Sources of Business Finance

Introduction

Every business, regardless of its size or nature, requires funds to carry out its operations. Whether it is to start a new venture, purchase raw materials, pay salaries, acquire assets, or expand operations, finance is needed at every step. The arrangement of these funds is known as business finance.

Just as blood is essential for the human body, finance is essential for a business organisation. Insufficient or improper management of finance can lead to business failure.

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Meaning Of Business Finance

Business Finance refers to the money required for carrying out business activities. This includes both fixed capital (funds required for purchasing fixed assets like land, building, machinery) and working capital (funds required for day-to-day operations like buying raw materials, paying wages, maintaining inventory).

The need for finance arises at the time of establishing the business, during its normal operations, and for its expansion and modernisation.

Meaning, Nature And Significance Of Business Finance

Meaning: As discussed, business finance is the capital used to support the activities of a business. It's the lifeblood that keeps the business going.

Nature:

1. Required by All Businesses: Whether sole proprietorship, partnership, or company; manufacturing, trading, or service; all businesses need finance.

2. Requirement Varies: The amount of finance needed varies depending on the size, nature, and stage of the business. A large manufacturing firm requires more finance than a small retail shop.

3. Continuous Need: Finance is not a one-time requirement. It is needed continuously for operations, growth, and diversification.

4. Deals with Procurement and Utilisation: Business finance involves not only obtaining funds but also their effective and efficient use.

Significance (Importance):

Sound financial planning and management are crucial for the survival and success of a business. The significance of business finance lies in:

1. Establishing a Business: Funds are required to purchase initial assets and meet preliminary expenses.

2. Running the Business: Finance is needed for working capital requirements like purchasing inventory, paying expenses, and managing receivables.

3. Modernisation and Expansion: Significant funds are required to upgrade technology, expand production capacity, or diversify into new areas.

4. Meeting Contingencies: Businesses face unforeseen events (e.g., recession, natural calamities). Finance is needed to deal with such contingencies.

5. Providing Rewards to Investors: Businesses need to generate sufficient returns to pay dividends to shareholders or interest to lenders.

Without adequate finance, a business cannot acquire assets, produce goods, sell products, or manage its daily affairs effectively.

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Classification Of Sources Of Funds

Sources of funds can be classified based on different criteria. Understanding these classifications helps in choosing the appropriate source for a specific need.

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Period Basis

Based on the time period for which finance is required, sources can be classified as:

1. Long-term Funds: Required for a period exceeding 5 years, usually 5 to 20 years or more. Used for acquiring fixed assets and funding long-term growth and expansion. Examples: Equity Shares, Preference Shares, Debentures, Long-term Loans from banks and financial institutions.

2. Medium-term Funds: Required for a period generally exceeding 1 year but less than 5 years. Used for purposes like modernisation, renovation, or major repairs. Examples: Public Deposits, Lease Financing, Medium-term Loans from banks and financial institutions.

3. Short-term Funds: Required for a period typically up to 1 year. Used for meeting working capital needs like buying raw materials, paying wages, and managing receivables. Examples: Trade Credit, Factoring, Commercial Paper, Short-term Loans from banks.

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Ownership Basis

Based on whether the funds are contributed by owners or are borrowed, sources can be classified as:

1. Owner's Funds (Equity Capital): Funds contributed by the owners of the business. It remains invested in the business for its lifetime. It forms the basis of the business and is a permanent source of finance. Examples: Equity Shares, Retained Earnings, Contribution by partners or sole proprietor.

2. Borrowed Funds (Debt Capital): Funds obtained through loans or borrowings. These funds are provided for a specific period, on certain terms and conditions, including the payment of interest. The amount needs to be repaid. Examples: Debentures, Loans from banks and financial institutions, Public Deposits, Commercial Paper, Trade Credit.

$$ \text{Total Funds} = \text{Owner's Funds} + \text{Borrowed Funds} $$

Owner's funds carry ownership risk (lowest priority for repayment, no fixed return) but also enjoy surplus profit. Borrowed funds have a fixed commitment (interest payment and repayment of principal) but do not participate in profits.

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Source Of Generation Basis

Based on whether funds are generated internally within the business or obtained from external sources:

1. Internal Sources (Owned Funds): Funds generated from within the business operations. Examples: Retained Earnings (ploughing back of profits), Sale of Surplus Assets, Collection of Receivables.

2. External Sources (Borrowed Funds & New Equity): Funds obtained from outside the business. Examples: Issue of Shares (Equity/Preference), Issue of Debentures, Public Deposits, Loans from banks and financial institutions, Trade Credit, Factoring, Commercial Paper, Lease Financing.

Internal sources are generally more reliable and do not create a fixed liability, but their availability is limited. External sources offer access to larger amounts but come with costs (interest, dividend) and obligations (repayment, dilution of control).

Basis	Categories	Examples
Period	Long-term ($>5$ years)	Shares, Debentures, Term Loans
	Medium-term ($1-5$ years)	Public Deposits, Lease Finance
	Short-term ($\leq 1$ year)	Trade Credit, Factoring, Commercial Paper, Bank Overdraft
Ownership	Owner's Funds	Equity Shares, Retained Earnings, Proprietor's Capital
	Borrowed Funds	Debentures, Loans, Public Deposits, Trade Credit
Source of Generation	Internal	Retained Earnings, Sale of Assets, Collection of Receivables
	External	Shares, Debentures, Loans, Public Deposits, Trade Credit, Factoring, Commercial Paper, Lease Finance

Sources Of Finance

Let's look at some of the common sources of business finance available to organisations in India.

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Retained Earnings

Retained Earnings (also known as Ploughing Back of Profits) is the portion of net profit that is not distributed to the shareholders as dividends but is kept back in the business for reinvestment. It is an internal source of self-financing.

Advantages:

1. Cheapest Source: No explicit cost (interest or dividend) is paid.

2. No Fixed Obligation: No commitment to repay the amount or pay a fixed return.

3. Increases Share Value: Retained earnings strengthen the company's financial position, which can increase the market value of its shares.

4. Flexibility: Funds are available for general use and can be used for various purposes like expansion or modernisation.

Disadvantages:

1. May Cause Dissatisfaction: Shareholders may be dissatisfied due to low dividends.

2. Possibility of Misuse: Management might use funds for less profitable projects if there is no pressure to pay dividends.

3. Based on Profits: Only available if the company earns sufficient profits.

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Trade Credit

Trade Credit is credit extended by one business to another for the purchase of goods and services. It is the credit granted by the supplier of goods to the buyer. It is a common source of short-term finance.

Example: A retailer buys goods from a wholesaler and is given 30 days to pay for them. This 30-day credit period is trade credit.

Advantages:

1. Readily Available: It is a spontaneous source of financing and does not require formal procedures.

2. Convenient and Flexible: The terms are usually flexible and can be adjusted based on the relationship between buyer and seller.

3. Increases Sales: Offering trade credit can help suppliers increase their sales.

Disadvantages:

1. Limited Amount: The amount of credit available depends on the creditworthiness of the buyer and the supplier's policy.

2. Costly: If cash discounts are offered for prompt payment, foregoing the discount makes trade credit implicitly costly.

3. Encourages Overtrading: Easy availability might lead firms to purchase more than they can sell or manage.

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Factoring

Factoring is a financial service where a business sells its accounts receivables (debt from customers) to a third party (a 'factor') at a discount. The factor then becomes responsible for collecting the debt from the customer.

Example: A company sells goods worth ₹1 Lakh to a customer on 60-day credit. Instead of waiting 60 days, the company sells this receivable to a factor for ₹95,000 immediately. The factor collects ₹1 Lakh from the customer after 60 days.

Advantages:

1. Provides Ready Cash: Business gets immediate funds, improving cash flow.

2. Reduces Risk: In some types of factoring (non-recourse factoring), the factor bears the risk of bad debts.

3. Saves Management Time: The business is relieved from the task and cost of collecting receivables.

Disadvantages:

1. Expensive: The discount charged by the factor can be high.

2. May Affect Customer Relations: The factor's collection methods might strain customer relationships.

3. Not Suitable for All Businesses: May not be available or suitable for very small businesses or those with low-quality receivables.

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Lease Financing

Lease Financing is a contractual agreement where one party (the 'lessor') owns an asset and allows another party (the 'lessee') to use the asset for a specified period in exchange for periodic payments (lease rent). Ownership remains with the lessor.

Example: A company needs heavy machinery for its factory. Instead of buying it, it takes the machinery on lease from a leasing company and pays monthly rent.

Advantages:

1. Reduces Capital Outlay: The business does not need to invest a large amount to acquire the asset initially.

2. Tax Benefits: Lease payments are usually treated as an expense, which is tax deductible.

3. Flexibility: Provides flexibility in choosing the asset and terms of the lease.

4. Off-Balance Sheet Financing: Operating leases may not appear as a liability on the balance sheet.

Disadvantages:

1. No Ownership: The lessee does not become the owner of the asset.

2. Lease Rent May Be Higher: Over the long term, total lease payments might exceed the cost of buying the asset.

3. Restrictions: Lease agreements may impose restrictions on the use of the asset.

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Public Deposits

Public Deposits refer to the deposits raised by organisations directly from the public. Companies invite the public to deposit their savings with them for a fixed period, offering a fixed rate of interest.

This is a medium-term source of finance, regulated by the Reserve Bank of India (RBI) and the Companies Act, 2013.

Advantages:

1. Simple Procedure: The procedure for obtaining deposits is relatively simple compared to issuing shares or debentures.

2. Cheaper: The interest rate offered on public deposits is usually lower than the interest on bank loans.

3. No Charge on Assets: Companies generally do not mortgage their assets to obtain public deposits.

Disadvantages:

1. Limited Amount: The amount that can be raised is limited by the RBI guidelines.

2. Unreliable: Public may not respond favourably, especially during economic downturns.

3. Not Suitable for New Companies: New companies may find it difficult to attract public deposits due to lack of reputation.

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Commercial Paper

Commercial Paper (CP) is a short-term, unsecured promissory note issued by large, creditworthy companies to raise funds for a short period (usually 90 days to 1 year). It is issued at a discount to its face value and is redeemed at par.

Example: A company needs ₹95 Lakhs for 90 days. It issues a CP with a face value of ₹1 Crore, which is bought by investors for ₹95 Lakhs. After 90 days, the company repays ₹1 Crore to the investors.

Advantages:

1. Flexible: Provides flexibility in terms of maturity period.

2. Cheaper: The cost of CP is often lower than bank loans for creditworthy companies.

3. No Restriction on Use: Funds can be used for various purposes.

4. Highly Liquid: Investors can sell CP in the secondary market.

Disadvantages:

1. Only for Large Companies: Only financially strong and creditworthy companies can issue CP.

2. Limited Funds: The amount that can be raised is limited by the market's willingness to buy CP.

3. Unsecured: It is an unsecured instrument, which might be risky for investors.

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Issue Of Shares

A company can raise funds by issuing shares. There are two main types of shares: Equity Shares and Preference Shares.

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Equity Shares

Equity Shares represent the ownership capital of a company. Equity shareholders are the owners of the company. They have voting rights and participate in the management. They are paid dividends out of profits after all other claims (like debenture interest, preference dividends) are met. Their return is variable, and they bear the highest risk but also enjoy the residual profit.

Advantages:

1. Permanent Capital: Equity capital is a permanent source of funds, repayable only during winding up.

2. No Fixed Burden: Dividend payment is not compulsory and is paid only out of profits. There is no obligation to pay interest.

3. Creates Ownership: Equity shareholders are owners, who are interested in the long-term growth of the company.

4. Enhances Creditworthiness: Equity capital acts as a base for raising borrowed funds.

Disadvantages:

1. Costly: Issue of equity shares involves significant flotation costs (expenses for issuing shares).

2. Risk of Dilution of Control: Issuing more shares can dilute the control of existing shareholders.

3. Difficulty in Future Financing: If the company earns high profits, the cost of equity (dividend payout) can be higher than interest on debt.

4. Market Fluctuation: Share prices fluctuate based on market conditions.

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Preference Shares

Preference Shares are shares that carry preferential rights over equity shares. These rights usually relate to:

1. Dividend: Receiving dividends at a fixed rate before any dividend is paid to equity shareholders.

2. Repayment of Capital: Receiving their capital back before equity shareholders in case of winding up of the company.

Preference shareholders generally do not have voting rights.

Advantages:

1. No Charge on Assets: Assets are not mortgaged to issue preference shares.

2. No Interference in Management: Preference shareholders usually do not have voting rights, so control remains with equity shareholders.

3. Fixed Dividend: Provides a steady income to investors.

4. Aids in Raising Debt: Helps maintain the debt-equity ratio.

Disadvantages:

1. Not Suitable for Companies with Fluctuating Income: Dividend payment is a fixed commitment (though only out of profits), which can be difficult if income fluctuates.

2. Dividend is Not Tax Deductible: Unlike interest on debentures, preference dividend is paid out of after-tax profits, making it a costlier source than debt from the company's perspective.

3. Limited Appeal to Investors: Investors seeking high returns may prefer equity; those seeking security may prefer debentures.

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Debentures

Debentures are instruments acknowledging a debt of the company. Debenture holders are creditors of the company. They are paid interest at a fixed rate, regardless of whether the company makes a profit or not. The principal amount is repaid at a specified future date.

Debentures can be secured (backed by company assets) or unsecured. They can be redeemable (repayable) or irredeemable (perpetual, though rare now). They can be convertible (into shares) or non-convertible.

Advantages:

1. Cheaper Source: Interest rate on debentures is usually lower than the dividend rate on shares.

2. Tax Benefit: Interest paid on debentures is a tax-deductible expense, reducing the company's tax liability.

3. No Dilution of Control: Debenture holders are creditors and do not have voting rights, so control is retained by shareholders.

4. Suitable for Stable Income Companies: Companies with stable earnings can easily meet fixed interest obligations.

Disadvantages:

1. Fixed Obligation: Payment of interest and repayment of principal are compulsory, even if the company suffers losses.

2. Charge on Assets: Secured debentures create a charge on the company's assets, reducing the ability to raise further secured loans.

3. Reduces Creditworthiness: High debt levels can reduce the company's capacity to borrow further.

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Commercial Banks

Commercial Banks are a major source of funds for businesses, especially for working capital needs and medium-term loans. Banks provide funds in various forms like cash credit, overdraft, term loans, discounting of bills of exchange.

1. Overdraft: Permission to overdraw funds from the current account up to a specified limit. Interest is charged only on the amount actually overdrawn.

2. Cash Credit: A borrower is allowed to withdraw funds up to a certain limit against the security of goods or other assets. Interest is charged on the amount withdrawn.

3. Term Loans: Provided for a fixed period (medium or long term) for purposes like purchasing assets. Repaid in instalments.

4. Discounting Bills of Exchange: Banks provide immediate funds by discounting (purchasing at a discount) a bill of exchange before its maturity date.

Advantages:

1. Flexibility: Loans can be adjusted based on the business's needs.

2. Secrecy: The details of finance are not disclosed to the public.

3. Timely Assistance: Banks can provide funds relatively quickly once formalities are completed.

Disadvantages:

1. May Require Security: Banks usually require assets as security for loans.

2. Lender Imposes Restrictions: Banks may impose certain conditions or restrictions on the business operations.

3. Formalities: Obtaining a loan involves detailed procedures and documentation.

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Financial Institutions

In India, besides commercial banks, there are specialised Financial Institutions (also known as Development Banks) established by the central and state governments to provide medium and long-term finance to businesses for investment purposes. Examples include Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India (ICICI - now merged with ICICI Bank), Industrial Development Bank of India (IDBI - now a bank), Small Industries Development Bank of India (SIDBI), State Financial Corporations (SFCs).

Advantages:

1. Provide Long-term Finance: They are a major source of long-term and medium-term funds.

2. Financial and Managerial Advice: They often provide expert advice and guidance to businesses.

3. Promote Industrial Growth: They play a crucial role in the industrial development of the country.

Disadvantages:

1. Stringent Criteria: They often have strict eligibility criteria and require detailed feasibility studies.

2. Delays: The process of obtaining funds can sometimes be time-consuming.

3. Restrictions: They may impose conditions regarding dividend payment, management structure, etc.

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International Financing

With increasing globalisation, Indian businesses can also raise funds from international sources. These sources can provide access to larger pools of capital and potentially lower costs of funds, but they also involve complexities related to foreign exchange fluctuations and international regulations.

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Commercial Banks

International commercial banks provide foreign currency loans to Indian companies. These loans can be short-term or long-term and are often used for importing machinery, raw materials, or funding overseas operations.

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International Agencies And Development Banks

International institutions like the International Finance Corporation (IFC), Asian Development Bank (ADB), and World Bank provide financial assistance, including loans and equity investments, to promote development projects in developing countries like India. They often provide long-term finance for infrastructure and large-scale industrial projects.

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International Capital Markets

Indian companies can access international capital markets by issuing securities like Global Depository Receipts (GDRs), American Depository Receipts (ADRs), and Euro Issues (Eurobonds and Euro-equity).

1. Global Depository Receipts (GDRs): Instruments issued by an International Depository Bank (IDB) outside the company's home country, representing ownership of a certain number of the company's shares. These are traded on stock exchanges in various countries.

2. American Depository Receipts (ADRs): Similar to GDRs, but issued by a US bank and traded on stock exchanges in the USA.

3. Euro Issue: Refers to the issue of securities by an Indian company in the international market outside India. This includes:

- Eurobonds: Debt instruments issued by an Indian company in foreign currency on stock exchanges outside India.

- Euro-equity: Equity shares issued by an Indian company in foreign currency on stock exchanges outside India.

Advantages: Access to large funds, lower cost of funds, enhances global image, diversifies investor base.

Disadvantages: Exposure to foreign exchange risk, compliance with international regulations, requires strong financial performance and transparency, high issue costs.

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Factors Affecting The Choice Of The Source Of Funds

The choice of the most appropriate source of finance for a business is a critical decision. Managers consider various factors before selecting a source:

1. Cost: The cost of raising funds is a primary consideration. Cost includes interest payment on loans/debentures, dividend payment on shares, and flotation costs (expenses incurred in raising funds like brokerage, underwriting commission, advertising). The source with the lowest cost is usually preferred, but other factors must also be considered.

2. Financial Strength and Stability of the Business: A financially strong company with stable earnings can afford to use more debt (debentures, loans) because it can easily meet the fixed interest obligations. A less stable company may rely more on equity or retained earnings.

3. Form of Organisation: The legal form of the business (sole proprietorship, partnership, company) determines the available sources. A sole proprietor is limited to personal savings and loans, while a public limited company can issue shares and debentures to the public.

4. Purpose and Time Period: The purpose for which funds are needed (fixed capital vs. working capital) and the time period (short-term, medium-term, long-term) are crucial factors. Long-term needs require long-term sources (shares, debentures, term loans), while short-term needs are met by short-term sources (trade credit, bank overdraft, CP).

5. Risk Profile: Borrowed funds (debt) carry higher risk for the company as interest and principal payments are mandatory. Owner's funds (equity) are less risky as dividend payment is discretionary. Companies with high business risk might prefer less debt (low gearing).

6. Control: Issue of equity shares dilutes the ownership and control of existing shareholders. Debt financing (debentures, loans) generally does not affect control. If existing owners want to retain control, they may prefer debt or retained earnings.

7. Market Conditions: Conditions in the capital market (stock market) influence the ease and cost of raising funds through shares and debentures. During a boom, it is easier to issue shares; during a recession, debt might be preferred.

8. Tax Planning: Interest on debt is tax-deductible, which reduces the effective cost of debt. Dividends on shares are paid out of after-tax profits. This tax advantage often makes debt a cheaper source of finance compared to equity or preference shares.

9. Flexibility and Ease: Some sources (like trade credit or retained earnings) are easily available and flexible. Others (like public issue of shares or loans from financial institutions) involve lengthy procedures and formalities.

10. Regulations: Rules and regulations set by regulatory bodies like SEBI and RBI affect the terms and conditions of issuing securities or taking loans.

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