Class 11-commerce NCERT Solutions Business Studies Chapter 8 - Sources of Business Finance

Business finance refers to funds required for carrying out business activities.

Small business owners and big entrepreneurs face the biggest challenge when raising funds. Finding the right funds and growing eventually is what everyone is looking out for. As the business grows, there is an inevitable greater call for funds to finance expansion and to meet its day-to-day expenses. Liquid cash is needed to meet short-term requirements during the operating cycle. These operations include purchase of premises and payment of wages and salaries. Funds required to finance the expansion of a business are also considered part of business finance. Reasons why a business needs funds:

1. Fixed capital requirements: The funds required to purchase fixed assets such as building, machinery, furniture and fixtures are termed fixed capital requirement. The quantum of funds required varies from business to business depending on the nature and size of a business.
2. Working capital requirements: The funds required for meeting day-to-day business activities such as purchasing raw materials, payment of wages and salaries to employees and payment of rent are known as the working capital of an organisation. 

Sources of raising long-term finance:

1. Equity shares: Equity share is the most important source of raising long-term capital. Capital raised from equity shares is called ownership capital or owner's funds. Thus, equity shareholders are the owners of the company.
2. Retained earnings: For the future expansion of the company, part of the profits is retained in the organisation instead of distributing profits completely in the form of dividends among shareholders.
3. Preference shares: These shares get preference over equity shares regarding the repayment of capital and payment of earnings after a certain specified period of time.
4. Debentures: They are one of the common securities issued for securing long-term financial capital of companies. A fixed rate of interest is paid to debenture holders at specified intervals.

Sources of raising short-term finance:

1. Trade credit: It refers to the credit granted to manufacturers and traders of goods and services by the suppliers of raw materials and components. No immediate cash payments are made by the purchaser if trade credit is extended.
2. Bank credit: It is short-term finance advanced by commercial banks to a business firm. The borrower needs to mortgage assets and credit may be granted by way of overdraft, loan or cash. It can be either secured or unsecured depending on the circumstances.
3. Commercial paper: It can be termed an unsecured promissory note which acts as a source of short-term finance for organisations to meet short-term debt obligations, account receivables and inventories. 

Preferential rights enjoyed by preference shareholders:

1. Fixed dividends are to be paid to preference shareholders before paying dividends to equity shareholders.
2. Payment of capital of preference shareholders is done before equity shareholders at the time of liquidation of the company. 

Special financial institutions:

1. Industrial Finance Corporation of India (IFCI): It was set up as a statutory corporation under the Industrial Finance Corporation Act, 1948, in July 1948. The main objectives of IFCI comprise helping in balanced regional development and encouraging new entrepreneurs to enter the priority sectors of the economy.
2. State Financial Corporation (SFC): It was established under the State Corporations Act, 1951, to provide short and medium-term finance to industries which were not under the scope of IFCI.
3. Industrial Credit and Investment Corporation of India (ICICI): It was established in 1955 to facilitate the creation, modernisation and expansion of enterprises in the private sector.

Global Depository Receipt (GDR): In return for the local currency shares deposited in the account, the depository bank issues receipts, accounted in some foreign currency (US dollars), known as global deposit receipt (GDR). It is termed a negotiable instrument listed freely in the foreign stock exchange and can be bought and sold like any other security. It can be listed and traded on the stock exchange of any country other than the United States.

American Depository Receipt (ADR): A negotiable depository receipt or certificate which represents the shares of companies based in the United States. Unlike GDR, it can be listed only in the U.S. stock exchange and can only be issued to American citizens. American investors thus gain the ability to purchase shares in international firms.

Trade credit refers to the credit granted to manufacturers and traders of goods and services by suppliers. No immediate cash payments are made by the purchaser if trade credit is extended. It is granted only to customers or traders who are considered creditworthy by the supplier and have a good financial standing. The credit term varies from one industry to another and from person to person.

Merits of trade credit:

1. It is considered to be quite popular and the cheapest form of working capital finance. 
2. Trade credit leads to increase in sales of the organisation. 

Demerits of trade credit:

1. Trade credit generates only limited amount of funds depending on the creditworthiness of the firm.
2. It is an expensive source of finance as compared to other sources of raising money.

Bank credit is short-term finance lent by commercial banks to business organisations. The banks charge an interest rate which is prevailing in the economy, i.e. the interest can be either fixed or varied.

 Merits of bank credit:

1. It can be easily procured with significantly lower interest rates than credit cards. These interest rates are tax-deductible.
2. It maintains secrecy of the business as information provided by the borrower is not shared with outsiders.

Demerits of bank credit:

1. Loan is generally provided for short periods and it is difficult to extend and renew the loan.
2. Mostly banks impose difficult terms and conditions on mortgaged goods or property. 

Sources from which a large industrial enterprise can raise capital for financing modernisation and expansion:

1. Equity share: Equity share is the most important source of raising long-term capital. Capital raised from equity shares is called ownership capital or owner's funds. Thus, equity shareholders are the owners of the company.
2. Retained earnings: For the future expansion of the company, part of the profits is retained in the organisation instead of distributing profits completely in the form of dividends among shareholders.
3. Preference shares: These shares get preference over equity shares regarding the repayment of capital and payment of earnings after a certain specified period of time.
4. Debentures: They are one of the common securities issued for securing long-term financial capital of companies. A fixed rate of interest is paid to debenture holders at specified intervals.
5. Loans from banks and financial institutions: Banks and financial institutions advance money to firms. The interest rate along with the loan amount is stated in advance while taking a loan. 

Advantages of debentures over the issue of equity shares:

1. Issue of debentures does not dilute the control of existing shareholders on the management as debenture holders do not have voting rights.
2. Cost of raising funds through debentures is low as compared to equity shareholders. This is because interest payments made to debenture holders is a tax-deductible expense.
3. Debenture holders are paid a fixed amount irrespective of the profit or loss situation of the company. However, equity shareholders are paid more dividends when the firm is making more profits. 

Public deposits: These are directly raised from the public by organisations to finance both medium and short-term financial requirements. These deposits provide higher interest rates as compared to bank deposits. Reserve Bank of India regulates the acceptance of public deposits.

Merits of public deposits:

1. It is a convenient source of acquisition of business finance with only a few regulations involved and no cumbersome legal formalities.
2. The administrative cost of public deposits is generally lower than the cost involved in borrowing loans from commercial banks and less than that involved in issue of debentures and shares. Thus, funds can be borrowed from a larger segment of people.
3. Depositors cannot interfere with the company's internal management as they do not have any voting or management rights. Thus, acceptance of public deposits does not result in any dilution of ownership of the business.

Demerits of public deposits:

1. Uncertain conditions of the economy affect people which make them unwilling to invest much in the concerned company. Being called an unsecured debt, depositors have to bear the risk of money loss in case of the company's failure.
2. Long-term financial goals cannot be met through public deposits as its maturity period is short.

Retained earnings: For the future expansion of the company, part of the profits is retained in the organisation instead of distributing profits completely in the form of dividends among shareholders.

Merits of retained earnings:

1. No acquisition cost is involved as these funds are raised internally and do not depend on any outside resource.
2. These are permanent sources of funds as they are raised internally without any cost.
3. Organisations can deal with losses through retained earnings.

Demerits of retained earnings:

1. Business fluctuations occur from time to time because of which retained earnings are an uncertain source of finance.
2. Shareholders are dissatisfied when an organisation retains a significant portion of the earnings in the organisation.
3. Failure in recognising the opportunity cost of retained earnings will result in the funds being used sub-optimally. 

Financial instruments used in international financing:

1. Commercial banks: These banks are located all over the world and provide foreign currency loans to firms. Different types of loans and services are provided by banks to different  countries.
2. Global Depository Receipt (GDR): In return for the local currency shares deposited in the account, the depository bank issues receipts, accounted in some foreign currency (US dollars), known as global deposit receipt (GDR). It is termed a negotiable instrument listed freely in the foreign stock exchange and can be bought and sold like any other security. It can be listed and traded on the stock exchange of any country other than the United States.
3. American Depository Receipt (ADR): A negotiable depository receipt or certificate which represents the shares of companies based in the United States. Unlike GDR, it can be listed only in the U.S. stock exchange and can only be issued to American citizens. American investors thus gain the ability to purchase shares in international firms. 

Commercial paper is an unsecured promissory note which acts as a source of short-term finance for organisations to meet short-term debt obligations, account receivables and inventories. The maturity period of a commercial paper usually ranges from 90 to 364 days.

Advantages:

1. It is a low cost alternative. It is cheaper to draw a commercial paper than a commercial bank loan which offers funds at higher interest rates.
2. It is transferable to anyone at anytime and is negotiable by endorsement and delivery. Thus, it functions as a liquid asset with more options because of its tradability.
3. A company's capital cost gets reduced if its commercial papers are given a good rating along with earning good returns when surplus investments are made in commercial papers.
4. Being an unsecured instrument, it does not create any liens on the company's assets and can be issued in large chunks without any noticeable restriction from the regulatory authorities such as federal SEC and State Securities.

Limitations:

1. Limited eligibility; one of the major drawbacks is that it is an unsecured security. It can only be used by large firms and blue-chip corporations having a strong market position and cannot be afforded by the public and start-ups.
2. Bank credit limits take a fall because of commercial paper. Although the amount raised through commercial paper is high, it has its limits owing to its dependency on the availability of funds with buyers at the time of its issue.
3. Commercial paper does not have a secondary market and thus has a maturity which ranges from 90 to 364 days. Therefore, if the funds are tied up or if a firm is unable to redeem its commercial paper on time because of unavailability of funds, then it cannot extend the time period of the commercial paper.