Sources of Business Finance: An Overview
Any company needs funds to purchase fixed assets, meet working capital needs, and implement corporate growth and expansion plans. This chapter explains the owner’s fund in detail and also talks about the various sources of finance and how they are categorised in the real world.
Owner’s funds refer to the funds that the owners of an enterprise provide. Also known as the company’s accumulated profit. The company has no liability to return these funds.
Classification of Sources of Funds
The Classification of sources of Funds is generally done using different basis, Period basis sources, Ownership basis sources, and Generation basis sources. A brief explanation of these classifications and the sources are provided as follows:
1. Period-based Sources
Short-term Funds: These funds are required for a period not exceeding one year. This includes trade credits, commercial bank loans, and commercial paper.
Medium-term Funds: These funds are required for a period of no less than 1 year and no more than 5 years. Borrowings from commercial banks, lease financing, and loans from financial institutions are the type of medium-term sources of finance.
Long-term Funds: These funding sources cover the company's financial needs for over five years. It includes stocks, bonds, long-term loans, loans from financial institutions, etc.
2. Ownership-based Sources
Owner’s Fund: Owner's funds mean funds provided by the owners of an enterprise.
Borrowed Fund: Borrowed funds are raised through loans and borrowings. These sources provide funds for a specific period of time. Loans from commercial banks, public deposits, and trade credit are some examples of borrowed funds.
3. Generation-based Sources
Internal Sources: Internal sources funds refer to those funds that are generated from within the business. A business can generate funds internally by disposing of surplus inventories and retained earnings.
External Sources: External sources include funding that is external to your organisation. The funds raised from external sources are considered costly compared to the internal source of funds. These include issues of debentures and borrowing from commercial banks and financial institutions.
What Do You Mean by Owner’s Fund?
The financing required for a company to start and operate a business is known as Business finance. Therefore, it is said that finance is the lifeblood of any business. A business cannot function without sufficient funds available. The initial capital brought in by the entrepreneur is not always enough to cover all the company's financial needs. Entrepreneurs should therefore seek out a variety of other sources that can meet their funding needs. Funds can be raised from personal sources or by borrowing from banks, friends, etc.
Owner’s funds mean funds provided by the owners of an enterprise, which may be sole traders, partners, or shareholders of a company. In addition to capital, this includes profits reinvested in the company. The owner's capital remains invested in the company for a long time and does not have to be repaid during the life of the company. This capital forms the basis for the owner to acquire the right to control the business. Issue of equity shares and retained earnings are the two essential sources from which the owner’s funds can be obtained.
Sources of Funds
Some of the sources of funds are discussed below:
1. Retained Earnings: Retained earning refers to a part of the profit which is not distributed among the shareholders as dividends but is retained in the business for use in the future. Also referred to as ploughing back of profits.
Advantages
A continuous source of funding available to an organisation.
It has no explicit cost in the form of interest, dividends, or floatation costs.
The funds are generated internally; that is why there is greater operational freedom and flexibility.
It improves the business's ability to absorb unexpected losses, and it may increase the market price of a company's equity shares.
Disadvantages
Excessive ploughing back may cause shareholder dissatisfaction because it results in lower dividends.
It is an uncertain source of funds because business profits fluctuate.
Many firms do not recognise the opportunity cost associated with these funds. This may result in inefficient use of funds.
2. Trade Credit: Trade credit is credit extended by one trader to another to buy and sell goods and services. The buyer of goods' records appears as various creditors or accounts payable.
Advantages
Trade credit is an easy and consistent source of funds.
Trade credit may be readily available if the seller knows the customers' creditworthiness.
An organisation's sales must be promoted through trade credit.
If a company wants to increase its inventory level to meet an expected increase in sales volume in the near future, it can use trade credit to finance it; it does not charge the company's assets while providing funds.
Disadvantages
The availability of simple and flexible trade credit facilities may induce a firm to engage in overtrading, which may increase the firm's risks.
Trade credit can only generate a limited amount of funds; it is generally a costly source of funds when compared to most other methods of raising funds.
2. Commercial Papers: Commercial papers (CP) are unsecured money market instruments that take the form of a promissory note. It was first introduced in India in 1990 to allow highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide investors with an additional instrument.
Advantages
A commercial paper is sold unsecured and without any restrictive conditions; it has high liquidity because it is a freely transferable instrument, and it provides more funds than other sources.
The cost of commercial paper to the issuing firm is generally lower than commercial bank loans; commercial paper provides a continuous source of funds.
This is due to the fact that their maturity can be tailored to the needs of the issuing firm.
Furthermore, maturing commercial paper can be repaid by selling new commercial paper; businesses can park excess funds in commercial paper, earning a good return on the money raised.
Disadvantages
Commercial papers are only available to financially sound and highly rated companies.
This method is ineffective for raising funds for new and moderately rated businesses.
The amount of money that can be raised through commercial paper is limited by the excess liquidity available with fund suppliers at any given time.
Case Study
Jane saw her father watching the news on TV. She asked his father why he was so focused on the news today. Jane’s father told her that the news was about the stock market as he had invested in some shares. However, Jane could not understand anything that her father explained about shares. Can you explain to Jane what shares are? Also, clarify important types of shares.
Ans: A company's capital is divided into small units known as shares. Share capital is the capital obtained by the issue of shares. We can divide the shares into equity shares and preference shares.
Equity Shares: These shares represent the ownership of the company. Such shareholders do not get a fixed dividend and are known as residual owners. After all other claims on the company’s income and assets have been settled, they are entitled to what is left.
Preference Shares: Holders of these shares get priority over equity shareholders in two ways:
Receiving a fixed rate of dividend.
Receiving their capital after the claims of the company’s creditors have been settled at the time of winding up.
Summary
Businesses are engaged in producing and distributing goods and services to meet the needs of society. You cannot operate a business without sufficient funds. Once the decision to start a business is made, the need for funding begins. Finance is said to be the lifeline of a company. Assessing your organisation's financial needs and identifying various sources of funds is critical.
FAQs on Sources of Business Finance: An Overview
1. What are the main ways to classify the sources of business finance?
Sources of business finance can be classified on several bases to understand their nature and suitability for different business needs. The three primary classifications are:
- On the Basis of Period: This categorises funds based on the duration for which they are required. It includes long-term sources (for over 5 years, e.g., shares, debentures), medium-term sources (1 to 5 years, e.g., bank loans, public deposits), and short-term sources (up to 1 year, e.g., trade credit, commercial paper).
- On the Basis of Ownership: This distinguishes funds based on who provides them. It includes Owner's Funds (capital contributed by owners, like equity shares and retained earnings) and Borrowed Funds (capital acquired through loans or credit, like debentures and bank loans).
- On the Basis of Source of Generation: This classifies funds based on whether they are generated from within or outside the business. It includes Internal Sources (e.g., retained earnings, disposal of surplus assets) and External Sources (e.g., issue of shares, loans from financial institutions).
2. What is the fundamental difference between owner's funds and borrowed funds?
The fundamental difference lies in ownership, obligation, and return. Owner's funds, also known as equity capital, are provided by the owners of the company (shareholders). These funds remain permanently with the business and there is no legal obligation to repay them during the company's lifetime. In return, owners get voting rights and a share in profits (dividends), which is not fixed. In contrast, borrowed funds are sourced from external parties like banks or the public. These must be repaid after a specific period, and the company is legally obligated to pay a fixed rate of interest, regardless of whether it earns a profit or not.
3. Explain the key features of equity shares and preference shares.
Equity and preference shares are the two main types of shares a company can issue:
- Equity Shares: These represent the ownership capital of a company. Equity shareholders are the real owners who bear the ultimate risk. They have voting rights, which allows them to participate in management. Their dividend rate is not fixed and depends on the company's profits. They are paid only after all other claims, including those of preference shareholders, have been settled.
- Preference Shares: These shareholders enjoy two preferential rights over equity shareholders. First, they receive dividends at a fixed rate before any dividend is paid to equity shareholders. Second, at the time of the company's winding up, their capital is repaid before the capital of equity shareholders. However, they generally do not have voting rights.
4. What are debentures, and how do they differ from shares?
A debenture is a written instrument or certificate issued by a company that acknowledges a debt. It is a key component of borrowed funds. Debenture holders are creditors of the company, not owners.
The main differences between shares and debentures are:
- Ownership: A shareholder is an owner of the company, whereas a debenture holder is a creditor.
- Return: Shareholders receive a dividend (a portion of profits), which is not fixed for equity shares. Debenture holders receive interest at a fixed rate, which is a charge against profit and must be paid even if the company makes a loss.
- Repayment: Share capital is generally not returned during the company's life. Debentures are issued for a specified period and are repaid on the maturity date.
- Control: Shareholders (especially equity) have voting rights and control over the company's management. Debenture holders have no such voting rights.
5. What are the main advantages and limitations of raising funds through public deposits?
Public deposits refer to the unsecured deposits invited by companies directly from the public. While a popular source of medium-term finance, they have distinct advantages and limitations.
Advantages:
- The procedure for obtaining deposits is simpler than that for share or debenture issues.
- The cost of public deposits is generally lower than the cost of borrowings from banks and financial institutions.
- They do not create any charge on the company's assets, leaving them free to be used as security for other loans.
Limitations:
- New companies generally find it difficult to raise funds through this method due to a lack of credit history.
- It is an unreliable source of finance, as the public may not always respond when the company needs money.
- The amount that can be raised through public deposits is limited by legal restrictions.
6. Why is trade credit considered an important source of short-term finance?
Trade credit is the credit extended by one trader to another for the purchase of goods and services. It is a crucial source of short-term finance because it is convenient and continuous. When a business buys raw materials or inventory from a supplier, it is often given a period (e.g., 30, 60, or 90 days) to make the payment. This effectively provides the business with free, short-term funding to manage its operating cycle. It is readily available without complex paperwork and does not require the mortgage of assets, making it easily accessible for managing inventory and day-to-day operations.
7. What key factors should a business consider when selecting a suitable source of finance?
Choosing the right source of finance is a critical decision that impacts a company's profitability and control. Key factors to consider include:
- Cost: This includes the explicit cost, like interest on loans or dividends on shares, as well as the implicit cost, like floatation expenses for issuing securities.
- Financial Risk: Borrowed funds carry a high degree of risk as interest payments are mandatory. Owner's funds are less risky from this perspective.
- Control: Issuing new equity shares can dilute the control of existing owners. In contrast, borrowed funds do not affect management control.
- Time Period: The duration for which funds are needed determines whether a short-term, medium-term, or long-term source is appropriate.
- Flexibility and Covenants: Some loans come with restrictive conditions (covenants) that may hamper business operations. Owner's funds offer more operational freedom.
- Tax Benefits: Interest paid on borrowed funds is a tax-deductible expense, which can lower the effective cost of debt.
8. Why might a highly profitable company still need to raise external finance?
Even a highly profitable company may need external finance because profits alone may not be sufficient to fund major strategic initiatives. Retained profits (internal funds) are often used for day-to-day operational needs. However, for significant capital-intensive activities like business expansion into new markets, diversification into new product lines, acquiring another company, or undertaking a major technological upgrade, the required investment can far exceed the available profits. In such cases, the company must turn to external sources like issuing new shares or taking long-term loans to fund its growth and maintain a competitive edge.
9. How does 'ploughing back of profits' contribute to a company's financial strength?
'Ploughing back of profits', also known as retained earnings, is the process of reinvesting a portion of the company's net profit back into the business instead of distributing it as dividends. This significantly strengthens a company's financial position in several ways:
- It is a source of funds with no explicit cost, as the company doesn't have to pay interest or dividends on it.
- It increases the company’s capacity to absorb unexpected losses or economic downturns.
- It provides funds for growth and expansion without diluting ownership or increasing debt.
- A strong base of retained earnings enhances the company's creditworthiness in the eyes of lenders and investors, making it easier to raise borrowed funds in the future.
10. What are the primary risks for a business that relies too heavily on borrowed funds?
Relying excessively on borrowed funds, or being highly leveraged, introduces significant risks for a business. The primary risks are:
- Financial Risk: The company has a fixed legal obligation to pay interest on the borrowed amount, regardless of its profitability. During periods of low earnings, this can lead to a financial crisis or even insolvency.
- Increased Cost of Capital: Beyond a certain point, too much debt increases the perceived risk of the company, causing lenders to demand higher interest rates on new loans.
- Restrictive Covenants: Lenders often impose conditions, such as restrictions on paying dividends, raising further loans, or selling assets, which can limit the management's operational freedom and flexibility.
- Cash Flow Strain: Regular repayment of the principal amount along with interest puts a continuous strain on the company's cash flow, which could otherwise be used for growth opportunities.
