SOURCES OF BUSINESS FINANCE Flashcards
What do you mean by Business Finance?
Business is concerned with the production and distribution of goods and services for the
satisfaction of needs of society.
For carrying out various activities, business requires finance. Therefore it is the life blood of
any business.
types of finance requirements of a business.
Fixed capital requirements
Working capital requirements
Fixed capital requirements:
These funds which are required to start the business. These are required to
purchase fixed assets like land and building, plant and machinery, and furniture and
fixtures etc.
These funds remain invested in the business for a long period of time. The
requirement of fixed capital may be different for different kinds of business.
A trading enterprise may require small amount of fixed capital as compared to a
manufacturing enterprise.
Working capital requirements:
These are the funds which are required for day-to-day operations of the business.
These funds are invested in the business for shorter time period.
They are used for holding current assets such as stock of material, bills receivables
and for meeting current expenses like salaries, wages, taxes and rent etc.
A trading firm requires more amount of working capital as compare to a
manufacturing concern.
classification of sources of funds
On the basis of period:
On the basis of ownership
On the basis of generation:
classification of sources of funds On the basis of period
Short term funds
Medium term funds
Long term funds
Explain Short term funds
These funds are required for a period not exceeding one year.
Eg- trade credit, loans from commercial banks and commercial papers.
Explain Medium term funds-
When the funds are required for a period of more than one year but less
than five years.
These sources includes- borrowings from commercial banks, public deposits,
lease financing and loans from financial institutions.
explain Long term funds
The long-term sources fulfil the financial requirements of an enterprise for a
period exceeding 5 years.
It includes sources such as- shares and debentures, long-term borrowings
and long loan from financial institutions.
classification of sources of funds on the basis of ownership
Owners funds
Borrowed funds
explain Owners funds
Owners funds means funds that are provided by the owners of an enterprise.
They remains invested in the business for a longer duration and is not required
to be refunded during the life period of the business.
The two important sources of owners funds area. Equity shares
b. Retained earnings
explain . Borrowed funds-
These funds are raised through loans and borrowings. These sources provide
funds for a specific period, on certain terms and conditions and have to be
repaid after the expiry of that period.
A fixed rate of interest is paid by the borrowers on such funds and are provided
on the security of some fixed assets.
These includes- loan from commercial banks, loan from financial institutions,
issue of debentures, public deposits and trade credit
classification of sources of funds on the basis of generation
internal source
external source
explain Internal sources-
Internal sources of funds are those that are generated from within the business.
A business can generate funds internally by
a) Disposing of surplus inventories
b) Retained earnings
explain External sources-
External sources of funds include those sources that lie outside an organization.
It may be costly as compared to those raised through internal sources.
These includes- issue of debentures, borrowing from commercial banks and
financial institutions and accepting public deposits.
What do you mean by Retained earnings?
Retained earnings refers to a part of profit which is not distributed among the shareholders
as dividends but is retained in the business for use in the future.
It is a source of internal financing or self-financing and it is also known as ‘ploughing back of
profits’.
Explain the merits of retained
earnings.
- Retained earnings is a permanent source of funds available to an organization.
- It does not involve any explicit cost in the form of interest, dividend or floatation cost.
- As the funds are generated internally, there is a greater degree of operational freedom and
flexibility. - It enhances the capacity of the business to absorb unexpected losses.
- It may lead to increase in the market price of the equity shares of a company.
Explain the limitations of retained
earnings.
- It is an uncertain source of funds as the profits of business are fluctuating
- Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would
get lower dividends.
. What do you mean by Trade credit?
s. Trade credit:
Trade credit is the credit extended by one trader to another for the purchase of goods and
services. It appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts
payable’.
It is commonly used as a source of short-term financing by business organizations. It is
granted to those customers who have reasonable amount of financial standing and goodwill
Merits of trade credit
- Trade credit is a convenient and continuous source of funds.
- It may be readily available in case the credit worthiness of the customers is known to the
seller. - It does not create any charge on the assets of the firm while providing funds.
- It needs to promote the sales of an organization.
Limitations of trade merit
- Availability of easy and flexible trade credit facilities may induce a firm to indulge in
overtrading, which may add to the risks of the firm. - Only limited amount of funds can be generated through trade credit.
- It is generally a costly source of funds as compared to most other sources of raising money.
Explain the types of issue of shares
The capital obtained by issue of shares is known as ‘share capital’. The capital of a company
is divided into small units called ‘shares’. Each share has its own nominal value. The person
holding the share is known as ‘shareholder’.
There are two types of shares i.e.
a) Equity shares
b) Preference shares
The money raised by issue of equity shares is called equity share capital. The money raised
by issue of preference shares is called preference share capital.
Equity shares:
Equity shares is the most important source of raising long term capital by a company.
Equity shares represents the ownership of the company.
Equity shareholders do not get a fixed d dividend but are paid on the basis of earnings by
the company. They are the residual owners of the company and enjoy the reward as well
as bear the risk of ownership.
Their liability is limited to the extent of the company. These shareholders have a right to
participate in the management of the company.
Merits of Equity shares
- Equity shares are suitable for investors who are willing to assume risk for higher returns.
- Payment of dividend to the equity shareholders is not compulsory. Therefore, it does not
create any burden on the company. - Equity capital serves as permanent capital as it is to be repaid only at the time of liquidation
of a company. - It provides credit worthiness to the company and confidence to prospective loan providers.
- Democratic control over management of the company is assured due to voting rights of
equity shareholders.
Limitations of Equity shares
- Investors who want steady income may not prefer equity shares as equity shares get
fluctuating returns. - The cost of equity shares is generally more as compared to other sources.
- Formalities and procedural delays are involved while raising funds through issue of equity
share. - Issue of additional equity shares dilutes the voting power, and earnings of existing equity
shareholders.
Preference shares
The capital raised by issue of preference shares is called preference share capital. The
preference shareholders enjoy a preferential position over equity shareholders in two
ways:
(i) Receiving a fixed rate of dividend, before any dividend is declared for equity
shareholders.
(ii) Receiving their capital after the claims of the company’s creditors have been
settled, at the time of liquidation.
Merits of Preference shares
- Preference shares provide reasonably steady income in the form of fixed rate of return and
safety of investment. - These are useful for those investors who want fixed rate of return with comparatively low
risk. - It does not affect the control of equity shareholders over the management as preference
shareholders don’t have voting rights. - Preference capital does not create any sort of charge against the assets of a company.
Limitations of Preference shares
- Preference shares are not suitable for those investors who are willing to take risk and are
interested in higher returns. - Preference capital dilutes the claims of equity shareholders over assets of the company.
- The dividend paid is not deductible from profits as expense. So there is no tax savings as in
the case of interest on loans. - The rate of dividend on preference shares is higher than the rate of interest on debentures.
Explain the difference between Equity shares and Preference shares
Face value
The face value of equity shares is
generally low.
The face value of preference shares is generally high.
Risk
The equity shareholders are the
primary risk bearers.
The risk involved in preference shares is relatively less.
Dividend
Equity share holders are given
dividend depending upon the
profits of the company.
Preference shareholders get fixed rate of dividend.
Refund of
capital
At the time of winding up of company the equity share holders are refunded only after preference shares are paid. At the time of winding up, preference shares get priority over equity shares for refund of capital.
Payment of
dividend
Equity shareholders are given
dividend after the settlement of
preference shareholders.
Preference shareholders are entitled to dividend after the settlement of outsider’s liability but before dividend to equity shareholders.
Voting rights
Equity shareholders get all the
voting rights in the company.
In normal conditions no voting rights are provided but if the dividend is not paid for 2 years or there is any decision which
affects the
various types of preference shares
Cumulative and non-cumulative:
Participating and non-participating:
Convertible and non-convertible:
