • Limitations: Not for steady income seekers, higher cost, dilutes existing ownership/earnings, more formalities.
• (b) Preference Shares: Preferential rights: fixed dividend before equity, capital repayment after creditors. No voting rights.
  • Merits: Steady income, safety for investors, no control dilution, potential for higher equity dividends, preferential repayment, no asset charge.
  • Limitations: Not for high-return seekers, dilutes equity claims on assets, dividend higher than debentures, no assured return (depends on profit), dividend not tax deductible.

8.4.8 Debentures

• Meaning: Important instrument for “raising long term debt capital.” Fixed interest, acknowledgment of debt. Holders are “creditors.” Requires credit rating.
• Merits: For fixed-income/low-risk investors, fixed charge, suitable with stable earnings, no dilution of control, interest is tax deductible (less costly).
• Limitations: Permanent burden, repayment provision needed, reduces future borrowing capacity.

8.4.9 Commercial Banks

• Meaning: Provide funds for various purposes/periods (cash credits, overdrafts, term loans, etc.). Not permanent. Requires security.
• Merits: Timely assistance, secrecy, easier formalities than public issues, flexible.
• Limitations: Funds usually short-term (uncertain renewal), detailed investigation/security required (difficult), potential restrictive terms.

8.4.10 Financial Institutions

• Meaning: Government-established institutions for business finance (long and medium term). Also ‘development banks’. Provide expert advice.
• Merits: Long-term finance, expert advice, boosts investor confidence, funds available in difficult markets, easy installment repayment.
• Limitations: Rigid loan conditions, potential restrictions (dividends, directors), detailed investigations cause delays.

8.5 International Sources of Finance

Indian companies can raise finance from international markets, particularly with economic liberalization.

8.5.1 Commercial Banks

• Role: Provide foreign currency loans to Indian companies. These loans are short-term or medium-term.
• Merits:
  • Easier access to funds from diverse global sources.
  • Loans often available at favorable interest rates, especially for firms with good credit ratings.
• Limitations:
  • Exchange rate fluctuations pose a risk, increasing repayment cost if the rupee depreciates.
  • More formalities and strict compliance requirements compared to domestic loans.

8.5.2 International Agencies and Development Banks

• Role: Provide long-term project finance and foreign currency loans. Key institutions include International Finance Corporation (IFC), Asian Development Bank (ADB), and International Bank for Reconstruction and Development (IBRD – World Bank).
• Merits:
  • Access to large-scale, long-term funding for development projects.
  • Often provide technical assistance and expertise alongside financial aid.
• Limitations:
  • Strict eligibility criteria and lengthy approval processes.
  • Funds may come with conditions regarding project implementation and economic policies.

8.5.3 International Capital Markets

Indian companies access these markets through:

1. Global Depository Receipts (GDRs)

• Meaning: Financial instruments denominated in US dollars. Issued by an Indian company, but held by an overseas depository bank, which in turn issues shares to foreign investors.
• Trading: Traded like normal shares on stock exchanges (e.g., London Stock Exchange, Luxembourg Stock Exchange).
• Features:
  • No voting rights directly for GDR holders.
  • Listed on international exchanges, facilitating trading.
  • Easily convertible into underlying shares.
• Merits:
  • Access to large pools of foreign capital.
  • Less stringent disclosure requirements than direct equity listings abroad.
  • Helps build global presence and reputation.
• Limitations:
  • Exchange rate risk for investors.
  • Depends on market conditions and investor confidence.

2. American Depository Receipts (ADRs)

• Meaning: Similar to GDRs, but can only be issued to American citizens and traded in the US financial markets.
• Trading: Subject to regulations of the US Securities and Exchange Commission (SEC).
• Features:
  • Enable US investors to buy shares of non-US companies.
  • Traded on major US stock exchanges (NYSE, NASDAQ).
• Merits & Limitations: Similar to GDRs, but specific to the US market.

3. Foreign Currency Convertible Bonds (FCCBs)

• Meaning: Debt instruments issued in foreign currency that can be converted into equity shares of the issuing company at a pre-determined price.
• Features:
  • Combine features of debt (fixed interest payments) and equity (conversion option).
  • Investors receive interest until conversion, then potential capital appreciation from equity.
• Merits:
  • Attractive to investors due to safety of debt and upside potential of equity.
  • Lower interest cost for company compared to non-convertible debt, especially if conversion is expected.
• Limitations:
  • Potential equity dilution upon conversion.
  • Complexity in structuring and managing.

8.6 Factors Affecting the Choice of Source of Finance

The selection of a finance source depends on various factors:

1. Cost:
   • Procurement Cost: Expenses incurred to raise funds (e.g., underwriting commission, brokerage, legal fees).
   • Utilization Cost: Interest, dividend payments, or returns on retained earnings.
   • Lower cost sources are generally preferred.
2. Financial Strength and Stability of the Business:
   • Stronger companies can access a wider range of sources (e.g., commercial papers, public deposits).
   • New businesses may rely on owner’s funds or trade credit due to limited options.
3. Form of Organization:
   • Proprietary/Partnership firms are limited to owner’s capital, bank loans, and trade credit.
   • Companies have wider options including shares, debentures, public deposits, and international sources.
4. Purpose and Period of Finance:
   • Long-term needs (fixed assets): Equity, preference shares, debentures, long-term loans.
   • Short-term needs (working capital): Trade credit, commercial papers, short-term bank loans.
5. Risk Profile:
   • Borrowed funds carry financial risk (fixed interest, repayment obligation).
   • Owned funds (equity) do not create a fixed obligation.
   • Higher-risk ventures may prefer equity to avoid fixed debt burdens.
6. Control:
   • Equity shares dilute owner’s control due to voting rights.
   • Debentures, public deposits, and loans do not dilute control.
   • Management may prefer non-dilutive sources.
7. Tax Benefits:
   • Interest on loans/debentures is tax-deductible, reducing effective cost.
   • Dividends on shares are not tax-deductible.
8. Flexibility and Ease:
   • Sources with simple procedures (e.g., retained earnings, trade credit) are easier.
   • Public issues (shares/debentures) involve more formalities and time.
9. Availability:
   • Some sources may not be available to all companies (e.g., commercial paper for highly-rated firms only).
10. Impact on Creditworthiness:
    • Raising equity can enhance creditworthiness.
    • High debt levels can reduce future borrowing capacity.

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Business Studies Chapter 8 Notes NCERT Class 11th – Sources of Business Finance