Imagine you have been working with your friend in his small fast food shop.
You always loved food.
But you are unable to reach more people.
Although you are making enough money but you are feeling incomplete somewhere in your heart.
Now you have decided to expand your reach but you are at this point of time, unaware of :-
How you can arrange money?
What are the sources of business finance
What are the basics you need to know before taking these decisions?
If its sounds intresting, then keep reading.
Today you will have answers to the above questions and much more.
Sources of Business Finance – The Brief Introduction
It is important for every business to acquire finance in the time of need.
Whether to start a business or expand a business.
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 money.
For any person who is going to start a business. it’s advisable to not only know sources of business finance but also to understand the pros and cons attached to it.
The initial capital contributed by the entrepreneur is not always sufficient to take care of all financial requirements of the business.
A business person, therefore, has to look for different other sources from where the need for funds can be met.
A clear assessment of the financial needs and the identification of various sources of finance can help you making the right financial decisions.
Finance, therefore, is called the life blood of any business.
The requirements of funds by business to carry out its various activities is called business finance.
A business cannot function unless adequate funds are made available to it.
2 Important requirements to remember
The initial capital contributed by the entrepreneur is not always sufficient to take care of all financial requirements of the business.
The financial needs of a business can be categorised as follows:
(A) Fixed capital requirements
(B) Working capital requirements
Fixed Capital Requirements
In order to start a business, funds are required to purchase fixed assets like land and building, plant and machinery, and furniture and fixtures.
This is known as the fixed capital requirements of the enterprise.
The funds required in fixed assets remain invested in the business for a long period of time.
Different business units need a varying amounts of fixed capital depending on various factors such as the nature of business, etc.
A trading concern, for example, may require a small amount of fixed capital as compared to a manufacturing concern.
Likewise, the need for fixed capital investment would be greater for a large enterprise, as compared to that of a small enterprise.
Working Capital Requirements
The financial requirements of a business do not end with the procurement of fixed assets.
No matter how small or large a business is, it needs funds for its day-to-day operations.
This is known as the working capital of a business, which is used for holding current assets such as stock of material, bills receivables, and for meeting current expenses like salaries, wages, taxes, and rent.
The amount of working capital required varies from one business concern to another depending on various factors.
A business unit selling goods on credit, or having a slow sales turnover.
For example, would require more working capital as compared to a concern selling its goods and services on a cash basis or having a speedier turnover.
The requirement for fixed and working capital increases with the growth and expansion of business.
At times additional funds are required for upgrading the technology employed so that the cost of production or operations can be reduced in sources of business finance
Similarly, larger funds may be required for building higher inventories for the festive season or to meet current debts or expand the business, or to shift to a new location.
It is, therefore, important to evaluate the different sources from where funds can be raised.
Classification of funds – Class 11 Diagram
In Class 11 business studies book there was one diagram given which explains various sources of business finance.
However, you don’t need to read every one of them but reading them will suffice our need of knowing sources of finance which you will see in next section.
So please don’t skip this part.
(A) On the basis of period in source of finance
On the basis of period, the different sources of funds can be categorised into three parts.
These are long-term sources, medium-term sources and short-term sources.
The long-term sources fulfil the financial requirements of an enterprise for a period exceeding 5 years and include sources such as shares and debentures, long-term borrowings and loans from financial institutions.
Such financing is generally required for the acquisition of fixed assets such as equipment, plant, etc.
Where the funds are required for a period of more than one year but less than five years, medium-term sources of finance are used in sources of business finance.
These sources include borrowings from commercial banks, public deposits, lease financing and loans from financial institutions.
Short-term funds are those which are required for a period not exceeding one year.
Trade credit, loans from commercial banks, and commercial papers are some of the examples of the sources that provide funds for a short duration.
Short-term financing is most common for financing of current assets such as accounts receivable and inventories.
Seasonal businesses that must build inventories in anticipation of selling requirements often need shortterm financing for the interim period between seasons.
Wholesalers and manufacturers with a major portion of their assets tied up in inventories or receivables also require a large number of funds for a short period.
(B) On the basis of ownership in source of finance
On the basis of ownership, the sources can be classified into ‘owner’s funds’ and ‘borrowed funds’.
Owner’s funds means funds that are provided by the owners of an enterprise, which may be a sole trader or partners or shareholders of a company.
Apart from capital, it also includes profits reinvested in the business.
The owner’s capital remains invested in the business for a longer duration and is not required to be refunded during the life period of the business.
Such capital forms the basis on which owners acquire their right of control of management.
Issue of equity shares and retained earnings are the two important sources from where owner’s funds can be obtained.
‘Borrowed funds’ on the other hand, refer to the funds raised through loans or borrowings.
The sources for raising borrowed funds include loans from commercial banks, loans from financial institutions, issue of debentures, public deposits and trade credit.
Such sources provide funds for a specified 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.
At times it puts a lot of burden on the business as payment of interest is to be made even when the earnings are low or when loss is incurred in source of finance.
Generally, borrowed funds are provided on the security of some fixed assets.
(C) On the basis of generation in source of finance
The sources of funds can be whether the funds are generated from within the organisation or from external sources.
Internal sources of funds are those that are generated from within the business.
A business, for example, can generate funds internally by accelerating the collection of receivables, disposing of surplus inventories, and ploughing back its profit.
The internal sources of funds can fulfill only limited needs of the business.
External sources of funds include those sources that lie outside an organisation, such as suppliers, lenders, and investors.
When a large amount of money is required to be raised, it is generally done through the use of external sources.
External funds may be costly as compared to those raised through internal sources.
In some cases, business is required to mortgage its assets as security while obtaining funds from external sources.
Some of the examples of external sources of funds are the Issue of debenture, borrowing from commercial banks and financial institutions, and accepting public deposits.
5 important sources of business finance
When you are working alone or with your friends most of the work can be done through your own savings or borrowings from friends or relatives.
Also savings plays an important part in business and life as well, so you should read my very first post on savings (its boring but you should read)
However, when its not something that can sustain for long time. So one time you will be faced with these kind of situations.
So its better to understand other sources of business finance.
Following are the important sources of business finance about which you should know really well.
(1) Commercial Banks as source of finance :-
Commercial banks occupy a vital position as they provide funds for different purposes as well as for different time periods.
Banks extend loans to firms of all sizes and in many ways, like, cash credits, overdrafts, term loans, purchase/discounting of bills, and the issue of letters of credit.
The rate of interest charged by banks depends on various factors such as the characteristics of the firm and the level of interest rates in the economy.
The loan is repaid either in lump sum or in installments. You can check paisabazaar.com for many types of loans.
Bank credit is not a permanent source of funds. In case you want to more about sources of finance in UK, then this post on liberis finance can be good.
Though banks have started extending loans for longer periods, generally such loans are used for medium to short periods.
The borrower is required to provide some security or create a charge on the assets of the firm before a loan is sanctioned by a commercial bank.
(i) Banks provide timely assistance to businesses by providing funds as and when needed by it.
(ii) Secrecy of business can be maintained as the information supplied to the bank by the borrowers is kept confidential;
(iii) Formalities such as the issue of prospectus and underwriting are not required for raising loans from a bank. This, therefore, is an easier source of funds;
(iv) Loan from a bank is a flexible source of finance as the loan amount can be increased according to business needs and can be repaid in advance when funds are not needed.
(i) Funds are generally available for short periods and its extension or renewal is uncertain and difficult;
(ii) Banks make a detailed investigations of the company’s affairs, financial structure etc., and may also ask for the security of assets and personal sureties.
This makes the procedure of obtaining funds slightly difficult;
(iii) In some cases, difficult terms and conditions are imposed by banks. for the grant of loan.
For example, restrictions may be imposed on the sale of mortgaged goods, thus making normal business working difficult.
(2) Public Deposits :-
Public deposits are raised by organisations directly from the public.
Rates of interest offered on public deposits are usually higher than that offered on bank deposits.
Any person who is interested in depositing money in an organisation can do so by filling up a prescribed form.
The organisation in return issues a deposit receipt as acknowledgment of the debt.
Public deposits can take care of both medium and short-term financial requirements of a business.
The deposits are beneficial to both the depositor as well as to the organisation.
While the depositors get higher interest rate than that offered by banks, the cost of deposits to the company is less than the cost of borrowings from banks.
Companies generally invite public deposits for a period upto three years.
The acceptance of public deposits is regulated by the Reserve Bank of India.
(i) The procedure of obtaining deposits is simple and does not contain restrictive conditions as are generally there in a loan agreement;
(ii) Cost of public deposits is generally lower than the cost of borrowings from banks and financial institutions;
(iii) Public deposits do not usually create any charge on the assets of the company. The assets can be used as security for raising loans from other sources;
(iv) As the depositors do not have voting rights, the control of the company is not diluted.
(i) New companies generally find it difficult to raise funds through public deposits;
(ii) It is an unreliable source of finance as the public may not respond when the company needs money;
(iii) Collection of public deposits may prove difficult, particularly when the size of deposits required is large.
(3) Trade Credits :-
Trade credit is the credit extended by one trader to another for the purchase of goods and services.
Trade credit facilitates the purchase of supplies without immediate payment.
Such credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’.
Trade credit is commonly used by business organisations as a source of short-term financing.
It is granted to those customers who have reasonable amount of financial standing and goodwill.
The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market.
Terms of trade credit may vary from one industry to another and from one person to another.
A firm may also offer different credit terms to different customers.
(i) Trade credit is a convenient and continuous source of funds;
(ii) Trade credit may be readily available in case the credit worthiness of the customers is known to the seller;
(iii) Trade credit needs to promote the sales of an organisation;
(iv) If an organisation wants to increase its inventory level in order to meet expected rise in the sales volume in the near future, it may use trade credit to, finance the same;
(v) It does not create any charge on the assets of the firm while providing funds.
(i) 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;
(ii) Only limited amount of funds can be generated through trade credit;
(iii) It is generally a costly source of funds as compared to most other sources of raising money.
(4) Retained Earnings :-
A company generally does not distribute all its earnings amongst the shareholders as dividends.
A portion of the net earnings may be retained in the business for use in the future.
This is known as retained earnings.
It is a source of internal financing or selffinancing or ‘ploughing back of profits’.
The profit available for ploughing back in an organisation depends on many factors like net profits, dividend policy, and age of the organisation.
(i) Retained earnings is a permanent source of funds available to an organisation;
(ii) It does not involve any explicit cost in the form of interest, dividend or floatation cost;
(iii) As the funds are generated internally, there is a greater degree of operational freedom and flexibility;
(iv) It enhances the capacity of the business to absorb unexpected losses;
(v) It may lead to increase in the market price of the equity shares of a company.
(i) Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividends;
(ii) It is an uncertain source of funds as the profits of business are fluctuating;
(iii) The opportunity cost associated with these funds is not recognised by many firms. This may lead to sub-optimal use of the funds.
(5) Lease Financing :-
A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right to use the asset in return for a periodic payment.
In other words it is a renting of an asset for some specified period.
The owner of the assets is called the ‘lessor’ while the party that uses the assets is known as the ‘lessee’
The lessee pays a fixed periodic amount called lease rental to the lessor for the use of the asset.
The terms and conditions regulating the lease arrangements are given in the lease contract.
At the end of the lease period, the asset goes back to the lessor.
Lease finance provides an important means of modernisation and diversification to the firm.
Such type of financing is more prevalent in the acquisition of such assets as computers and electronic equipment which become obsolete quicker because of the fast changing technological developments.
While making the leasing decision, the cost of leasing an asset must be compared with the cost of owning the same.
(i) It enables the lessee to acquire the asset with a lower investment;
(ii) Simple documentation makes it easier to finance assets;
(iii) Lease rentals paid by the lessee are deductible for computing taxable profits;
(iv) It provides finance without diluting the ownership or control of business;
(v) The lease agreement does not affect the debt raising capacity of an enterprise;
(vi) The risk of obsolescence is borne by the lesser.
This allows greater flexibility to the lessee to replace the asset.
(i) A lease arrangement may impose certain restrictions on the use of assets.
For example, it may not allow the lessee to make any alteration or modification in the asset;
(ii) The normal business operations may be affected in case the lease is not renewed;
(iii) It may result in a higher payout obligation in case the equipment is not found useful and the lessee opts for premature termination of the lease agreement.
(iv) The lessee never becomes the owner of the asset. It deprives him of the residual value of the asset.
3 Terms that you should know at every cost
Yeah, you are right above headline is kinda clickbait or it is, anyway.
BUT you won’t regret it because you are going to confront this all the time.
This post cannot be completed without mentioning this.
So lets look at this and once for all understand this with our mind and heart.
(A) Equity Shares or Equity Capital
(B) Preference Share or Preference Share Capital
Equity shares is the most important source of raising long term capital by a company.
Equity shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owner’s funds.
Equity share capital is a prerequisite to the creation of a company.
Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company.
They are referred to as ‘residual owners’ since they receive what is left after all other claims on the company’s income and assets have been settled.
They enjoy the reward as well as bear the risk of ownership.
Their liability, however, is limited to the extent of capital contributed by them in the company.
Further, through their right to vote, these shareholders have a right to participate in the management of the company.
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, out of the net profits of the company, before any dividend is declared for equity shareholders; and
(ii) receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation.
In other words, as compared to the equity shareholders, the preference shareholders have a preferential claim over dividend and repayment of capital.
Preference shares resemble debentures as they bear fixed rate of return.
Also as the dividend is payable only at the discretion of the directors and only out of profit after tax, to that extent, these resemble equity shares.
Thus, preference shares have some characteristics of both equity shares and debentures. Preference shareholders generally do not enjoy any voting rights.
Debentures are an important instrument for raising long term debt capital.
A company can raise funds through issue of debentures, which bear a fixed rate of interest.
The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date.
Debenture holders are, therefore, termed as creditors of the company.
Debenture holders are paid a fixed stated amount of interest at specified intervals say six months or one year.
Public issue of debentures requires that the issue be rated by a credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.) on aspects like track record of the company, its profitability, debt servicing capacity, credit worthiness and the perceived risk of lending.
A company can issue different types of debentures.
Issue of Zero Interest Debentures (ZID) which do not carry any explicit rate of interest has also become popular in recent years.
The difference between the face value of the debenture and its purchase price is the return to the investor.
Look if someone saying the same thing to me again and again.
I will myself get frustrated.
Don’t take my words to offend you. I had to say to these to be honest with you.
Its been my 4th month now and on my blog FinanceBread, I have written some 12 articles.
Yes, this number is not too big but I post content on social media too.
So its get quite overwhelming.
Please all I am asking to you is to check my blog on other platforms also and provide me with your support if you like my work.
Or in fact, if you don’t. I still urge you to share that also so, I can do my work better.
That’s it readers, i don’t want to bore you with my stuff.
Thanks for spending your valuable time with FinanceBread.
Take Care and Be Healthy.