Chapter 8 — Sources of Business Finance

Chapter 8 covers Sources of Business Finance. It explains the meaning and significance of business finance, classifies sources on the basis of period, ownership, and source of generation, discusses the merits and limitations of each source, introduces international financing instruments, and identifies factors affecting the choice of an appropriate source.

The requirements of funds by a business to carry out its various activities is called business finance. Finance is described as the life blood of any business because no business can function unless adequate funds are made available to it.

Sources of business finance are classified on three bases: (i) period — long-term (exceeding 5 years), medium-term (1 to 5 years), and short-term (up to 1 year); (ii) ownership — owner's funds and borrowed funds; and (iii) source of generation — internal sources and external sources.

Owner's funds are provided by the owners of an enterprise — proprietors, partners, or shareholders — and include capital as well as profits reinvested in the business; they remain invested for a longer duration and are not required to be refunded during the life of the business. Borrowed funds are raised through loans or borrowings from lenders, carry a fixed rate of interest, must be repaid after a specified period, and are generally provided on the security of fixed assets.

Equity shareholders are residual owners who receive dividends only after all other claims are settled, bear the risk of ownership, and enjoy voting rights in the management of a company. Preference shareholders receive a fixed rate of dividend before any dividend is declared for equity shareholders and have a preferential right of repayment of capital at the time of liquidation; they generally do not enjoy voting rights.

Debentures are long-term debt instruments issued by a company that bear a fixed rate of interest; debenture holders are creditors of the company. Unlike equity shareholders, debenture holders do not participate in profits and do not carry voting rights. The interest paid on debentures is tax deductible, whereas dividends on shares are not.

Retained earnings are the portion of a company's net earnings that is not distributed as dividends and is kept back for future use; this is also called ploughing back of profits. Their merits include being a permanent source of funds with no explicit cost in the form of interest or dividend, providing greater operational flexibility, enhancing the capacity to absorb unexpected losses, and potentially leading to an increase in the market price of equity shares.

Trade credit is the credit extended by one trader to another for the purchase of goods and services, facilitating the purchase of supplies without immediate payment. It appears in the records of the buyer as sundry creditors or accounts payable, and the volume and period of credit depends on factors such as the reputation of the purchasing firm, financial position of the seller, and volume of purchases.

Commercial paper is an unsecured money market instrument issued in the form of a promissory note, introduced in India in 1990. It can be issued for maturities between a minimum of 7 days and a maximum of up to one year and in denominations of Rs. 5 lakh or multiples thereof. Only financially sound and highly rated firms can issue commercial paper; new and moderately rated firms are not in a position to raise funds through this method.

Factoring is a financial service under which the factor discounts bills and collects the client's debts, taking over credit control and providing protection against bad debt losses. Under recourse factoring, the client bears the risk of bad debts; under non-recourse factoring, the factor assumes the entire credit risk. The factor charges fees for these services.

International sources include commercial banks providing foreign currency loans, international agencies and development banks such as IFC, EXIM Bank, and Asian Development Bank, and international capital market instruments. The prominent instruments are Global Depository Receipts (GDRs), American Depository Receipts (ADRs), Indian Depository Receipts (IDRs), and Foreign Currency Convertible Bonds (FCCBs).

A Global Depository Receipt (GDR) is an instrument issued abroad by an Indian company to raise funds in foreign currency and is listed and traded on a foreign stock exchange. An American Depository Receipt (ADR) is similar to a GDR except that it can be issued only to American citizens and can be listed and traded only on a stock exchange of the USA.

The chapter identifies nine factors: cost of procurement and utilisation, financial strength and stability of operations, form of organisation and legal status, purpose and time period for which funds are required, risk profile, effect on control of management, effect on credit worthiness, flexibility and ease of obtaining funds, and tax benefits associated with the source.

Public deposits are deposits raised by organisations directly from the public; companies generally invite public deposits for a period up to three years, and their acceptance is regulated by the Reserve Bank of India. Rates of interest on public deposits are usually higher than those offered on bank deposits, while the cost of deposits to the company is less than the cost of borrowings from banks.

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