Introduction to Business Finance

This chapter provides a comprehensive overview of the various sources from which funds can be procured for both establishing a new business and sustaining the operations of an existing one. It delves into the specific advantages and limitations of each financial source and examines the key factors that must guide a business in choosing the most appropriate mix of finance for its unique situation.

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A deep understanding of the landscape of business finance is a non-negotiable prerequisite for any successful entrepreneur or business manager. The ability to make sound financial decisions is what separates thriving enterprises from failing ones. It is essential to know not only the different avenues from where money can be raised but also the specific merits, demerits, and costs associated with each option. This knowledge enables a business to craft a financial strategy that aligns perfectly with its long-term goals and operational needs.

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Consider the classic business dilemma faced by Mr. Anil Singh, a successful restaurant owner. Motivated by his initial success, he wishes to expand his business by opening a chain of new restaurants. However, his personal funds are insufficient for such an ambitious project. He is at a financial crossroads, facing a confusing array of options. He could enter into a partnership, which would inject the necessary capital but would also mean surrendering a share of his profits and, crucially, his complete control over the business. Alternatively, he could seek a bank loan, which would allow him to retain full ownership but would impose a fixed burden of interest and principal repayment, regardless of the new restaurants' profitability. His friend introduces even more sophisticated methods, like issuing shares and debentures, which are exclusive to the company form of organisation. This scenario perfectly highlights the central theme of this chapter: learning to navigate the world of finance by understanding the unique characteristics of each source and making an informed choice based on the purpose, time period, and cost of the funds required.

Meaning, Nature, and Significance of Business Finance

A business is an economic entity engaged in the production and distribution of goods and services to satisfy the needs of society. To perform these diverse activities, every business requires a continuous flow of money. For this fundamental reason, finance is often aptly described as the lifeblood of any business. The requirement of funds by a business to establish, operate, and expand its various activities is known as business finance.

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A business simply cannot function, let alone grow and prosper, unless an adequate amount of funds is made available to it. The initial capital contributed by the entrepreneur, while crucial, is rarely sufficient to cover all the financial requirements of the business throughout its life. Therefore, a business must constantly explore and evaluate various other sources to meet its evolving need for funds. A clear and accurate assessment of its financial needs, coupled with the identification of the most suitable sources of finance, are, therefore, cornerstone activities of successful business management.

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The need for funds is present at every stage of a business's life cycle. From the very moment an entrepreneur decides to launch a new venture, funds are needed to finance the initial setup. As the business grows and expands, its need for funds increases to finance new projects, upgrade technology, or build up inventory to meet seasonal demand. The financial needs of a business can be broadly categorized as follows:

(a) Fixed Capital Requirements

To establish a business, funds are required to purchase long-term fixed assets. These include assets like land and buildings, plant and machinery, and furniture and fixtures. The capital used to procure these assets is known as the fixed capital requirement of the enterprise. The funds invested in fixed assets remain locked in the business for a long period of time and are essential for its production capacity. The amount of fixed capital needed varies significantly depending on the nature and scale of the business. For example, a large, capital-intensive manufacturing concern like a steel plant will require a vastly higher amount of fixed capital compared to a small, service-based trading concern or a software development company.

(b) Working Capital Requirements

The financial needs of an enterprise do not end with the acquisition of fixed assets. A business, regardless of its size, needs a continuous supply of funds for its day-to-day operations. This is known as the working capital of an enterprise. Working capital is the capital available for conducting day-to-day business operations and is used for holding current assets, such as the stock of raw materials, work-in-progress, and finished goods, and for meeting current expenses and liabilities like salaries, wages, taxes, and rent. The amount of working capital required is influenced by the length of the business's operating cycle (the time it takes to convert raw materials into cash from sales). For instance, a business that sells goods on long credit terms or has a slow inventory turnover will require a much larger amount of working capital than a business that operates primarily on a cash basis and has a very quick turnover.

Classification of Sources of Funds

While sole proprietorships and partnership firms primarily rely on personal funds and simple borrowings, a company has access to a much wider and more complex array of financial sources. To bring clarity and structure to these diverse options, the sources of business finance can be classified on three different bases, providing a clear framework for understanding their nature and suitability.

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On the Basis of Period

This classification is based on the time duration for which the funds are required, which should ideally match the life of the asset or purpose for which the funds are being used (the matching principle).

• Long-term Sources: These sources provide finance for a period exceeding five years. Long-term funds are essential for financing fixed capital requirements, such as the acquisition of land, buildings, and heavy machinery, or for funding major expansion and diversification projects. The main sources include the issue of shares (equity and preference) and debentures, and long-term loans from specialized financial institutions.

• Medium-term Sources: These sources fulfill financial needs for a period of more than one year but less than five years. They are typically used for purposes like financing a major advertising campaign, purchasing vehicles, or carrying out small-scale modernization. Common sources include borrowings from commercial banks, public deposits, and lease financing.

• Short-term Sources: These sources provide funds for a period not exceeding one year. Short-term finance is primarily used for funding working capital requirements, such as building up inventory for a festive season or financing accounts receivable. The main sources include trade credit, short-term loans and overdrafts from commercial banks, and commercial papers.

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On the Basis of Ownership

This fundamental classification distinguishes between funds contributed by the owners and funds raised from external creditors. This choice involves a crucial trade-off between control and financial risk.

• Owner's Funds: Also known as ownership capital or equity, this refers to the funds provided by the owners of the enterprise. For a company, this includes the capital contributed by shareholders through the issue of equity shares, as well as profits that are reinvested in the business (retained earnings). Owner's funds represent the risk capital of the business; they are permanent in nature (not required to be repaid during the company's lifetime) and grant the owners the rights of control and management.

• Borrowed Funds: Also known as debt capital, this refers to all funds raised through loans or borrowings. These funds are provided for a specified period and come with a legal obligation to be repaid with interest at a fixed rate, regardless of the company's profitability. Common sources include debentures, loans from commercial banks and financial institutions, public deposits, and trade credit. Raising borrowed funds often requires the business to provide some form of security or collateral (a charge on assets).

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On the Basis of Source of Generation

This classification differentiates between funds that are generated from within the business's own activities and those that are raised from sources outside the organization.

• Internal Sources: These are the funds generated from within the business's own operations, without any reliance on external parties. The most significant internal source is the ploughing back of profits (retained earnings). Other methods include accelerating the collection of receivables from customers and disposing of surplus inventories or unneeded assets to generate cash. Internal sources are the most cost-effective source of finance but can usually fulfill only a limited portion of a business's total financial needs.

• External Sources: These include all sources of finance that lie outside the organization. When a large amount of money is required for growth or expansion, a business must invariably tap into external sources, such as individual investors, financial institutions, and suppliers. Common external sources include the issue of shares and debentures to the public, taking loans from banks, accepting public deposits, and lease financing. Raising funds from external sources is typically more complex and costly and often involves greater scrutiny of the business's affairs.

Sources of Finance

A business has a diverse menu of options for raising the necessary funds to finance its operations and growth. Each source possesses unique characteristics, advantages, and limitations. A careful and strategic evaluation is necessary to identify the best available source, or more often, the optimal combination of sources, as there is no single best option that fits all situations. The choice is a complex decision that depends on critical factors like the purpose for which funds are needed, the cost of the funds, and the level of risk the business is willing to undertake. A brief description of the various major sources is provided below.

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Retained Earnings

When a company earns a net profit, it typically does not distribute the entire amount to its shareholders in the form of dividends. A portion of these earnings is often kept and reinvested back into the business for future use. This is known as retained earnings, and the process is commonly referred to as ploughing back of profits. It is the most significant source of internal financing or self-financing. The amount of profit available for ploughing back is influenced by several factors, including the company's overall net profits, its dividend policy (the proportion of profits it decides to distribute), and its age and stage of growth.

Merits

• It is a permanent source of funds that remains with the organization and does not have to be repaid.

• It involves no explicit costs like interest payments, dividend obligations, or floatation costs (the expenses incurred when making a public issue of shares or debentures).

• As the funds are generated internally, it provides the management with greater operational freedom and flexibility without any external interference or restrictive covenants.

• It creates a strong financial foundation and enhances the company's capacity to absorb unexpected losses or economic shocks.

• A consistent track record of ploughing back profits is a sign of financial health, which often leads to an increase in the market price of the company's equity shares.

Limitations

• Excessive ploughing back of profits can lead to dissatisfaction among shareholders, who may feel that the management is hoarding cash and depriving them of higher, immediate returns in the form of dividends.

• It is an uncertain source of funds because it is entirely dependent on the future profitability of the business, which can fluctuate significantly.

• Management may ignore the opportunity cost associated with these funds (the return shareholders could have earned if the money were paid out and invested elsewhere). This can lead to complacency and the sub-optimal or inefficient use of the retained funds on less profitable projects.

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Trade Credit

Trade credit is a form of short-term financing that arises in the normal course of business when a supplier of goods or services allows a customer to make a purchase on credit, i.e., to buy now and pay later. This arrangement facilitates the purchase of supplies without requiring an immediate cash payment. In the buyer's accounting records, this liability appears as 'sundry creditors' or 'accounts payable'. It is a crucial and ubiquitous source of short-term financing, especially for small and medium-sized businesses. The duration and amount of trade credit offered depend on factors like the buyer's creditworthiness and reputation, the seller's own financial position, and the degree of competition in the market.

Merits

• It is a convenient and continuous source of funds that is readily available to a business with a good credit record, without the need for extensive negotiation or paperwork.

• By offering flexible payment terms, it helps in promoting the sales of an organization.

• It allows a firm to finance an increase in its inventory to meet anticipated demand without needing an immediate cash outlay.

• It is an unsecured source of finance and does not create any charge or lien on the assets of the firm.

Limitations

• The easy availability of trade credit may tempt a firm to indulge in overtrading (purchasing more inventory than it can realistically sell or pay for), which can dangerously increase the financial risk of the business.

• Only a limited amount of funds can be generated through this source, as it is directly tied to the volume of purchases.

• It can be a surprisingly costly source of funds. This is because the supplier may charge a higher price for goods sold on credit, or more commonly, the buyer may lose out on a valuable 'cash discount' that is offered for prompt payment. The loss of this discount is the implicit interest cost of trade credit.

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Factoring

Factoring is a comprehensive financial service in which a business sells its accounts receivable (i.e., its invoices from credit sales) to a specialized financial institution known as a 'factor', at a discount. The factor then provides a range of services, which primarily includes:

• Discounting of bills and collection of debts: The factor typically pays the firm a large percentage of the total invoice value upfront (usually between 75% to 90%). The factor then takes on the responsibility for collecting the full amount from the firm's customers (the debtors). Once the full amount is collected, the factor pays the remaining balance to the firm, after deducting its commission and fees for the service.

• Credit protection: Factoring can be of two types. In non-recourse factoring, the factor assumes the entire risk of bad debts. If a customer fails to pay their invoice, the factor bears the loss, providing complete credit protection to the firm. In recourse factoring, the risk of bad debts remains with the firm, and if a customer defaults, the firm must reimburse the factor.

• Providing credit information: Factors maintain large databases on the payment histories and creditworthiness of various firms and can provide valuable information to their clients, helping them to avoid dealing with risky customers.

Merits

• Obtaining funds through factoring is often cheaper and faster than other short-term financing options, especially when considering the internal costs of maintaining a dedicated credit and collections department.

• It provides a definite and predictable pattern of cash inflows from credit sales, which greatly improves a company's cash flow management and liquidity.

• It is a flexible source of funds; as a company's credit sales increase, the amount of finance available through factoring also increases automatically.

• It allows the client company to concentrate on its core business activities, such as production and marketing, as the time-consuming responsibility of credit control and debt collection is effectively outsourced to the factor.

Limitations

• This source can become very expensive for businesses that have a large number of invoices for smaller amounts, as the administrative costs for the factor are high.

• The advance finance provided by the factor is generally at a higher implicit interest cost than the rate of interest charged on a conventional bank loan.

• The firm's customers, who are used to dealing directly with the firm, may not feel comfortable dealing with a third-party factor for payments and follow-ups, which could strain customer relationships.

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Lease Financing

A lease is a contractual agreement under which the owner of an asset (the lessor) grants another party (the lessee) the exclusive right to use that asset for a specified period in return for a series of periodic payments, known as the lease rental. In simple terms, it is a form of renting an asset for business use. At the end of the lease period, the asset is returned to the lessor. Lease financing is a very popular method for acquiring assets that are subject to rapid technological obsolescence, such as computers, electronic equipment, and vehicles, as it allows a firm to use the latest technology without the risks and costs of ownership.

Merits

• It enables the lessee to acquire and use an asset with a very low initial investment, thus conserving the company's precious cash for other core business purposes.

• The documentation involved in a lease agreement is much simpler and the process is generally faster compared to securing a term loan from a bank.

• The lease rentals paid by the lessee are treated as an operating expense and are fully tax-deductible from the taxable profits, providing significant tax benefits.

• It is a source of finance that does not dilute the ownership or control of the business.

• The risk of the asset becoming outdated or obsolete is borne entirely by the lessor, giving the lessee greater flexibility to replace the asset and upgrade to newer technology.

Limitations

• A lease agreement is a rigid contract and may impose certain restrictions on the use of the asset. For example, it may prohibit the lessee from making any alterations or modifications to the asset.

• The non-renewal of a lease for a critical asset can seriously disrupt the normal business operations.

• If the asset is no longer useful, opting for a premature termination of the lease agreement can result in a heavy penalty or a higher payout obligation.

• The lessee never becomes the owner of the asset. This means they are deprived of the asset's residual value at the end of its useful life.

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Public Deposits

Public deposits refer to the unsecured deposits that are raised by companies directly from the general public. To attract these deposits, companies typically offer a rate of interest that is higher than what is offered on bank deposits. Any interested member of the public can deposit money with a company by filling out a prescribed form, and the company, in return, issues a deposit receipt which is an acknowledgment of the debt. Public deposits can be used to meet both medium and short-term financial requirements, with the tenure usually extending up to three years. In India, the process of accepting public deposits is strictly regulated by the Reserve Bank of India (for financial companies) and the Companies Act (for non-financial companies).

Merits

• The procedure for obtaining public deposits is simple and does not involve the complex and restrictive conditions that are generally part of a loan agreement with a bank.

• The cost of public deposits (the interest paid) is generally lower than the cost of borrowings from banks and other financial institutions.

• Public deposits are typically unsecured and do not create any charge on the company's assets. This leaves the assets free to be used as security for raising other loans if needed.

• As depositors are creditors and do not have voting rights, the control of the company's existing shareholders is not diluted.

Limitations

• New, less-known, or lower-rated companies generally find it very difficult to raise funds through public deposits as they lack the trust and reputation to attract public savings.

• It is an unreliable source of finance because the public response can be highly uncertain and may not be forthcoming, especially when the company is in urgent need of money.

• The collection of public deposits can prove difficult and administratively cumbersome, particularly when the size of the deposits required is very large.

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Commercial Paper (CP)

A Commercial Paper (CP) is an unsecured, short-term money market instrument that is issued in the form of a promissory note by large, financially strong, and highly creditworthy companies to raise funds for their short-term working capital requirements. It was introduced in India in 1990 as a way for top-rated corporate borrowers to access a cheaper source of short-term borrowing. CPs are issued for maturities ranging from a minimum of 7 days to a maximum of one year. A key feature of a CP is that it is issued at a discount to its face value and is redeemed at par (its face value). The difference between the issue price and the redemption price constitutes the interest paid to the investor.

Merits

• A CP is sold on an unsecured basis and does not contain any restrictive covenants or conditions.

• Being a freely transferable instrument (it can be sold to another investor before maturity), it has high liquidity.

• The cost of raising funds through a CP is generally lower than the cost of commercial bank loans for a prime-rated borrower.

• It provides a continuous source of funds, as a maturing CP can be easily repaid by selling a new CP, a process known as rollover.

• Companies with temporary surplus funds can invest in the CPs of other companies and earn a good short-term return on their idle cash.

Limitations

• Only financially sound, large, and highly-rated firms can successfully raise money through commercial papers. New and moderately rated firms are not in a position to use this method.

• The total amount of money that can be raised through a CP is limited by the excess liquidity available with the potential suppliers of funds in the money market at a particular time.

• It is an impersonal method of financing. If a firm finds itself in a difficult financial position and is unable to redeem its paper on the due date, extending the maturity of a CP is not possible, which can severely damage its credit rating and reputation.

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Issue of Shares

The capital raised by a company through the issue of shares is known as its share capital. A share is a single, small unit into which the total capital of the company is divided. Each share has a nominal or face value. The person who holds a share in a company is known as a shareholder. There are two primary types of shares that are normally issued by a company: equity shares and preference shares.

(a) Equity Shares

Equity shares represent the fundamental ownership of a company. Therefore, the capital raised by issuing these shares is known as ownership capital or owner's funds. Equity shareholders are the true owners of the company and are the ultimate risk-bearers. They do not receive a fixed dividend; instead, their dividend is paid out of the residual profits of the company, i.e., what is left after all other claims (like interest to lenders and dividends to preference shareholders) have been paid. For this reason, they are referred to as the 'residual owners'. They bear the ultimate risk of ownership (if the company fails, they get nothing), but they also enjoy the ultimate rewards of ownership (if the company is highly successful, their returns are unlimited). Their liability, however, is limited to the capital contributed by them. Most importantly, equity shareholders have the right to participate in the management of the company through their voting rights.

Merits

• They are suitable for investors who are willing to assume a higher degree of risk in exchange for the potential for higher returns.

• The payment of dividends to equity shareholders is not a legal compulsion, so there is no fixed financial burden on the company, which provides great financial flexibility.

• Equity capital is permanent capital for the company, as it is required to be repaid only at the time of the liquidation of the company, providing a stable long-term capital base.

• A strong equity base provides creditworthiness to the company and builds the confidence of prospective lenders.

• Raising funds through an equity issue does not create any charge or mortgage on the assets of the company.

• It ensures democratic control over the management of the company, as equity shareholders exercise their voting rights to elect the board of directors.

Limitations

• Investors who desire a steady and predictable income may not prefer equity shares due to their fluctuating and uncertain returns.

• The cost of equity shares (which includes floatation costs and the high expected rate of return of shareholders to compensate for their risk) is generally higher than the cost of raising funds through other sources like debt.

• The issue of new equity shares to the public dilutes the voting power and, consequently, the earnings of the existing equity shareholders.

• The process of raising funds through a public issue of equity shares is lengthy, expensive, and involves many complex legal formalities.

(b) Preference Shares

The capital raised by issuing preference shares is known as preference share capital. As their name suggests, preference shareholders enjoy two crucial preferential rights over equity shareholders:

1. They have the right to receive a dividend at a fixed rate out of the company's net profits before any dividend is declared or paid to the equity shareholders.

2. In the event of the company's liquidation, they have the right to the repayment of their capital before the claims of the equity shareholders are settled.

Preference shares are often considered a hybrid security as they possess characteristics of both equity shares (the dividend is payable only at the discretion of the directors and only out of distributable profits) and debentures (they carry a fixed rate of return). Preference shareholders generally do not have any voting rights, except in special circumstances that affect their interests.

Merits

• They provide a reasonably steady income in the form of a fixed rate of return, with a comparatively lower level of risk than equity shares.

• Financing through preference shares does not affect the control of equity shareholders over the management, as preference shareholders typically lack voting rights.

• The payment of a fixed rate of dividend to preference shareholders can enable a company to declare higher rates of dividend for its equity shareholders during periods of high profitability (a concept known as trading on equity).

• Preference shareholders have a preferential right of repayment over equity shareholders in the event of the company's liquidation.

Limitations

• They are not suitable for investors who are willing to take risks and are interested in the potential for higher returns.

• The rate of dividend on preference shares is generally higher than the rate of interest on debentures.

• As the dividend on these shares is to be paid only when the company earns a profit, there is no legally assured return for the investors, which may make them less attractive compared to debentures.

• Unlike the interest on loans, the dividend paid on preference shares is not a tax-deductible expense for the company. Thus, there is no tax saving.

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Debentures

Debentures are one of the most important instruments for raising long-term debt capital. A debenture is a written instrument issued by a company under its common seal, acknowledging a debt. It contains a contract for the repayment of the principal sum at a specified future date and for the payment of interest at a fixed rate at specified intervals. Debenture holders are, therefore, creditors of the company, not owners. The interest paid on debentures is a charge against the profits of the company, meaning it must be paid irrespective of whether the company makes a profit or incurs a loss. Public issues of debentures are required to be rated by a credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.).

Merits

• Debentures are preferred by investors who want a fixed and regular income with a lower level of risk.

• The interest paid on debentures is a tax-deductible expense. This reduces the company's tax liability and makes debentures a less costly source of finance compared to shares.

• Financing through debentures does not dilute the control of the equity shareholders, as debenture holders are creditors and do not have any voting rights.

• It is a particularly suitable source of finance when the company's sales and earnings are relatively stable and predictable.

Limitations

• As a fixed-charge instrument, debentures place a permanent and legally binding burden on the company's earnings. The obligation to pay interest can become a major strain, especially when the company's earnings are fluctuating or low.

• In the case of redeemable debentures, the company has to make provisions for the repayment of the principal amount on the specified date, which can cause a significant cash flow strain, especially during periods of financial difficulty.

• Every company has a certain borrowing capacity. With the issue of debentures, the capacity of a company to further borrow funds is reduced.

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Commercial Banks

Commercial banks are a vital and fundamental source of finance for businesses of all sizes. They provide funds for a wide range of purposes and for different time periods, although their lending is predominantly for short to medium-term needs. Banks extend loans to firms in various ways, such as cash credits (a flexible credit limit against which the firm can draw funds as needed), overdrafts (allowing a firm to withdraw more than its account balance), term loans (for a fixed period, repaid in installments), and the purchase or discounting of bills of exchange. The rate of interest charged by banks depends on various factors, including the creditworthiness of the firm, the purpose of the loan, and the prevailing interest rates in the economy. The borrower is almost always required to provide some form of security or create a charge on its assets before a loan is sanctioned.

Merits

• Banks can provide timely assistance to a business by making funds available as and when they are needed.

• The secrecy of the business can be maintained, as the financial information and business plans supplied to the bank by the borrower are kept confidential.

• Compared to a public issue of securities, obtaining a loan from a bank is an easier source of funds, as it does not require complex formalities like issuing a prospectus and underwriting.

• A loan from a bank is a flexible source of finance, as the loan amount can often be increased according to the business's growing needs and can sometimes be repaid in advance when surplus funds are available.

Limitations

• Bank funds are generally available for short or medium periods, and the extension or renewal of a loan is always uncertain and can be difficult.

• Banks conduct a very detailed investigation of the company’s affairs and financial structure and may also ask for the security of assets and personal guarantees from the directors. This makes the procedure for obtaining funds somewhat difficult and time-consuming.

• In some cases, banks impose difficult and restrictive terms and conditions as part of the loan agreement. For example, restrictions may be imposed on the sale of mortgaged goods, which can make the normal working of the business difficult.

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Financial Institutions

The central and state governments in India have established a number of specialized Financial Institutions (FIs) across the country with the specific objective of providing finance to promote industrial growth. These institutions, such as the Industrial Finance Corporation of India (IFCI), the Small Industries Development Bank of India (SIDBI), and various State Financial Corporations (SFCs), are also known as 'development banks'. They play a crucial role by providing both owned capital (by subscribing to shares) and loan capital for the long and medium-term requirements of businesses. They supplement the services offered by traditional financial agencies like commercial banks. In addition to providing financial assistance, these institutions also conduct market surveys and provide valuable technical and managerial services to the enterprises they finance. This source of financing is particularly suitable when large funds are required for a longer duration for purposes of expansion, reorganization, and modernization.

Merits

• Financial institutions provide long-term finance, which is not generally provided by commercial banks.

• Besides providing funds, many of these institutions provide valuable financial, managerial, and technical advice and consultancy services to business firms.

• Obtaining a loan from a reputable financial institution increases the goodwill of the borrowing company in the capital market. Consequently, such a company can often raise funds more easily from other sources as well.

• The repayment of the loan can often be made in easy installments, which does not prove to be much of a burden on the business.

• These institutions often continue to make funds available even during periods of economic depression, when other sources of finance may dry up.

Limitations

• Financial institutions follow very rigid criteria for granting loans. The requirement for too many formalities makes the procedure time-consuming and expensive.

• Certain restrictions, such as a restriction on dividend payments or the appointment of key personnel, are often imposed on the powers of the borrowing company by the financial institutions as part of the loan agreement.

• Financial institutions may insist on having their nominees on the Board of Directors of the borrowing company, thereby restricting the powers and autonomy of the company's management.

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International Financing

With the liberalization and globalization of the economy, the options for raising funds are no longer limited to the domestic market. Indian companies now have significant access to funds from international markets. The various international sources from where funds may be generated include:

(i) Commercial Banks

Major commercial banks all over the world, such as Standard Chartered, Citibank, and HSBC, extend foreign currency loans for business purposes. They are an important source of financing for international trade and non-trade operations.

(ii) International Agencies and Development Banks

A number of international agencies and development banks have been established to finance international trade and business, with a focus on promoting development in economically backward areas. These bodies provide long and medium-term loans and grants. The most notable among them include the International Finance Corporation (IFC), the Export-Import (EXIM) Bank, and the Asian Development Bank (ADB).

(iii) International Capital Markets

Modern organizations, especially multinational companies, often require sizeable borrowings in both rupees and foreign currencies. The prominent financial instruments used for this purpose are:

• Global Depository Receipts (GDRs): A GDR is a negotiable financial instrument that is issued by a depository bank in a foreign country (like London or Luxembourg) against a certain number of underlying shares of an Indian company. These receipts are denominated in a foreign currency, typically US dollars, and are listed and can be traded freely on a foreign stock exchange. A holder of a GDR can, at any time, convert it into the number of shares it represents. The holders of GDRs do not carry any voting rights but are entitled to receive dividends and benefit from capital appreciation. Many leading Indian companies like Infosys, Reliance, and Wipro have successfully raised money through the issue of GDRs.

• American Depository Receipts (ADRs): An ADR is a specific type of depository receipt that is issued by a company in the United States. ADRs are similar to GDRs, except that they can be issued only to American citizens and can be listed and traded only on a stock exchange in the USA, such as the New York Stock Exchange (NYSE).

• Indian Depository Receipts (IDRs): An IDR is the Indian version of the GDR. It is a financial instrument denominated in Indian Rupees, created by an Indian Depository, which enables a foreign company to raise funds from the Indian securities market. The foreign company deposits its shares with an Indian Depository, which then issues receipts to investors in India against these shares. Standard Chartered PLC was the first foreign company to issue an IDR in the Indian securities market.

• Foreign Currency Convertible Bonds (FCCBs): FCCBs are equity-linked debt securities that are issued in a foreign currency. An FCCB is essentially a bond that carries a fixed rate of interest, but it also gives the bondholder the option to either convert the bond into equity shares or depository receipts of the company at a predetermined price and exchange rate after a specific period, or to retain the bond and receive the principal amount upon maturity. FCCBs are listed and traded on foreign stock exchanges.

Factors Affecting the Choice of the Source of Funds

The selection of the right source or, more commonly, the right mix of sources of finance is one of the most critical and complex decisions that the management of a business has to make. There is no single, ideal source of funds that is best for all companies in all situations. The choice is a strategic one and involves a careful evaluation of various competing factors, weighing the pros and cons of each option in the specific context of the business's current needs and long-term goals. The key factors that influence this crucial decision are briefly discussed below:

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(i) Cost

This is often the most important factor. The cost of finance has two components: the cost of procurement (the expenses incurred in raising the funds, such as underwriting commission, brokerage, and printing expenses for a public issue, collectively known as floatation costs) and the cost of utilizing the funds (the interest that must be paid on borrowed funds or the dividends that are expected by shareholders). A prudent business will always try to select the source that has the lowest combined cost.

(ii) Financial Strength and Stability of Operations

The financial health and stability of a business are key determinants. A business that enjoys a strong financial position and has stable and predictable earnings can easily service fixed-charge funds like debentures and term loans, as it is confident of its ability to pay the regular interest charges. However, a business with highly fluctuating or uncertain earnings should be very cautious about using debt, as the legal obligation to pay interest remains even during periods of low profit or loss. Such a firm might prefer to rely more on equity capital, where the payment of dividends is not a legal compulsion.

(iii) Form of Organisation and Legal Status

The legal structure of the business itself limits the available financing options. For example, a partnership firm or a sole proprietorship cannot raise money by issuing equity shares, as this is an option available only to a joint stock company. Similarly, a small, privately-held company has much more limited access to formal credit and capital markets compared to a large, publicly-listed corporation.

(iv) Purpose and Time Period

The source of finance must be carefully matched with the purpose and the time period for which the funds are required. This is known as the matching principle. A short-term need, such as funding an increase in inventory for a festive season, should be met through short-term sources like trade credit or a bank overdraft. A long-term need, such as financing the construction of a new factory or a major expansion project, requires long-term sources like the issue of shares, debentures, or long-term loans. Financing a long-term asset with a short-term loan would be a serious financial mismatch.

(v) Risk Profile

Every source of finance carries a different level of risk for the business. Equity capital is considered the least risky from the company's perspective, as the capital has to be repaid only at the time of winding up, and dividends need not be paid if there are no profits. On the other hand, debt capital (loans and debentures) is the riskiest. It involves a legal and non-negotiable obligation to pay both the interest and the principal amount according to a fixed schedule, regardless of the company's profitability. The risk of being unable to meet these fixed payments is known as financial risk.

(vi) Control

The choice of a source of finance can have a significant impact on the control that the existing owners have over the management of the firm. Issuing new equity shares to the public leads to a dilution of control, as it brings in a large number of new shareholders who have voting rights. Conversely, raising funds through debt (loans or debentures) does not affect control, as lenders and debenture holders are creditors and do not have any voting rights. Therefore, business owners who are keen to retain their complete and undiluted control over the business may prefer to raise funds through debt rather than equity.

(vii) Effect on Credit Worthiness

The capital structure of a company, or its dependence on certain sources of finance, can affect its creditworthiness in the market. For example, a company that already has a very high level of debt may find it difficult to secure further loans, as potential new lenders may perceive it as being too risky and over-leveraged.

(viii) Flexibility and Ease of Obtaining Funds

Another important aspect affecting the choice of a source of finance is the flexibility and ease with which funds can be obtained. Borrowings from banks and financial institutions often involve a lengthy and cumbersome process of detailed investigation, extensive documentation, and the imposition of restrictive covenants in the loan agreement. In contrast, other sources like trade credit or the use of retained earnings are much more flexible and easier to access, without such stringent conditions.

(ix) Tax Benefits

The tax implications of different sources of finance can be a very significant factor in the decision-making process. The interest paid on debentures and loans is a tax-deductible expense for the company. This means it is subtracted from the company's revenues before calculating the taxable profit. This effectively lowers the company's tax liability and significantly reduces the real, after-tax cost of debt. On the other hand, the dividend paid on preference shares and equity shares is not a tax-deductible expense; it is an appropriation of after-tax profits. This significant tax advantage often makes debt a more attractive and cheaper source of finance compared to equity.

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