Learning Objectives
- Understand the meaning and significance of business finance
- Learn about owner's funds and borrowed funds
- Know the various sources of short-term, medium-term, and long-term finance
- Understand equity shares, preference shares, debentures, and retained earnings
- Learn about trade credit, factoring, and lease financing
Key Concepts
Classification of Sources
Business finance can be classified based on period (short-term: up to 1 year, medium-term: 1-5 years, long-term: more than 5 years), ownership (owner's funds and borrowed funds), and source (internal sources and external sources).
Owner's Funds
- Equity Shares: Represent ownership in the company. Equity shareholders are the real owners, bear the highest risk, and receive dividends only after preference shareholders are paid. They have voting rights and control over the company. Dividend is not guaranteed. Advantages: no fixed obligation, no charge on assets, voting rights. Disadvantages: risk of dilution of control, uncertain returns.
- Preference Shares: Carry preferential rights regarding payment of dividend (at a fixed rate) and repayment of capital on winding up. Types: Cumulative (unpaid dividend accumulates), Non-cumulative, Participating (share in surplus profits), Convertible (can be converted to equity), Redeemable (repayable after a specified period). Preference shareholders generally do not have voting rights.
- Retained Earnings (Ploughing Back of Profits): The portion of net profit not distributed as dividends but retained in the business for reinvestment. It is an internal source of finance. Advantages: no cost of raising funds, no dilution of control, increased creditworthiness. Disadvantages: limited by the amount of profit earned, may lead to dissatisfaction among shareholders expecting dividends.
Borrowed Funds
- Debentures: Long-term debt instruments issued by the company carrying a fixed rate of interest. Debenture holders are creditors, not owners. Interest is a charge against profit (paid regardless of profit). Types: Secured/Unsecured, Convertible/Non-convertible, Redeemable/Irredeemable. Advantages: no dilution of ownership, interest is tax-deductible. Disadvantages: fixed obligation, charge on assets.
- Term Loans from Banks and Financial Institutions: Medium to long-term loans from commercial banks, IDBI, IFCI, ICICI, and other development banks. Repaid in instalments. Require collateral security.
- Public Deposits: Deposits accepted directly from the public by companies for a fixed period at a specified interest rate. Governed by RBI guidelines. Maximum period: 36 months. Used as a source of medium-term finance.
Short-term Sources
- Trade Credit: Credit extended by suppliers for purchase of goods (usual period: 30-90 days). It is an automatic and informal source of short-term finance.
- Factoring: Selling accounts receivable (debtors) to a factor (financial institution) at a discount to get immediate cash.
- Commercial Paper (CP): Unsecured, short-term promissory notes issued by large, creditworthy companies to raise short-term funds (maturity: 15 days to 1 year).
- Bank Overdraft and Cash Credit: Facilities provided by banks to withdraw more than the balance in the current account (overdraft) or to borrow against the security of stock and debtors (cash credit).
Other Sources
Lease Financing: The owner of an asset (lessor) grants the right to use the asset to another party (lessee) for a specified period in exchange for periodic rent. It avoids the need for large capital outlay for purchasing assets.
Venture Capital: Financing provided to start-up companies and small businesses with high growth potential in exchange for equity stake. Common in technology and innovation-driven sectors.
Summary
Business finance encompasses all funds required for starting, operating, and expanding a business. Sources are classified by period, ownership, and origin. Owner's funds (equity shares, preference shares, retained earnings) provide permanent capital without a fixed repayment obligation. Borrowed funds (debentures, term loans, public deposits) carry fixed interest obligations and have to be repaid. Short-term needs are met through trade credit, factoring, commercial paper, and bank facilities. Lease financing and venture capital provide alternative funding options. The choice of source depends on factors like cost, risk, control, flexibility, and duration of need.
Important Terms
- Equity Shares
- Ownership securities giving voting rights and variable dividends; shareholders bear the highest risk and are residual claimants.
- Preference Shares
- Shares with preferential dividend rights at a fixed rate and priority in capital repayment, but usually without voting rights.
- Debentures
- Long-term debt instruments issued by a company carrying a fixed interest rate; holders are creditors, not owners.
- Retained Earnings
- Profits not distributed as dividends but reinvested in the business; an internal source of finance.
- Trade Credit
- Short-term credit extended by suppliers allowing businesses to purchase goods and pay later (30-90 days).
- Factoring
- Selling trade receivables to a financial institution at a discount to obtain immediate cash.
- Lease Financing
- Obtaining the use of an asset by paying periodic rent to the owner (lessor) instead of purchasing it outright.
Quick Revision
- Owner's Funds: Equity Shares, Preference Shares, Retained Earnings (no fixed repayment).
- Borrowed Funds: Debentures, Term Loans, Public Deposits (fixed interest, must be repaid).
- Equity shareholders: real owners, voting rights, variable dividends, highest risk.
- Debenture holders: creditors, fixed interest, priority in repayment, no voting rights.
- Retained earnings: internal source, no cost, no dilution, limited by profits earned.
- Short-term: Trade Credit, Factoring, Commercial Paper, Bank Overdraft, Cash Credit.
- Interest on debentures is tax-deductible (reduces taxable income); dividend is not.
Practice Tips
- Create a comprehensive table comparing equity shares, preference shares, and debentures on at least 8 parameters.
- Understand the concept of "trading on equity" -- using borrowed funds to increase returns on equity.
- Practice differentiating between internal and external sources with examples.
- For essay-type questions, discuss the factors affecting the choice of source of finance.