Sources of Business Finance

Written and reviewed by Rohit Singh, Computer Science & Commerce faculty at UniDrill (MCA, Osmania University · 6 years teaching). Based on NCERT Business Studies Class XI, Chapter 8.

Meera needs Rs. 25 lakh: where does it come from?

Meera runs a successful biryani cafe and wants to open two more outlets. Her savings are not enough. She can borrow from a bank, ask her suppliers for longer credit, bring in a partner, lease the kitchen equipment instead of buying it, or, if her business were a company, sell shares. Each choice costs something different, carries a different risk and gives a different amount of control to someone else. Choosing well is the point of this chapter.

Finance is the life blood of a business, because no business can start, run or grow without it.

Why a business needs money

A business that sells on credit, or whose stock sells slowly, needs more working capital than one that sells for cash and turns its stock over quickly.

Three ways to classify sources of funds

By period.

By ownership. Owner's funds come from the sole trader, partners or shareholders. They include the capital invested and the profits reinvested, and they carry the right of control. The main sources are equity shares and retained earnings. Borrowed funds are raised as loans. They carry a fixed rate of interest, must be repaid and are usually secured against fixed assets. Sources include bank loans, debentures, public deposits and trade credit.

By source. Internal sources are generated inside the business, for example by collecting receivables faster, selling surplus stock and ploughing back profits. They cover only limited needs. External sources come from suppliers, lenders and investors. They can be costly and may need assets to be pledged.

Pause and predict: which source is both an owner's fund and an internal source?

Check your answer: Retained earnings. They belong to the owners and they are generated inside the business from its own profits.

The sources, one by one

Retained earnings (ploughing back of profit, or self financing) are the part of net profit not paid out as dividend. How much a company can keep depends on its net profits, its dividend policy and its age.

Beyond the textbook. For the exam: retained earnings have no explicit cost, because no interest or dividend has to be paid on them. In reality: they are not free. Shareholders could have received that profit as dividend and invested it elsewhere, so there is a hidden opportunity cost. If management earns less on the retained money than shareholders could have earned themselves, it is using the money badly.

Trade credit is credit one trader gives another for buying goods or services. In the buyer's books it appears as "sundry creditors" or "accounts payable". How much credit and for how long depends on the buyer's reputation, financial position, volume of purchases, payment record and the level of competition.

Factoring. A factor collects a client's debts and discounts its bills, and also gives information about the creditworthiness of the client's customers.

Lease financing. The lessor (owner) lets the lessee use an asset for a periodic lease rental, and the asset returns to the lessor at the end. It suits assets that become outdated quickly, such as computers and electronic equipment, because the lessee is not stuck with an obsolete asset.

Public deposits are deposits a company raises directly from the public. Companies generally invite them for up to three years, so they meet medium and short term needs. Interest is higher than on bank deposits, yet cheaper for the company than a bank loan, and acceptance is regulated by the Reserve Bank of India.

Commercial paper (CP) is an unsecured money market instrument issued as a promissory note, introduced in India in 1990. Maturity ranges from 7 days to one year, the denomination is Rs. 5 lakh or multiples, and the maturity cannot go beyond the validity of the issuer's credit rating. Investors include individuals, banks, companies, NRIs and foreign institutional investors.

Beyond the textbook. For the exam: CP is a short term source that is cheaper than a bank loan. In reality: since CP is unsecured and depends only on the issuer's credit rating, only large, financially strong companies with a good rating can find buyers for it. A small business with no rating cannot use this route.

Inter corporate deposits (ICDs) are unsecured short term deposits made by one company with another. The minimum period under Reserve Bank guidelines is 7 days, extendable up to one year. They come in three types: three months, six months and call deposits, and they pay a higher interest than banks.

Commercial banks give cash credit, overdrafts, term loans, purchase or discounting of bills and letters of credit. Bank credit is not a permanent source of finance and is generally used for medium and short periods. The borrower must give security or create a charge on assets.

Financial institutions (also called development banks) are set up by the central and state governments to provide owned and loan capital for long and medium term needs. They also give market surveys, technical help and management services, and suit large funds for expansion, reorganisation and modernisation.

Shares and debentures: owner, creditor or in between

Equity shareholders are the residual owners because they receive what is left after every other claim on the company's income and assets has been met. Their liability is limited to the capital they contributed, and their capital is permanent because it is repaid only on liquidation.

Preference shares look like debentures because the return is fixed, and like equity because dividend is paid only out of profit and at the directors' discretion.

A public issue of debentures needs a credit rating from an agency such as CRISIL.

Worked example. A zero interest debenture of face value Rs. 1,000 is bought for Rs. 700 and repaid at Rs. 1,000 after a few years. No interest is paid on the way, so the investor's return is Rs. 1,000 minus Rs. 700 = Rs. 300.

Pause and predict: a partnership firm wants to raise Rs. 10 lakh by issuing equity shares to the public. Can it?

Check your answer: No. Shares and debentures can be issued only by a company, so a partnership firm cannot use them. The form of organisation decides which sources are open to a business.

Merits and limits at a glance

Borrowing across borders

Standard Chartered PLC was the first company to issue an IDR, in June 2010. Besides these, a company can borrow from international commercial banks (foreign currency loans) and from agencies such as the IFC, EXIM Bank and the Asian Development Bank.

Why it works this way. An Indian company that sells a GDR gets foreign money without moving its shares to a foreign market directly. The depository holds the shares and foreign investors trade the receipts instead. An IDR does the same job in the opposite direction.

Choosing the right source

There is no best source, only the best for a given business. Nine factors decide the choice.

A realistic example: Meera's choices

Meera's cafe is a proprietorship. Her supplier gives 30 days of trade credit (short term, external, borrowed). She leases two ovens for 3 years, because new kitchen technology keeps improving (medium term, lease). She keeps Rs. 4 lakh of this year's profit in the business (retained earnings, internal and owner's funds). For the remaining amount she takes a term loan from a bank, secured against her property, which keeps full control with her but adds fixed instalments. She cannot raise money through shares or debentures, because those are open only to companies.

Exam traps

60-second revision

Where this chapter connects

• Previous: Formation of a Company shows how a public company comes to the point where it can issue shares.
• Next: MSME and Business Entrepreneurship lists finance as the first problem of small businesses.
• Class XII link: Financial Management uses these sources when it discusses the financing decision and the cost of capital.