Big picture
Every business needs money: fixed capital for long-term assets (land, machinery) and working capital for day-to-day operations (stock, wages, credit to customers). Business finance is the money required to start, run and expand a business.
Funds come from many sources, each with its own cost, risk and conditions. The right source depends on the amount, the period, the cost, and how much control the owners want to keep. Exam questions ask you to identify a source from its features or recommend one for a situation.
Learning goals
Explain the meaning and need for business finance.
Classify sources of finance by period, ownership and source of generation.
Explain each source of finance with its merits and limitations.
Explain international sources of finance.
Explain the factors affecting the choice of a source of funds.
Core ideas
1. Need for business finance
Fixed capital requirements: buying land, buildings, plant and machinery, furniture.
Working capital requirements: paying for raw materials, wages, rent and other running expenses, and supporting credit sales.
Diversification and expansion: new products, markets or capacity.
Technology upgradation to stay competitive.
2. Classification of sources
Basis | Categories |
|---|---|
Period | Long-term (more than five years: shares, debentures, long-term loans, retained earnings); medium-term (one to five years: bank loans, public deposits, lease financing); short-term (up to one year: trade credit, factoring, commercial paper, bank overdraft) |
Ownership | Owner's funds (shares, retained earnings): permanent, no fixed return, carry voting rights; borrowed funds (debentures, loans, public deposits, trade credit): fixed interest, repayable, usually secured |
Source of generation | Internal (retained earnings, collecting receivables faster, disposing of surplus stock); external (shares, debentures, loans, trade credit, factoring) |
3. Retained earnings
A portion of net profit that is not distributed as dividend but kept in the business (also called ploughing back of profit or self-financing).
Merits | Limitations |
|---|---|
Permanent source; no cost of raising | Excessive retention may dissatisfy shareholders who want dividends |
No explicit cost (interest, dividend, floatation) | An uncertain source, since profits fluctuate |
No dilution of control | Opportunity cost is often ignored, leading to sub-optimal use |
Increases the company's capacity to absorb losses | |
May raise the market price of shares |
4. Trade credit
Credit extended by one trader to another when goods are bought on credit, recorded as sundry creditors or accounts payable. It is a common short-term source.
Merits | Limitations |
|---|---|
Convenient and continuous source | Easy availability may tempt over-trading, increasing risk |
Readily available if the firm is creditworthy | Only limited funds can be raised |
Helps promote sales and build stock | Generally costlier than other sources (loss of cash discount) |
No charge on the firm's assets |
5. Factoring
A financial service in which the factor (a bank or specialised firm) buys the business's receivables (debtors) and collects them, giving the business cash immediately, for a fee. Factoring may be with recourse (the business bears bad debts) or without recourse (the factor bears them). Factors also offer credit information about customers.
Merits | Limitations |
|---|---|
Cheaper than other short-term borrowing in many cases | Can be expensive when invoices are many and small |
Improves liquidity, as receivables become cash quickly | Advance finance is usually costlier than ordinary bank loans |
Doesn't create a charge on assets | Customers may not like dealing with a third party |
The firm can focus on its core business |
6. Lease financing
A contract in which the owner of an asset (the lessor) allows another party (the lessee) to use it in return for periodic payments called lease rentals. At the end of the lease, the asset returns to the lessor.
Merits | Limitations |
|---|---|
Asset is acquired with lower investment | Restrictions on using or modifying the asset |
Simpler documentation than term loans | Normal business may be disrupted if the lease isn't renewed |
Lease rentals are tax-deductible | Can be costlier than buying in the long run |
Risk of obsolescence lies with the lessor | The lessee never becomes the owner |
7. Public deposits
Deposits raised by companies directly from the public, usually for one to three years, at interest rates higher than bank deposits. Regulated by the RBI and the Companies Act.
Merits | Limitations |
|---|---|
Simple procedure; no restrictive conditions | New companies find it hard to raise them |
Cost is generally lower than bank loans | Unreliable source; the public may not respond |
No dilution of control | Difficult to collect large sums |
No charge on assets |
8. Commercial paper (CP)
An unsecured promissory note issued by large, creditworthy companies to raise short-term funds, usually for 90 to 364 days (allowed from 7 days to one year), at a discount to face value. Often used for bridge financing (meeting floatation costs before a share issue).
Merits | Limitations |
|---|---|
No collateral needed | Only financially sound, highly rated firms can issue it |
Freely transferable, highly liquid | Amount is limited to the surplus liquidity in the market |
Raises large funds compared with other short-term sources | Can't be extended; must be repaid on maturity |
Cost is generally lower than bank loans |
9. Issue of shares
Equity shares are the most important source of permanent capital. Equity shareholders are the owners: they get dividends from profits after preference shareholders, and have voting rights.
Merits of equity shares | Limitations |
|---|---|
Permanent capital; no repayment during the company's life | Investors who want steady income may avoid them |
No burden of fixed dividend | Costlier than other sources (higher expected return, floatation costs) |
Provide a cushion for creditors, building confidence | New issues dilute control of existing shareholders |
No charge on assets | More formalities and delays |
Preference shares carry two preferential rights: a fixed rate of dividend paid before equity dividend, and repayment of capital before equity shareholders on winding up. They usually have no voting rights except on matters affecting them.
Types of preference shares: cumulative and non-cumulative (whether unpaid dividends accumulate); participating and non-participating (whether they share in surplus profits); convertible and non-convertible (whether they can become equity); redeemable and irredeemable.
Merits of preference shares | Limitations |
|---|---|
Fixed dividend suits cautious investors | Not suitable for investors who want higher returns or control |
No dilution of control (no voting rights) | Dividend is not tax-deductible, unlike interest |
No charge on assets | Usually a higher rate of dividend than interest on debentures |
Increase the borrowing capacity of the company |
10. Debentures
Debentures are borrowed funds: a company borrows and issues debentures acknowledging the debt, paying fixed interest. Debentureholders are creditors, not owners.
Types: secured and unsecured; registered and bearer; convertible and non-convertible; redeemable and irredeemable; and zero coupon (issued at a discount, no interest).
Merits | Limitations |
|---|---|
Suit investors who want fixed income with low risk | Fixed interest is a burden in years of low earnings |
Interest is tax-deductible, so debt is cheaper | Must be repaid on a fixed date |
No dilution of control | Charge on assets reduces future borrowing capacity |
Cheaper than equity |
11. Commercial banks and financial institutions
Commercial banks provide loans for short and medium periods through cash credit, overdraft, term loans, discounting of bills and letters of credit.
Merits | Limitations |
|---|---|
Timely, flexible finance | Usually short-term; renewal is uncertain |
Secrecy maintained | Detailed investigation and security required |
Easier than issuing securities | Restrictive conditions may be imposed |
Financial institutions (development banks set up by central and state governments, such as industrial and state financial corporations) provide medium- and long-term finance, plus technical and managerial advice, especially for new and expanding businesses.
12. International sources of finance
Source | Meaning |
|---|---|
Commercial banks abroad | Foreign banks lend in foreign currency |
International agencies and development banks | Bodies such as the International Finance Corporation and the Asian Development Bank lend for development projects |
Global Depository Receipt (GDR) | Shares of an Indian company held by a depository bank abroad, which issues receipts traded on foreign stock exchanges (other than the USA). Holders get dividends but have no voting rights |
American Depository Receipt (ADR) | Like a GDR, but traded only in the USA and held by American investors |
Indian Depository Receipt (IDR) | Issued in India by a foreign company's Indian depository, against the foreign company's shares, traded on Indian exchanges |
Foreign Currency Convertible Bond (FCCB) | Bonds issued abroad in foreign currency, carrying fixed interest, convertible into the company's shares |
External Commercial Borrowing (ECB) | Loans raised by Indian companies from foreign lenders under RBI rules |
Inter-corporate deposits (ICD) are unsecured short-term deposits made by one company with another, usually for funds requirement for a few days to a year.
13. Factors affecting the choice of source
Factor | Consideration |
|---|---|
Cost | Both the cost of raising funds (floatation) and the cost of using them (interest or dividend) |
Financial strength and stability of operations | Firms with stable earnings can use fixed-charge sources like debt |
Form of organisation and legal status | Only companies can issue shares and debentures; a sole trader can't |
Purpose and time period | Short-term needs from short-term sources; long-term from long-term sources |
Risk profile | Equity is least risky for the firm (no fixed burden); debt is riskier |
Control | Issuing equity dilutes control; debt doesn't |
Effect on creditworthiness | Secured borrowing may reduce the firm's ability to borrow further |
Flexibility and ease | Some sources involve fewer formalities |
Tax benefits | Interest on debt is tax-deductible; dividends are not |
A reliable approach to case-based questions
Decide the period needed (short, medium, long) and the purpose (fixed or working capital).
Check the form of organisation: only companies issue shares and debentures.
Weigh cost, risk and control: wants no dilution of control (debt, retained earnings); wants no fixed burden (equity).
Identify the source from its clue: selling receivables (factoring), using an asset owned by someone else (leasing), unsecured short-term note by a big company (commercial paper), receipts traded in the USA (ADR).
Connections that matter
Forms of business organisation decides which sources are available.
Class 12 financial management covers financing decisions, capital structure and trading on equity.
Class 12 financial markets explains where shares, debentures and commercial paper are traded.
Common mistakes
Calling debentureholders owners. They are creditors.
Treating retained earnings as costless in every sense. They have an opportunity cost.
Confusing GDR and ADR. ADRs trade only in the USA; GDRs trade outside the USA.
Saying preference shareholders have full voting rights.
Recommending equity shares to a sole proprietor.
Revision checklist
I can explain the need for business finance and classify its sources.
I can explain each source with its merits and limitations.
I can explain GDR, ADR, IDR, FCCB, ECB and ICD.
I can explain the factors affecting the choice of source.