Class 11 Business Studies Notes Chapter 8 (Sources of Business Finance) – Business Studies Book
Detailed Notes with MCQs of a very crucial chapter for your understanding of how businesses operate and certainly important for your exam preparation: Chapter 8 - Sources of Business Finance. Every business, big or small, needs money to start, run, and grow. This money is called 'finance', and understanding where it comes from is fundamental.
Concept of Business Finance
- Meaning: Business finance refers to the money and credit employed in the business. It's the lifeblood of any enterprise.
- Need: Funds are required for:
- Fixed Capital Requirements: To purchase fixed assets like land, building, plant, machinery, furniture, etc. These are used over a long period.
- Working Capital Requirements: To meet day-to-day operating expenses like purchasing raw materials, paying wages and salaries, rent, electricity bills, etc. This is needed for the short term to ensure smooth operations.
Classification of Sources of Funds
Sources of finance can be classified in several ways:
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On the Basis of Period:
- Long-term: Required for more than 5 years (e.g., for purchasing fixed assets). Sources include shares, debentures, long-term loans.
- Medium-term: Required for a period of 1 to 5 years (e.g., for heavy advertising, R&D). Sources include preference shares, debentures, medium-term loans, public deposits.
- Short-term: Required for less than 1 year (e.g., for working capital). Sources include trade credit, bank overdraft, cash credit, short-term loans, public deposits.
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On the Basis of Ownership:
- Owner's Funds (Equity): Provided by the owners of the enterprise. It remains invested for the longest duration and forms the capital base. Not required to be refunded during the life of the company. Owners get profits (dividends) in return. Examples: Equity Shares, Preference Shares, Retained Earnings.
- Borrowed Funds (Debt): Funds raised through loans or borrowings. These have to be repaid after a specific period, and regular interest payments must be made. Lenders do not get voting rights. Examples: Debentures, Loans from Banks/Financial Institutions, Public Deposits, Trade Credit.
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On the Basis of Source of Generation:
- Internal Sources: Generated from within the business (e.g., Retained Earnings, collection of receivables).
- External Sources: Come from outside the organisation (e.g., Shares, Debentures, Loans, Public Deposits).
Detailed Sources of Finance
Let's delve into the specific sources:
A. Owner's Funds
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Equity Shares:
- Meaning: Represent the ownership capital of a company. Equity shareholders are the real owners.
- Features:
- Primary risk bearers.
- Get dividends (residual profits). Payment is not compulsory.
- Have voting rights and control the management.
- Funds are permanent, not refunded during the company's lifetime (except in buy-back or winding up).
- Carry a pre-emptive right (right to subscribe to new shares issued by the company).
- Merits: Permanent capital, no charge on assets, high creditworthiness, democratic control.
- Demerits: Risk of fluctuating returns, potential dilution of control for existing shareholders, higher cost than debt (due to flotation costs and expectation of higher returns), delays in fundraising due to procedural requirements.
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Preference Shares:
- Meaning: Shareholders enjoy preferential rights regarding (i) payment of dividend at a fixed rate, and (ii) repayment of capital on winding up, over equity shareholders.
- Features:
- Fixed rate of dividend.
- Preferential right to dividend and capital repayment.
- Generally do not carry voting rights (except under specific circumstances).
- Appeal to cautious investors seeking fixed income with moderate risk.
- Types: Cumulative/Non-Cumulative, Participating/Non-Participating, Convertible/Non-Convertible, Redeemable/Irredeemable.
- Merits: Fixed return for investors, no voting rights (so no dilution of equity control), no charge on assets, preference in repayment over equity.
- Demerits: Costlier than debt (dividend is not tax-deductible), dividend payment is not compulsory but arrears may accumulate (cumulative shares), perceived as a burden if profits are low, limited appeal to aggressive investors.
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Retained Earnings (Ploughing Back of Profits / Internal Financing):
- Meaning: Portion of the net profit which is not distributed as dividend but retained in the business for future use.
- Features:
- Internal source of finance.
- Depends on profitability, dividend policy, and age of the company.
- Considered the most inexpensive source (no explicit cost like interest or dividend, no flotation costs).
- Merits: No explicit cost, no dilution of control, enhances capacity to absorb unexpected losses, increases financial strength and creditworthiness, operational flexibility.
- Demerits: May cause dissatisfaction among shareholders expecting higher dividends, uncertain source (depends on profits), opportunity cost involved (funds could have been invested elsewhere), potential for suboptimal use if management is inefficient.
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Global Depository Receipts (GDRs) / American Depository Receipts (ADRs) / Indian Depository Receipts (IDRs):
- GDR: An instrument issued abroad by an Indian company to raise funds in foreign currency, listed and traded on a foreign stock exchange. Denominated usually in US Dollars. Can be converted into equity shares.
- ADR: Similar to GDRs, but issued only to US citizens and traded on US stock exchanges.
- IDR: An instrument denominated in Indian Rupees created by a foreign company to raise funds from India, issued by an Indian Depository.
- Purpose: Allow companies to access international capital markets.
B. Borrowed Funds
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Debentures:
- Meaning: An instrument acknowledging a debt by the company. Debenture holders are creditors.
- Features:
- Fixed rate of interest, payable irrespective of profits.
- Repayable after a specified period.
- Usually secured by a charge (fixed or floating) on the assets of the company.
- No voting rights.
- Types: Secured/Unsecured, Registered/Bearer, Convertible/Non-Convertible, First/Second, Redeemable/Irredeemable (though now only redeemable are issued as per law).
- Merits: Cheaper source (interest is tax-deductible), no dilution of control, suitable for stable earnings, flexibility in repayment.
- Demerits: Fixed obligation (interest payment is compulsory), charge on assets restricts further borrowing, reduces borrowing capacity, risk of financial distress if unable to pay interest/principal.
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Loans from Financial Institutions:
- Meaning: Specialised institutions established by central/state governments to provide medium and long-term finance (e.g., IFCI, ICICI, IDBI, SFCs, SIDBI).
- Features: Provide both owned capital (by underwriting/subscribing shares) and loan capital. Offer technical/managerial advice.
- Merits: Long-term finance available, expert advice, easy installments for repayment, enhances goodwill.
- Demerits: Strict terms and conditions, procedural delays, may impose restrictions on management (e.g., nominee director).
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Loans from Commercial Banks:
- Meaning: Banks provide funds through various means like term loans, cash credit, overdraft, discounting of bills. Primarily a source for short and medium-term finance.
- Features: Interest rate charged, security often required, flexibility in repayment for some forms (like overdraft).
- Merits: Timely assistance, secrecy maintained, easier formalities than issuing shares/debentures, flexibility.
- Demerits: Generally for shorter duration, requires security/collateral, sometimes difficult documentation, close monitoring by banks.
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Public Deposits:
- Meaning: Deposits raised directly from the public by companies.
- Features: Generally for short to medium term (up to 3 years), interest rate offered is usually higher than bank deposits, unsecured. Regulated by RBI/Companies Act.
- Merits: Simple procedure, lower cost than bank loans, no charge on assets, does not dilute control.
- Demerits: Unreliable source (depends on public sentiment), limited amount can be raised, not suitable for new companies, restricted by regulations.
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Trade Credit:
- Meaning: Credit extended by one trader (supplier) to another for the purchase of goods and services. Common between manufacturers, wholesalers, and retailers.
- Features: Short-term, informal, arises in the normal course of business, no explicit interest (though cost may be embedded in price or loss of cash discount).
- Merits: Convenient and continuous source, readily available, increases purchasing power, no charge on assets.
- Demerits: Limited amount and period, implicit costs (loss of discount, higher price), can lead to overtrading.
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Inter-Corporate Deposits (ICDs):
- Meaning: Short-term, unsecured deposits made by one company with another. Primarily used by companies with surplus funds lending to those with temporary deficits.
- Features: Short duration (up to 6 months), higher interest rates than banks, transaction between corporates.
- Merits: Quick availability for borrower, good return for lender.
- Demerits: Risky for lender (unsecured), availability depends on market conditions.
Factors Affecting the Choice of Source of Finance
The selection of the appropriate source depends on various factors:
- Cost: Explicit cost (interest, dividend) and implicit cost (flotation costs). Debt is generally cheaper than equity.
- Financial Strength & Stability: Profitable, stable firms can easily use debt. Less stable firms should rely more on equity.
- Form of Organisation & Legal Status: Sole traders/partnerships have limited options compared to companies.
- Purpose & Time Period: Long-term needs met by long-term sources (shares, debentures, long loans); short-term needs by short-term sources (trade credit, bank overdraft).
- Risk Profile: Debt increases financial risk (fixed payments). Equity is less risky for the firm.
- Control: Equity dilutes owners' control; debt does not.
- Effect on Creditworthiness: Too much debt can lower credit rating.
- Flexibility & Ease: Some sources involve fewer formalities (e.g., retained earnings, trade credit) than others (e.g., shares, debentures).
- Tax Benefits: Interest on debt is tax-deductible, making it cheaper. Dividends are paid out of after-tax profits.
Understanding these sources and the factors influencing their choice is vital for any business to manage its finances effectively. Keep these points in mind for your exams.
Multiple Choice Questions (MCQs)
Here are 10 MCQs based on the chapter:
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Funds required for purchasing current assets and meeting day-to-day operational expenses are known as:
a) Fixed Capital
b) Working Capital
c) Owner's Capital
d) Loan Capital -
Which of the following is considered an 'Owner's Fund'?
a) Debentures
b) Public Deposits
c) Retained Earnings
d) Trade Credit -
Equity shareholders are often referred to as:
a) Creditors of the company
b) Residual claimants
c) Lenders of the company
d) Debtors of the company -
A key advantage of issuing Debentures for a company is:
a) Debenture holders get voting rights.
b) Interest paid on debentures is tax-deductible.
c) It increases the control of equity shareholders.
d) It is a permanent source of capital. -
Which source of finance does NOT dilute the control of existing equity shareholders?
a) Issue of new Equity Shares
b) Issue of Debentures
c) Issue of Preference Shares (generally)
d) Both (b) and (c) -
'Ploughing back of profits' refers to:
a) Issuing new shares to the public
b) Borrowing funds from banks
c) Retaining a part of profits for future investment
d) Paying dividends to shareholders -
ADRs (American Depository Receipts) allow:
a) Indian companies to raise funds from the US market.
b) US companies to raise funds from the Indian market.
c) Indian companies to borrow from American banks.
d) US companies to deposit funds in Indian banks. -
Which source of finance typically involves a 'charge' on the assets of the company?
a) Equity Shares
b) Retained Earnings
c) Secured Debentures
d) Public Deposits -
Trade Credit is primarily a source of:
a) Long-term finance
b) Medium-term finance
c) Short-term finance
d) Owner's capital -
A major factor influencing the choice between debt and equity is the 'Financial Risk'. Which type of financing increases this risk for the company?
a) Equity Financing
b) Debt Financing
c) Retained Earnings
d) Preference Shares
Answer Key:
- b) Working Capital
- c) Retained Earnings
- b) Residual claimants
- b) Interest paid on debentures is tax-deductible.
- d) Both (b) and (c) (Debentures are debt, Preference shares generally don't have voting rights)
- c) Retaining a part of profits for future investment
- a) Indian companies to raise funds from the US market.
- c) Secured Debentures
- c) Short-term finance
- b) Debt Financing
Study these notes carefully. Focus on the features, merits, and demerits of each source, and the factors influencing the choice. Good luck with your preparation!