Business Studies Chapter 8 Sources Of Business Finance

1. Permanent or fixed working capital.
2. Variable working capital.

2. Fall in the credit worthiness of the company : To get loans through debenture company has to pledge its assets. It affects the goodwill of the company adversely. Public and banks also do not have favourable opinion about such companies which get loans by issuing debentures.

1. Owned Funds : (a) Equity shares, (b) Preference shares, (c) Ploughing back of profit.

2. Borrowed Funds : (a) Debentures, (b) Financial institutions, (c) Public deposits, (d) Banks.

1. Business activities are not possible without finance. Financing is an essential business activity.

2. All business enterprises whether large or small need finance.

3. Small sized business enterprises need lesser funds, whereas large sized business houses need more funds.

4. Business finance includes borrowed funds and owned capital.

5. Business finance is a wider term. It is concerned with planning, acquiring, utilizing and managing funds.

The significance of finance can be summarized as under:

1. Meeting expenses concerning establishment of business.

2. Finance is required for purchasing fixed assets and current assets.

3. Prompt payment of debts builds credit worthiness of the business, so funds can be easily borrowed.

4. Smooth functioning of business.

5. Meeting day to day expenses of the business.

6. Bridging the gap between production and sales. Availability of funds is necessary to carry on production activities continuously.

7. Availability of adequate finance at proper time in the hands of competent management ensures the success of the business.

1. Long-Term Finance : Finance required for permanent fixed investment in revenue generating fixed capital is known as long-term finance. Long period consists of more than 5 or 10 years. Long-term finance cannot be withdrawn. 

2. Medium-Term Finance : Medium term consists of the period between 2 to 5 years (depending upon nature and size of enterprise).

3. Short-Term Finance: Short-term consists of the period not exceeding one year. It is also known as circulating or working capital. It meets the short-term day to day operating needs of the business. Trading firms require more working capital than manufacturing concerns.

1. Deposits are accepted for specified period for at least six months and at the most 36 months.

2. Deposits are made generally in the multiples of thousands.

3. No security is offered to depositors.

4. Interest is paid either monthly, quarterly, half yearly, annually or at the expiry of the period as per agreement. Maximum rate of interest is 15%.
5. Public deposits are cheaper than bank loan for the company and fetch interest at rates higher than deposits with the banks.

(ii) There is no need of creating any sort of charge against firm’s assets for obtaining the trade credit.

(iii) Trade credit is flexible means of financing since the firm does not have to sign a note, pledge, securities or adhere to strict payment schedule.

1. Trade credit (Accounts payable)

2. Accrued income.

3. Bank credit

4. Instalment credit

5. Accounts receivables financing

6. Customer advances.

The sources of long-term finance include :

1. Issue of shares, equity and preference

2. Issue of debentures.

3. Loans from financial institutions.

4. Retained profit and

5. Loan from banks.

Borrowed Capital: Borrowed fund include all funds available in the form of loans or credits. Loans are raised to business firms for specified periods at fixed rates of interest.

1. Equity shares have the risk of fluctuating returns and the risk of fluctuating market value of shares. In times of adversity, these may be low returns or even no returns.

2. Equity share capital is a permanent source of finance. It cannot be refunded during the life of the company. When there is no scope for expansion or new investment during periods of economic depression, the equity capital may remain idle, the rate of return may be reduced since there is no commitment to pay and no fixed obligations to be made on equity capital. There is always the possibility of putting it to such optimal uses.

3. There are too many procedural delays and too many time consuming formalities to be completed before any public issue of shares can be made.

4. An equity issue cannot be made any time the company wants. It depends on market conditions.

1. Finance required for a period more than 5 years is known as long-term finance. According to certain authorities finance for a period exceeding ten years is known as long-term finance.

2. Long-term finance is required for making investment in fixed assets, such as land, building, plant, machinery, vehicles equipments, furniture etc.

3. Long-term finance meets long-term financial needs of the business. These needs are permanent needs of the business.

4. Fixed assets purchased out of long-term finance are revenue generating.

5. Long-term finance once invested in the business cannot be taken back without dissolving the business or scaling down the business.

6. Long-term finance is acquired through issue of shares, debentures or loan from specialized financial institutions.

1. Redeemable debenture : The amount of the debentures are to be repaid within certain specified period as per the terms of their issue.

2. Irredeemable debentures : These are perpetual debentures. The company has no right to make the payment of the principal of these debentures during its life time. These debentures are repaid in case of winding up of the company.

3. Bearer debentures : These debentures are transferable by mere delivery. The name of holder is not registered with the company.

4. Registered debentures : These debentures are not transferable by mere delivery. The names of the debenture holders are registered with the company.

5. Naked debentures : These debentures are not mortgaged and they are issued without any charge on company’s assets. The issue of these debentures is not popular with the company.

6. Secured or Mortgaged debentures : These debentures are secured by a charge on company’s assets. This charge may be fixed or floating.

7. Collateral debentures : Debentures may also be issued to banks and financial institutions as an additional or subsidiary security in addition to certain principal security. Lending institutions can exercise their right as debenture holders, if the company does not pay loan and interest thereon and the principal security falls short.

1. Risk is minimised as well as capital is available for a longer period of time at relatively cheaper rates of interest. Special financial institutions provide underwriting and direct subscription facilities also.

2. Assistance is available for new companies when recourse to normal sources is impracticable or unprofitable.

3. As these institutions carry out a thorough investigations before granting assistance to a concern, relationship with them helps increase the credit worthiness of a company.

4. Loans and guarantees in foreign currency and deferred payment facilities are available for the import of required machinery and equipment.

5. The rate of interest and payment procedures are convenient and economical. Facilities for repayment in easy instalments are made available to deserving concerns.

6. Along with finance, a company can obtain expert advice and guidance for the successful planning and administration of projects.

(2) Many desiring concerns may fail to get assistance for want of security and other conditions laid down by these institutions.

(3) Sometimes, these institutions place restrictions on the autonomy of management. They lay down a convertibility clause in loan agreements. In some cases, they insist on the appointment of their nominees on the Board of Directors of the debtors company.

1. Excessive issue of equity shares may lead to over-capitalisation.

2. The affairs of the company can be manipulated by the powerful group of equity shareholders.

3. If the company issues only equity shares, it will lose the opportunity of trading on equity by issuing other securities.

4. Higher dividends on equity shares during prosperous periods push up their market value and generally lead to speculation.

2. If preference shares are cummulative and dividend is not paid in a particular year, then the dividend will be carried forward to the next year.

3. If preference shares are redeemable, they will be redeemed at the end of their term.

1. It does not affect the owners’ control over management;

2. Interest is treated as an expense, so it can be charged against income;

3. Fixed liability : Payment of interest and repayment of loans cannot be avoided even if there is no profit. Default in meeting these obligations may create problems for the business. To begin with, business may suffer on account of decline of its credit worthiness. Continuing default may even lead to insolvency of the firm.

4. Adequate security : It requires adequate security to be offered against loans. Borrowed fund are usually available upto 80% of the value of assets, depending on the nature and value of the asset.

Objects : The purpose of IFCI is “to make medium and long-term credits more readily available to industrial concerns in India, particularly incircumstances “Where normal banking accommodation is inappropriate or recourse to capital issue method is impractiable.” The corporation provides financial assistance for the setting up new ventures as well as the modernisation and expansion of existing enterprises. The IFCI gives priority to dispersal of industry development of backward areas, growth of industries in the co-operative sector, etc. It pays special attention to the following types of projects :

(a) Projects located in backward regions.

(b) Projects promoted by new entrepreneurs and technocrats.

(c) Projects based on indigenous technology.

(d) Projects having potential for exports and import substitution.

(e) Projects likely to meet growing demand for essential commodities.

(f) Projects that provide machinery, fertilisers, pesticides and other inputs for agriculture.

2. Industrial Credit and Investment Corporation of India (ICICI) : The ICICI was set up on January 5, 1955 as a public limited company under the Company Act. The corporation was set up as a privately owned institution but later on the Life Insurance Corporation of India (a statutory corporation) become its major shareholder.

The objectives of the ICICI are to : (a) assist in the promotion expansion and modernisation of induatrial enterprises in the private sector, (b) encourage and promote the participation of private capital, both Indian and foreign and (c) encourage and promote private ownerships of industrial investments and expansion of investment markets. The ICICI is a unique institution in several ways. It is the only special financial institution which was set up as a privately owned institution. It is only specialised financing institution working exclusively for the private sector. It was registered as a public limited company, not as a statutory corporation. It is international both in ownership and operation.

3. Insustrial Development Bank of India (IDBI) : The Industrial Development Bank of India was set up as an apex institution and it started its operations with effect from July 1, 1964. It was set up as a statutory corporation under Industrial Development Bank of India Act, 1964. The needs of rapid industrialisation, long-term financial needs of heavy industry beyond the resources of the then existing Institutions, absence of a central agency to coordinate the activities of other financial institutions and gaps in the financial and promotional services were the main causes behind the establishment of the IDBI. The Bank represent an attempt to combine in a single institution the requirements of and expanding economy and need for a coordinate approach to industrial financing. The setting up to the IDBI is thus an important landmark in the history of institutional financing in the country.

Objectives : (a) co-ordinate, regulate and supervise the activities of all financial institutions providing long-term finance to industry.

(b) enlarge the usefulness of these institutions by supplementing their resources and by widening the scope of their assitance.

(c) provide direct finance to industry to bridge the gap between demand and supply of long-term and medium-term finance and industrial concerns in both public and private sectors.

(d) locate and fill up gaps in the industrial structure of the country.

(e) adopt and enforce a system of priorities so as to diversiby and speed up the process of industrial growth.

1. It helps enlarge the sources of funds as some financial institutions and individuals prefer to invest in preference shares due to the assurance of a fixed return. This helps the company attract investors.

2. Dividend is payable only when there are profits. These are not fixed liabilities as in the case with loans and borrowings.

3. A higher return is possible if the company is in good times, as in the case of participating preference shares.

4. It does not affect the equity shareholders control over management.

Limitations are as follows :

1. Dividend paid cannot be charged to the company’s income as an expense; hence there is no tax saving as in the case of interest on loans.

2. Issue of preference shares does not attract many investors as there is no assured return, and the return is generally low and lesser than the rate of interest on loans.

3. The holders of preference shares have a right to vote on any resolution of the company directly affecting their rights, which includes any resolution for winding-up the company, repayment or reduction of its share capital, etc.

1. Equity shareholders have a residual claim in the firm. In other words, the income left after satisfying the claims of all creditors, outsiders, and preference shareholders, belongs to equity shareholders.

2. Equity shareholders are likely to enjoy a higher profit as well as increase in the value of the shares.

3. Equity share capital is the basis on which loans can be raised. It provides credibility to the company and confidence to the loan providers.

4. Since equity share holders have the right to vote for the election of the board of directors they ensure that the company is managed in the best interests of the shareholders.
Advantages :

1. It is a source of permanent capital without any commitment of a fixed return to the shareholders. The return on capital depends ultimately on the profitability of business.

2. It facilitates a higher rate of return to be earned with the help of borrowing funds because loans carry a fixed rate of interest. Hence, equity shareholders are likely to enjoy a higher rate of return based on profitability.
3. It is on the basis of equity share capital that loans can be raised. Equity provides the credibility to the company and confidence to the prospective loan provider.

4. Democratic control over management of the company is assured due to the voting rights of equity shareholders.

1. On the basis of the period,

2. Ownership basis,

3. Sources of Generation Basis.

1. On the Basis of Period : On the basis of period, the different sources of funds can be categorized into three parts.

a. Long-term finance : Long-term sources fulfil the financial requirements of an enterprise for a period exceeding 5 years and include sources such as shares and debentures.

b. Medium-term finance : The sources that fulfil the financial requirements for the period of more than one year but not exceeding 5 years are called medium-term sources.

c. Short-term finance : Short-term finance are those which are required for a period not exceeding one year.

2. Ownership Basis : On the basis of ownership, the sources can be classified into “owners funds” and “borrowed funds”. Owners funds means funds that are provided by the owners of an enterprise. Borrowed funds, refer to the funds raised through loans or borrowings.

3. Sources of Generation Basis : Sources of Generation Basis are as follows :

a. Internal Sources : Internal sources of funds are those that are generated from within the business. A business, for example, can generate funds internally by accelerating collection of receivables, disposing of surplus inventories and ploughing back its profit.

b. External Source : External sources of funds include those sources that lie outside an organization, such as supplies, lenders, and investors.

1. The cost of debt capital, represented by debentures is lower than the cost of preference or equity capital. This is because the interest on debentures is tax deductible and hence it helps in increasing the rate of return. Thus debenture issue is a cheaper source of finance.

2. Debenture financing does not result in dilution of control of equity shareholders, since debenture holders are not entitled to vote.

3. The fixed monetary payment associated with debentures is interest. This fixed return appeals to many investors, since they are not affected by the fluctuating fortunes of the company.

4. Funds raised by the issue of debentures may be used in business to earn a much higher rate of return than the rate of interest. As a result the equity shareholders earn more.

Demerits :

1. It involves a fixed commitment to pay interest regularly and fixed obligation to pay the amount when it is due on the part of the company.

2. This liability must be discharged even if the company has no earnings. The burden may be difficult to bear in times of falling profits.

1. As an internal source, it is more dependable than external sources. It does not depend on the investors’ preference and market conditions.

2. Use of retained profit does not involve any cost to be incurred for raising the funds. There are no expenses on prospectus, advertising, etc.

3. Control over the management of the company remains unaffected as there is no addition to the number of shareholders.

4. Unlike debentures, no charge is created against the assets and no restrictions are put on the management.
5. Retained earnings add to the financial strength and improved credibility of the company. A company with large reserves can face unforeseen contingencies, trade cycles and any other crisis.

No, a company cannot grow indefinitely by reinvesting surplus profit because there are certain limitations :

1. The management of a company may not always use the retained earnings in the best interest of shareholders. It may issue them by investing in unprofitable or undesirable channels. Excessive reserves may make the management wasteful and extravagant.

2. Large retention of earnings over a long period of time may cause dissatisfaction among shareholders as they do not receive the expected rate of dividend.

3. If the quantum of retained earnings is too high, the management may issue bonus shares to equity shareholders. Frequent capitalization of reserves may result in over capitalization.

1. Purchase of fixed assets, such as land, building, plant, machinery, furniture, fixture, etc.

2. Meeting the cost of current assets e.g. inventories, account receivable, etc.

3. Meeting the cost of formation of a company e.g., drafting of legal documents, registration fees, stamp duty etc.

4. Meeting the cost of raising finance e.g., underwriting commission, brokerage etc.

5. Purchase of intangible assets like goodwill, patents, copyright, etc. becomes easy.

6. Providing for the growth and expansion the business.

1. Financing through preference shares is a flexible financing arrangement, since payment of dividend is not a legal obligation of the company in issuing the preference shares. If earning declines and the financial condition of the company deteriorates, the company can omit to pay the dividend.

2. Preference shares have long maturity date and thus, in sense, the funds provided by them is a sort of long-term loan. They give sufficient flexibility to the company by allowing it to make interest payments or planning for repayment of principal.

3. Preference shares add to the equity base of the company and thereby strengthen its financial positions. Additional equity base enhances the ability of the company to borrow in future.

4. Preference shares capital also is a sort of cushion to the debentureholders and thus they save the company from paying higher rate of interest.

5. Issue of preference shares does not create any sort of charge against assets of the company. Thus the assets, are freely available for raising additional funds from any other sources.

6. Preference shares are entitled to a fixed rate of dividend. The company, may, therefore, pay dividend to the equity shareholders at a rate higher than the overall return on investment (ROI) and thus take advantage of trading on equity.

7. Issuing the performance shares does not materially disturb the existing pattern of control of the company as compared to the issue of equity share since preference share holders are entitled to vote only on such resolutions which directly affect their interests.

8. Financing through preference share is cheaper as compared to financing through equity shares.

9. Preference shares are particularly useful for those investors who want higher rate or return with comparatively lower risk.

10. The company can utilize huge surplus funds at its disposal by redeeming the redeemable preference shares as per provisions of the Companies Act.

1. Issue of shares : Issue of shares is the most important source of raising long-term finance. It refers to a share in the share capital of the company. It is one of the units into which the share capital of a company can be divided. Those who subscribe to the share capital becomes member of the company and also called shareholders. They are the owners of the company. Two types of shares may be issued : (i) Preference shares and (ii) Equity shares. Preference shares carry a fixed rate of dividend to be paid if there are profits, where as equity shares do not carry a fixed rate of dividend.

2. Issue of Debentures : A debenture is the instrument of certificate issued by a company to acknowledge is debt. It is also an undertaking to repay the specified sum with interest to its holder. Debentures are known as creditor securities. Those who invest money in debentures are known as ‘debenture holders’. They are the creditors of the company. Debentures carry a fixed rate of interest. Debentures may be secured debentures, insecured debentures convertible debentures and non-convertible debentures.

3. Loans from financial institutions : A number of financial institutions have been set up by government with the main object of promoting industrial development. The institutions play on important role as sources of company finance. Besides, they also assist companies to raise funds from other sources.

1. It is preferred by investors who want fixed income at lesser risk;

2. Debentures are fixed charge funds and do not participate in profits of the company.

3. The issue of debentures is suitable in the situation when the sales and earning are relatively stable;

4. As debentures do not carry voting rights, financing through debentures does not dilute control of equity shareholders on management.

5. Financing through debentures is less costly as compared to cost of preference or equity capital as the interest payment on debentures is tax deductibel.

Differences between debentures and shares :

1. Shares are parts of the capital of the company. Debentures constitute loan to the company. Shareholders are owners of the company. Debenture holders are creditors of the company. A shareholder enjoys all the rights of membership of a company such as right to vote, etc. these rights are not available to the debenture holders.

2. Payment of fixed interest on debentures shall be made prior to payment of any dividend to the shareholders out of the profits of the company.

3. Even with regard to return of principal, debentures will have prior claim over share capital.

4. Debentures usually have a charge on the assets of the company as distinguished from shares which have no such charge.

5. Interest on debentures is payable whether there are profit or not, but dividends on share are paid only where the company had earned profits. Interests on debentures is a debt and may be paid even out of capital. But a dividend on a share can never be paid out of capital.

6. Debentures carry a fixed rate of interest while dividends given to the shareholders may fluctuate from year to year according to the amount of profit.

7. Debentures do not carry voting rights, and therefore, debenture holders are not in position to exercise any control over the affairs of the company. Shareholders as members of the company, enjoy right to yote in general meetings and thus, can exercise control over the management of the company.

8. Unlike shares, debentures can be purchased and redeemed by the company unless they are perpetual or irredeemable. Debentures can not be issued at discount but a share can be issued at a discount, unless the company satisfies the conditions of section 79 of the Companies Act.

1. Trade credit is convenient and continuous source of funds.

2. Trade credit may be readily available in case the credit worthiness of the customers is known to the seller.

3. Trade credit needs to promote the sales of an organisation.

4. It an organisation wants to increase its inventory level in order to meet expected rise in the sales volume in the near future, it may use trade credit to, finance the same.

5. It does not create any charge on the assets of the firm while providing funds.

Demerits are as follows :

1. Availability of easy and flexible trade credit facilities may induce a firm to indulge in overtrading, which may add to the risks of the firm.

2. Only limited amount of funds can be generated through trade credit.

3. It is generally a costly source of funds as compared to most other sources of raising money.

1. Obtaining funds through factoring is cheaper than financing through other means such as bank credit.

2. With cash flow accelerated by factoring, the client is able to meet his liabilities promptly as and when these arise.

3. Factoring as a source of funds is flexible and ensures a definite pattern of eash inflows from the credit sales. It provides security for a debt that a firm might otherwise be unable to obtain.

4. It does not create any charge on the asses of the firm.

5. The client can concentrate on other functional areas of business as the responsibility of credit control is shouldered by the factor.

Limitations are as under :

1. This source is expensive when the invoices are numerous and smaller in amount.

2. The advance finance provided by the factor firm is generally available at a higher interest costs than the usual rate of interest.

3. The factor is a third party to the customer who may not feel comfortable while dealing with it.

1. It enables the lessee to acquire the asset with lower investment.

2. Simple documentation makes it easier to finance assets.

3. Lease rentals paid by the lesseee are deductible for computing taxable profits.

4. It provides finance without diluting the ownership or control of business.

5. The lease agreement does not affect the debt raising capacity of an enterprise.

6. The risk of obsolescence is born by the lessor. This allows greater flexibility to the lessee to replace the assets.

Limitations are as under :

1. A lease agreement may impose certain restrictions on the use of assets.

2. The normal business operations may be affected in case the lease is not renewed.

3. It may result in higher layout obligation in case the equipment is not funds useful and the lessee opts for premature termination of the lease agreement.

4. The lessee never becomes the owner of the asset. It deprives him of the residual value of the asset.

2. It provides more funds compared to other sources. Generally, the cost of CP to the issuing firm is lower than the cost of commercial bank loans.

3. As it is a freely transferable instrument, it has high liquidity.

4. Commercial paper provides a continuous sources of funds. This is because their maturity can be tailored to suit the requirements of the issuing firm. Further, maturing CP can be repaid by selling new CP.

5. Companies can park their excess funds in CP thereby earning some goods return on the same.

Limitations of commercial paper :

1. Only financial sound and highly rated firms can raise money through commercial papers. New and moderately rated firms are not in a position to raise funds by this method.

2. The size of money that can be raised through CP is limited to the excess liquidity available with the suppliers of funds at a particular time.

3. CP is an impersonal method of financing. As such if a firm is not in position to redeem its paper due to financial difficulties, extending the maturity of CP is not possible.

1. Banks provide timely assistance to business

periods and its extension or renewal is uncertain and difficult.

2. Banks make detailed investigation of company’s affairs, financial structure etc. and may also ask for security of assets and personal sureties. This makes the procedure of obtaining funds slightly difficult; and

3. In some cases, difficult terms and conditions are imposed by bank for the grant of loan. For example, restrictions may be imposed on the sale of mortgaged goods, thus making the normal business working difficult.

1. Financial institutions provide long-term finance, which are not provided by commercial banks.

2. Obtaining loan from financial institutions increases the goodwill of the borrowing company in the capital market. Consequently, such a company can raise funds easily from other sources as well.

3. Besides providing funds, many of the institutions provide financial, managerial and technical advice and consultancy to business firms.

4. As repayment of loan can be made in easy installments, it does not prove to be much of a burden on the business; and

5. The funds are made available even during the periods of depression, when other sources of finance are not available.

Limitations are :

1. Financial institutions are follows rigid criteria for grant of loans. Too many formalities make the procedure time-consuming and expensive.

2. Certain restrictions such as restriction on dividend payment are imposed on the powers of the borrowing company by the financial institutions.

3. Financial institutions may have their nominees on the Board of Director’s of the borrowing company there by restricting the powers of the company.

1. Commercial Banks : Commercial banks all over the world extend foreign currency loans for business purposes. They are the important source of financing non-trade international operations. The types of loans and services provided by banks vary from country to country.

2. International Agencies and Development Banks : A number of international agencies and development banks have emerged over the years to finance international trade and business. These bodies provide long and medium term loans and grants promote to development economically backward areas in the world. These bodies were set up by the Governments of developed countries of the world at national, regional and international levels for funding various projects.

3. International Capital Markets : Modern organisations including multinational companies depend upon sizeable borrowings in rupees as well as in foreign currency. The prominent financial instruments used for this purpose are :

(a)Global Depository Receipts (GDRs) : GDRs are issued to tap the global capital markets by way of global equity offerings. However these are indirect equity offerings and the shares issued

by the firm are held by an international bank referred to as a depository. This bank receives dividends, notices and reports and issues negotiable certificates as claims against these shares. These claims are the GDRs and such shares are called depository shares. GDRs are non voting equity holdings. In short, GDRs are dollar denominated instruments usually representing a certain number of equity shares denominated in rupees.

(b) American Depository Receipts (ADRs) : The depository receipts issued by a company in the USA are known as American Depository Receipts. ADRs are bought and sold in American markets like regular stocks. It is similar to a GDR except that it can be issued to the USA citizens only and can be listed and traded on a stock exchange of USA.

(c)Foreign Currency Convertible Bonds (FCCB’s): Foreign currency convertible bonds are equity linked debt securities that are to be converted into equity or depository receipts after a specific period. Thus, a holder of FCCB has to option of either converting them into equity shares at a predetermined price or exchange rate, or retaining the bonds.

1. Cost : There are two types of cost viz. the cost of procurement of funds and cost of utilizing the funds. Both these costs should be taken into account while deciding about the source of funds that will be used by an organisation.

2. Financial strength and stability of operations : In the choice of source of funds business should be in a sound financial position so to be able to repay the principal amount and interest on borrowed amount. When the earnings of the organisation are not stable, fixed charged funds like preference shares and debentures should be carefully selected as these add to the financial burden of the organisation.

3. Form of organisation and legal status: The form of business organization and status influences the choice of a source for raising money. A partnership firm, for example, cannot raise money by issue of equity shares as these can be issued only by a joint stock company.

4. Purpose and time period : Business should plan according to the time period for which the funds are required. A short-term need for example can be met through borrowing funds at low rate of interest through trade credit, commercial paper, etc. For long-term finance, sources such as issue of shares and debentures are more appropriate. Similarly the purpose for which funds are required need to be considered so that the sources is matched with the use.

5. Risk profile : Business should evaluate each of the source of finance in terms of the risk involved. For example, there is lest risk in equity as the share capital has to be repaid only at the time of winding up and dividends need not be paid if no profits are available. A loan on the other hand, has a repayment schedule for both the principal and the interest is required to be paid irrespective of the firm earning of profit or incurring a loss.

6. Control : A particular source of funds may affect the control and power of the owners on the management of a firm. Issue of equity shares may mean deletion of the control. For example, as equity sharesholders enjoy voting rights. Financial institutions may take control for the assets or impose conditions as part of the loan agreement. Thus, business firm should choose a source keeping in mind the extent to which they are willing to share their control over buriness.

7. Flexibility and ease : Another aspect affecting the choice of a source of finance is the flexibility and ease of obtaining funds. Restrictive provision, detailed, investigation and documentation in case of borrowings form banks and financial institutions for example maybe the reason that a business organization may not prefer it, if other options are readily available.

8. Effect on credit worthiness : The dependence of business on certain sources may affect its credit worthiness in the market. For example, issue of secured debentures may affect the interest of unsecured creditors of the company and may adversely affect their willingness to extend further loans a credit to the company.

9, Tax benefits : Various sources may also be weighed in terms of their tax benefits. For example, while the dividend on preference shares is not tax deductible, interest paid on debentures and loan is the tax deductible and may therefore be preferred by organisations seeking tax advantages.

1. It provides risk capital, which makes it possible for creditors to deal confidently with the company. Ownership capital forms the basis for rising loans.

2. It is a source of permanent capital, i.e. it is not returnable. It is non-refundable to such time that business ceases. Therefore, the company is confident of retaining such amounts to meet any problems and unforeseen contingencies.

3. Since management is separate from ownership, professional managers can be employed to look after the interests of all stockholders.

4. Since no security is required for equity, the assets of the company are free to be used for raising loans. Thus, it can be used to enhance the capital base of the firm.
5. Unlimited amount of capital can be raised. The capacity of the proprietor of a sole proprietorship firm is extremely limited. In a partnership, capital is limited to the financial capability of the partners. In the case of a company, large number of members may participate. Thus, it can generate huge amounts of capital.

Limitations :

1. Diffusion of control : A joint stock company can raise amounts by issuing shares to the public. But it leads to an increased number of people having ownership interest and right of control over management. This may reduce the original promoter’s power of control over management.

2. Possibility of under utilization of ownership funds : Being a permanent source of capital, ownership funds cannot be reduced easily in the case of a company. Share capital is not refundable as long as the company is in existence. This means a part of this fund remaining idle when there is no scope for expansion or fresh investment opportunities.

2. Participating or non-participating preference shares : Participating preference hsres give the holder the right to share in the residual profits left after the payment of dividend to preference and equity shareholders. This share is in addition to fixed dividend. On the contrary, the holders of non-participating preference shares do not enjoy the right to share in the surplus profits. They only get the fixed dividend.

3. Convertible and non-convertible preference shares : Holders convertible preference shares can get such shares converted into equity shares after a fixed period. On the other hand, preference shares which cannot be converted into equity shares are known as non-convertible preference shares. Unless otherwise stated all preference shares are deemed to be non-convertible.

4. Redeemble or non-redeemable preference shares : Redeembale, preference shares are those which the company undertakes to redeem after a specified period. Where there is no such undertaking, the shares are called irredeemable, preference shares. However, these shares can also be redeemed by the company after specified period by giving notice as per the term of issue. It may be noted that companies are no longer permitted to issue irredeemable preference shares.

1. As an internal source, it is more dependable than external sources. It does not depend on the investors’ preference and market conditions.

2. Use of retained profit does not involve any cost to be incurred for raising the funds,. There are no expenses on prospectus, advertising etc.
3. There is no fixed commitment to pay dividend on such funds.

4. Control over the management of the company remains unaffected as there is no addition to the number of shareholders.

5. Unlike debentures, no charge is created against the assets and no restrictions are put on the management.

6. Retained earnings add to the financial strength and improved credibility of the company. A company with large reserves can face unforeseen contingencies, trade cycles and any other crisis.

Demerits :

1. The management of a company may not always use the retained earnings in the best interest of shareholders. It may issue them by investing in unprofitable or undesirable channels. Excessive reserves may make the management wasteful and extravagant.

2. Large retention of earnings over a long period of time may cause dissatisfaction among shareholders as they do not receive the expected rate of dividend.

3. If the quantum of retained earnings is too high, the management may issue bonus shares to equity shareholders. Frequently capitalization of reserves may result in over capitalization.

Merits of Public deposits :

1. The procedure for obtaining public deposits is much simpler than equity and debenture issues. Thus there are fewer administrative costs for deposits.

2. Public deposits are unsecured. Thus the assets are free to be used as mortgage in future, if need be.

3. Interest paid on public deposits is tax deductible. Hence, it helps in bringing down the tax liability.

4. There is no dilution of shareholders’ control because the depositors have no voting rights.

Demerits of Public deposits :

1. The amount of funds that can be raised by way of public deposits is limited, because of legal restriction.

2. The maturity period is relatively short. The company can not depend on them for long term financing requirements.

3. Public deposits are an uncertain and unreliable source of finance. The depositors may not respond when conditions in the economy are uncertain. Also, deposits may be withdrawn whenever the depositors feel shaky about the financial health of the company.

Trade credit is a very simply and convenient method of raising short term finance. No formalities are involved and the credit is reality available to reputed business firms. No interest is payble and no security is to be paid. It is a flexible source of finance as no charge is created against the asset of the company. Trade credit is more economical than bank loans. The suppliers has to bear lossof bad debt in addition to the costs of adminis tering credit Accounts. He requires a larger working capital to supply goods on credit. The buyer losses cash discounts.

2. Bank Credit : Commercial banks serve as the single largest source of short-term finance to business firms. They provide following types of short-term finance :

(a) Outright loans : A loans is direct advance made in lumpsum which is credited to a separate loan A/C in the borrower. The borrower withdraws the full amount in cash immediately and undertakes to repay it in one single instalment. The borrower is required to pay the interest on the whole amount from the date of sanction.

(b) Cash credit : It is a formal and revolving credit agreement under which a borrower is allowed to borrow up to certain limit. Unlike, a loan, it is a running account from which the amounts canbe withdrawn from time to time, subject to the stipulated amount. Cash credit is of two types. When the cash credit is not backed by any security, it is known as clear cash credit.

(c) Line of credit : It is an informal arrangement under which a customer can borrow up to a specified limit. The maximum amount known as the ‘limit’ is determined according to the financial position of the borrower.

(d) Overdraft : It is kind of temporary financial accommodation extended by a bank to its regular customer. Under this arrangement, a customer having a Current A/c. with the bank is allowed to overdraw his account.

(e) Discounting of Bills : This implies procuring cash from a bank in exchange from credit instruments like bills of exchange, Promissory notes and hundies. Banks buy these instruments at prices lower than their face value the difference being the account.

2. Convertability ; Equity shares cannot be converted.

3. Voting Rights : Equity shareholders enjoy voting rights in general meeting.

4. Premium on Redemption : Not receive premium on redemption.

5. Redeemability ; Equity shares are not redeemable.

6. Arrears of dividend : Arrears of dividend cannot accumulate.
Preference shares :
1. Preferential Right :Payment of preference dividend is made before payment of equity dividend.

2. Convertability : Preference shares may be converted.

3. Voting Rights :  Preference shareholders donot have any voting right except at meeting of preference shareholders.

4. Premium on Redemption : Right to receive premium on redemption.

5. Redeemability : Preference shares are redeemable.

6. Arrears of dividend : Arrears of dividend may accumulate.

2. Bank credit : Commercial banks provide different types of short-term finances namely :

a. Outright loans. b. Cash credit.

c. Line of credit. d. Overdraft.

e. Discounting of bills.

Bank credit is a flexible source of finance as it can be paid whenever it is not needed, commercial banks donot interfere in the management of the borrowing concerns.

3. Instalment credit : It is the facility of buying machinery, equipment and other durable goods on credit. The buyer has to pay a part of the price of the asset at the time of delivery and the balance is payable in a number of instalments. The supplier charges interest on the balance due and the interest is included in the amount of instalment itself. Some suppliers provide instalment credit through finance companies and commercial banks.
A business firm may also buy fixed assets on hire-purchase basis. Under this arrangement the ownership of the assets remains with the suppliers until all the instalments are paid by the buyer.

4. Inter company loans : In this arrangements, a company may borrow funds from other companies under the same management. No interest is payable on such loans and no charge is created on assets.

5. Leasing : Under this method, a business enterprise that wants to buy machinery, equipment or any other fixed asset can get financial assistance from a leasing company. Leasing company is a firm that suplies finance against the security of fixed assets. The fixed assets purchased under a leasing arrangement is mortgaged with the leasing company.

6. Factoring : It refers to raising finance through the sale or mortgage of book debts. Finance companies or factors provide finance to business concerns through outright purchase of accounts receivable or against the security of accounts receivable.

7. Customer Advance : Sometimes, manufacturers or suppliers of goods require the customers to make an advance before the delivery of goods.
The customer advance shows a part of the price of the goods ordered/booked by the customers to be supplied at a later date. This arrangement is used in case of products which are in short supply or which involve a waiting period for delivery e.g. automobiles, telephone etc.

1. Trade credit,

2. Factoring,

3. Loans from commercial banks.

A.

A.

C.

D.

A.

C.

D.

C.

B.

D.

B.

D.

B.

C.

B.

B.

B.

B.

C.

C.

D.

C.

D.

B.

B.

C.