Sources of Business Finance

Main Idea

Business finance is the money required to start, operate, expand and modernise a business. Financial needs vary according to the nature, size, stage and objectives of the business, and may be met through owners, borrowed sources or financial institutions. Each source differs in cost, risk, control implications, repayment conditions and suitability.

Key Concepts and Definitions

• Business Finance: The money needed by a business to acquire assets, meet daily expenses, expand operations and achieve business objectives.
• Fixed Capital: Funds invested in long-term assets such as land, buildings, machinery, furniture and vehicles.
• Working Capital: Funds required for routine operations such as purchasing materials, paying wages, meeting expenses and maintaining inventory.
• Owner's Funds: Funds contributed by the owners or generated and retained by the business, such as equity shares, preference shares and retained earnings.
• Equity Shares: Shares representing ownership in a company. Equity shareholders usually have voting rights and receive dividends that are not fixed.
• Preference Shares: Shares that provide preferential rights regarding payment of dividend and repayment of capital. Their dividend is generally fixed.
• Retained Earnings: The portion of business profits kept in the business instead of being distributed to owners as dividends.
• Borrowed Funds: Money obtained from outside parties that must usually be repaid, often with interest.
• Debentures: Written instruments acknowledging a company's long-term debt. Debenture holders generally receive fixed interest and are creditors, not owners.
• Loans from Commercial Banks: Funds provided by banks for short-term or long-term needs against agreed terms, interest and repayment schedules.
• Public Deposits: Deposits invited directly by a company from the public for a specified period at an agreed rate of interest, subject to legal conditions.
• Trade Credit: Credit allowed by suppliers when goods or services are purchased now and payment is made later.
• Commercial Paper: An unsecured short-term promissory note issued by financially sound companies to raise funds for short-term needs.
• Financial Institutions: Specialised institutions that provide medium- and long-term finance, underwriting, guarantees and other financial assistance to businesses.
• International Sources: Funds raised from outside India through sources such as foreign commercial banks, international agencies, foreign investment and depository receipts, subject to applicable regulations.
• Cost of Capital: The cost paid by a business for using funds, such as interest on loans or expected returns of owners.
• Financial Risk: The risk of difficulty in meeting fixed financial obligations such as interest and repayment of borrowed funds.

Supporting Arguments and Evidence

• The two broad financial needs of a business are fixed capital and working capital. Fixed capital finances long-term assets, whereas working capital supports the regular operating cycle, including the purchase of materials, payment of wages, routine expenses and maintenance of inventory.

• Owner's funds generally comprise equity shares, preference shares and retained earnings. Equity capital does not normally create a compulsory fixed interest payment, but issuing equity shares may dilute the control of existing owners.

• Preference shareholders normally receive a fixed dividend before equity shareholders and have priority in repayment of capital over equity shareholders. Their preferential rights therefore distinguish them from ordinary equity shareholders.

• Retained earnings are an internal source of finance. They do not involve issue expenses or repayment obligations, although excessive retention may reduce current dividend payments to owners.

• Borrowed funds generally include debentures, loans from commercial banks, public deposits, trade credit and commercial paper. These sources normally involve interest and repayment obligations but do not usually dilute ownership control.

• Trade credit is particularly useful for purchasing goods and materials and is generally a short-term source. Commercial paper is an unsecured short-term financing instrument generally used by large, creditworthy companies.

• Loans from commercial banks may finance short-term or long-term needs and are provided against agreed terms, interest rates and repayment schedules. Public deposits are invited directly from the public for a specified period at an agreed interest rate and subject to legal conditions.

• Institutional finance may be provided by specialised financial institutions through loans, underwriting, guarantees and assistance for expansion or modernisation. International sources may include foreign commercial banks, international agencies, foreign investment and depository receipts, subject to applicable regulations.

• No single source of finance is appropriate for every business. The choice depends on the purpose, period, amount, cost, risk, financial strength, flexibility, control implications and legal requirements associated with the funds.

• A basic finance-cost relationship is:

Interest = Principal × Rate × Time

• A business should match the duration of finance with the duration of the need. Long-term requirements should generally be financed through long-term sources, while short-term requirements should generally be financed through short-term sources.

• Owner's funds provide financial stability and reduce repayment pressure, but they may be limited and may involve loss or dilution of control. Borrowed funds can increase the resources available for growth without transferring ownership to lenders, but fixed interest and repayment obligations create financial risk.

• Internal sources such as retained earnings are generally economical and convenient, whereas external sources may provide larger amounts but involve conditions and additional cost. Financial decisions should therefore consider the safety, profitability, control and flexibility of the business.

• A suitable balance between owner's funds and borrowed funds enables a business to grow without taking excessive financial risk. The final choice should reflect the business's needs, cost, risk and repayment capacity.

What to Remember

Business finance is required for both long-term investment in fixed assets and the day-to-day operating cycle. The main sources are owner's funds, borrowed funds, financial institutions and international sources, each with distinct costs, risks, control effects and repayment conditions. For examinations, remember the specific features of equity shares, preference shares, retained earnings, debentures, bank loans, public deposits, trade credit and commercial paper, as well as the rule that the duration of finance should match the duration of the financial need.