Sources of Business Finance

SOURCES OF BUSINESS FINANCE

8.1 INTRODUCTION

The chapter provides a comprehensive overview of how funds are procured for starting and running a business. It discusses various sources of finance, their merits and limitations, and the factors determining the choice of appropriate finance source. Understanding these sources is crucial for entrepreneurs as they need to know where to raise capital and what advantages and disadvantages each source offers.

8.2 MEANING, NATURE AND SIGNIFICANCE OF BUSINESS FINANCE

**Business Finance** is the requirement of funds by a business to carry out its various activities for production and distribution of goods and services. Finance is called the **life blood of business** because without adequate funds, no business can function effectively.

Key Points on Business Finance:

**Initial capital** contributed by the entrepreneur is often insufficient to meet all financial requirements

A business must assess its financial needs and identify appropriate sources to meet them

The need for funds arises from the initial stage of business decision-making and continues throughout the business lifecycle

Clear assessment of financial needs is a significant aspect of running any business organization

TYPES OF FINANCIAL REQUIREMENTS

**A. Fixed Capital Requirements**

**Definition:** Funds required to purchase fixed assets like land and building, plant and machinery, and furniture and fixtures needed to start the business.

Fixed capital remains invested in the business for a **long period of time**

Amount varies based on factors like nature of business and enterprise size

**Example:** A trading concern (retail shop) requires less fixed capital than a manufacturing concern (factory)

A large enterprise needs more fixed capital investment than a small enterprise

**B. Working Capital Requirements**

**Definition:** Financial requirements of an enterprise for day-to-day operations, used for holding current assets and meeting current expenses.

Used for **holding stock of material, bills receivables, salaries, wages, taxes, and rent**

Varies depending on the business model

**Example:** A business selling goods on credit requires more working capital than one selling on cash basis

A slow sales turnover business requires higher working capital than quick turnover businesses

Growth and Expansion Needs:

Fixed and working capital requirements **increase with business growth and expansion**

Additional funds needed for technology upgrades, building inventories for festive seasons, meeting current debts, expanding business, or relocating

Evaluation of different fund sources becomes essential during expansion phases

8.3 CLASSIFICATION OF SOURCES OF FUNDS

Sources of business finance are classified using **three different bases:**

8.3.1 PERIOD BASIS

Classification based on the **duration for which funds are required:**

**A. Long-Term Sources**

**Period:** Exceeding 5 years

**Purpose:** Generally required for acquisition of fixed assets like equipment and plant

**Examples:** Shares, debentures, long-term borrowings, loans from financial institutions

**B. Medium-Term Sources**

**Period:** More than 1 year but less than 5 years

**Purpose:** Intermediate capital requirements

**Examples:** Borrowings from commercial banks, public deposits, lease financing, loans from financial institutions

**C. Short-Term Sources**

**Period:** Not exceeding 1 year

**Purpose:** Financing current assets and temporary needs

**Examples:** Trade credit, bank loans, commercial papers

**Use Case:** Financing accounts receivable and inventories; seasonal businesses requiring inventory build-up; wholesalers and manufacturers with major assets tied up in inventories or receivables

8.3.2 OWNERSHIP BASIS

Classification based on **who provides the funds:**

**A. Owner's Funds (Equity Financing)**

**Definition:** Funds provided by the owners of an enterprise (sole trader, partners, or shareholders of a company).

Includes **capital contributed and profits reinvested in business**

Remains invested in business for **longer duration**

**Not required to be refunded** during business life period

Forms the basis for owners' right to **control and management**

**Important sources:** Issue of equity shares, retained earnings

**No fixed obligation** to pay interest or dividends

**B. Borrowed Funds (Debt Financing)**

**Definition:** Funds raised through loans or borrowings from external sources.

**Examples:** Loans from commercial banks, financial institutions, debentures, public deposits, trade credit

**Provided for specified period** with certain terms and conditions

**Must be repaid** after expiry of specified period

**Fixed rate of interest** must be paid by borrowers

**Burden on business:** Interest payment must be made even during low earnings or losses

**Generally provided on security** of fixed assets

**Advantages for lenders:** Fixed returns and priority over owners in case of liquidation

8.3.3 SOURCE OF GENERATION BASIS

Classification based on **whether funds are internal or external:**

**A. Internal Sources of Funds**

**Definition:** Funds generated from within the business organization.

**Methods:** Accelerating collection of receivables, disposing of surplus inventories, ploughing back profits

**Advantages:** No external obligations, full control retained

**Limitations:** Can fulfill **only limited financial needs** of the business

**Less costly** compared to external sources

**B. External Sources of Funds**

**Definition:** Funds obtained from sources outside the organization.

**Examples:** Suppliers (trade credit), lenders (banks, financial institutions), investors (share market)

**Used when:** Large amounts of money need to be raised

**Characteristics:** Generally **more costly** than internal sources

**May require:** Mortgaging of assets as security

**Common examples:** Issue of debentures, borrowing from commercial banks and financial institutions, accepting public deposits

**Advantage:** Can raise large capital amounts

8.4 SOURCES OF FINANCE

Each source of finance has unique characteristics requiring proper understanding. There is **no single best source** for all organizations; choice depends on situation, purpose, cost, and associated risk.

8.4.1 RETAINED EARNINGS (PLOUGHING BACK OF PROFITS)

**Definition:** Portion of net earnings not distributed to shareholders as dividends but retained in the business for future use. It is the source of **internal financing or self-financing**.

**Factors affecting retained earnings:** Net profits, dividend policy, age of the organization

**MERITS OF RETAINED EARNINGS:**

1. **Permanent source of funds** available to organization

2. **No explicit cost** in the form of interest, dividend, or floatation cost

3. **Greater operational freedom and flexibility** as funds are generated internally

4. **Enhances absorption capacity** for unexpected losses

5. **May increase market price** of equity shares of company

**LIMITATIONS OF RETAINED EARNINGS:**

1. **Shareholder dissatisfaction:** Excessive ploughing back causes lower dividends, leading to discontent

2. **Uncertain source:** Business profits fluctuate, making it unpredictable

3. **Opportunity cost ignored:** Many firms don't recognize the opportunity cost, leading to sub-optimal fund utilization

**Real-Life Application:** A software company earning ₹100 crore profits retains ₹60 crore for research and development instead of distributing full amount as dividends, leading to long-term innovation but short-term shareholder unhappiness.

8.4.2 TRADE CREDIT

**Definition:** Credit extended by one trader to another for the purchase of goods and services. Allows purchase of supplies without immediate payment, appearing in buyer's records as **'sundry creditors' or 'accounts payable'**.

**Common usage:** Business-to-business short-term financing

**Factors determining credit terms:**

Reputation of purchasing firm

Financial position of the seller

Volume of purchases

Past record of payment

Degree of competition in market

Different credit terms offered to different customers based on creditworthiness

**MERITS OF TRADE CREDIT:**

1. **Convenient and continuous source** of funds with no formal application process

2. **Readily available** if creditworthiness of customers is known to seller

3. **Promotes sales** by allowing customers to purchase without immediate cash outlay

4. **Useful for inventory buildup** when organization expects rise in sales volume

5. **No asset charge:** Does not create any charge on firm's assets

**LIMITATIONS OF TRADE CREDIT:**

1. **Encourages overtrading:** Easy and flexible credit may induce firm to purchase beyond capacity, adding risk

2. **Limited funds generation:** Only limited amount can be generated through trade credit

3. **Costly source:** Generally expensive compared to other sources of raising money due to hidden costs

**Real-Life Application:** A retail store purchasing ₹50,000 worth of goods from wholesaler on 30-day credit can sell those goods in 15 days and keep the difference as working capital, without requiring immediate cash payment.

8.4.3 FACTORING

**Definition:** Financial service under which a **'factor'** (specialized financial intermediary) provides various services to businesses.

**Services Provided by Factor:**

**A. Discounting of Bills and Collection of Debts**

**Function:** Receivables from sale of goods/services are sold to factor at certain discount

**Factor's responsibility:** All credit control and debt collection from buyer

**Protection:** Protection against bad debt losses to firm

**Two Methods of Factoring:**

1. **Recourse Factoring:** Client is **not protected** against risk of bad debts; client must repay factor if customer defaults

2. **Non-Recourse Factoring:** **Factor assumes entire credit risk**; full invoice amount paid to client even if debt becomes bad

**B. Information Provision**

Factors hold large information about trading histories of firms

Provides credit worthiness information about prospective clients

Helps avoid business with poor payment record customers

Offers consultancy services in finance, marketing, and related areas

**Factor Charges:** Fees charged for services rendered based on volume and nature of receivables

**History in India:** Appeared in early 1990s due to RBI initiatives

**Organizations Providing Factoring:**

SBI Factors and Commercial Services Ltd.

Canbank Factors Ltd.

Foremost Factors Ltd.

State Bank of India, Canara Bank, Punjab National Bank, Allahabad Bank

Non-banking finance companies and other agencies

**MERITS OF FACTORING:**

1. **Cheaper than alternatives:** Less expensive than financing through bank credit or other means

2. **Accelerated cash flow:** Client meets liabilities promptly as they arise

3. **Flexible and secured:** Ensures definite cash inflow pattern from credit sales; provides security for debt firm couldn't otherwise obtain

4. **No asset charge:** Does not create any charge on firm's assets

5. **Operational focus:** Client concentrates on other business areas; factor handles credit control responsibility

**LIMITATIONS OF FACTORING:**

1. **Expensive for small invoices:** Costly when invoices are numerous but smaller in amount

2. **Higher interest rates:** Advance finance provided at higher interest cost than usual rates

3. **Third-party discomfort:** Factor is third party to customer who may feel uncomfortable dealing with it; may affect customer relations

**Real-Life Application:** An exporting company with ₹10 lakh receivables outstanding for 60 days sells these to a factor at ₹9.5 lakh. Factor collects full ₹10 lakh from buyers, earning ₹0.5 lakh profit, while exporter gets immediate cash for operations.

8.4.4 LEASE FINANCING

**Definition:** Contractual agreement whereby the owner of an asset (lessor) grants another party (lessee) the right to use the asset in return for periodic payment. It is essentially **renting of an asset for specified period**.

**Key Participants:**

**Lessor:** Owner of the asset providing it for use

**Lessee:** Party using the asset and paying periodic lease rental

**Lease Rental:** Fixed periodic amount paid by lessee to lessor

**Lease Contract:** Regulates all terms and conditions of lease arrangement

**Asset Return:** At end of lease period, asset returns to lessor; lessee never becomes owner

**Purpose:** Provides means of modernization and diversification; especially prevalent for quick-obsolescence assets like computers and electronic equipment

**Decision Process:** Cost of leasing must be compared with cost of owning the asset

**MERITS OF LEASE FINANCING:**

1. **Lower initial investment:** Enables lessee to acquire asset with lower capital outlay

2. **Simple documentation:** Easier to finance assets with straightforward documentation

3. **Tax benefit:** Lease rentals are deductible for computing taxable profits

4. **No ownership dilution:** Provides finance without diluting ownership or control of business

5. **Debt capacity unaffected:** Lease agreement does not impact debt raising capacity of enterprise

6. **Obsolescence risk transfer:** Risk of asset becoming outdated borne by lessor, providing greater flexibility to replace assets

**LIMITATIONS OF LEASE FINANCING:**

1. **Use restrictions:** Lease may restrict asset use; may prohibit alterations or modifications

2. **Business operations disruption:** Normal operations affected if lease not renewed

3. **Early termination costs:** Higher payout obligations if equipment proves unuseful and lessee terminates lease prematurely

4. **No ownership benefit:** Lessee never becomes owner; cannot sell asset or use as collateral

**Real-Life Application:** IT company leases ₹50 lakh computer equipment for 4 years at monthly rental of ₹1.2 lakh instead of purchasing. After 4 years, returns equipment and leases new, advanced technology, avoiding obsolescence risk while maintaining operational flexibility.

8.5 FACTORS AFFECTING CHOICE OF APPROPRIATE SOURCE OF FINANCE

Various factors determine which source of finance is most appropriate for a business:

**A. Purpose of Funds**

**Fixed asset acquisition:** Long-term sources required (shares, debentures, long-term loans)

**Day-to-day operations:** Short-term sources appropriate (trade credit, bank loans)

**Expansion:** Medium to long-term sources needed

**B. Period or Duration Required**

**Short duration (up to 1 year):** Trade credit, bank loans, commercial papers

**Medium duration (1-5 years):** Bank borrowings, public deposits, lease financing

**Long duration (above 5 years):** Shares, debentures, long-term loans

**C. Cost of Finance**

**Internal sources:** Lower cost (retained earnings)

**Trade credit:** Moderate cost with hidden expenses

**Factoring:** Higher cost but faster cash flow

**Bank loans:** Competitive interest rates

**Share issuance:** Costly in terms of dilution of ownership

**D. Business Size and Structure**

**Sole proprietorship/partnership:** Limited to personal sources and bank loans

**Company:** Access to shares, debentures, public deposits

**Small business:** Restricted access; reliance on personal sources, trade credit

**Large business:** Multiple sources available and accessible

**E. Risk and Uncertainty**

**Borrowed funds:** Fixed obligations create risk during loss periods

**Owner's funds:** No fixed payment obligation; flexible but limited availability

**External financing:** Depends on market conditions and creditworthiness

**F. Amount Required**

**Small amount:** Internal sources, trade credit, personal loans

**Large amount:** External sources like public deposits, shares, institutional loans

**Moderate amount:** Bank loans, lease financing

**G. Ownership and Control Considerations**

**Retain full control:** Use borrowed funds (debt), lease, or retained earnings

**Accept shared control:** Issue equity shares

**Flexible approach:** Use mix of debt and equity

**H. Lender Requirements and Security**

**Availability of security:** Banks prefer secured loans

**No security availability:** Reliance on creditworthiness or internal sources

**Reputation factor:** Established firms get easier credit terms

**I. Business Profitability and Cash Flow**

**Profitable with good cash flow:** Can use retained earnings and meet debt obligations

**Uncertain profitability:** Avoid high debt; prefer equity or internal sources

**Good receivables:** Factoring becomes viable option

**J. Industry Norms and Practices**

Manufacturing industries: Typically use long-term financing

Trading businesses: Rely heavily on trade credit

Service sector: More flexible in financing options

**Real-Life Case Study:** Mr. Anil Singh's Restaurant Expansion (From Chapter Opening)

**Situation:** Running successful restaurant for 2 years; wants to expand chain to multiple locations

**Available options:**

1. **Partnership:** Brings additional capital but requires profit sharing and control sharing

2. **Bank loan:** Available but creates fixed obligation for interest repayment

3. **Equity shares:** Available only if business converts to company form; dilutes ownership

4. **Retained earnings:** Limited by single restaurant's profitability

**Decision factors:** Purpose (expansion), amount needed (large), structure (current proprietorship), risk tolerance, control preference

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KEY DIFFERENCES TABLE: INTERNAL VS EXTERNAL SOURCES

| **Parameter** | **Internal Sources** | **External Sources** |

|---|---|---|

| **Source of Funds** | Generated within organization | Obtained from outside sources |

| **Examples** | Retained earnings, accelerated receivables collection | Bank loans, debentures, shares, trade credit |

| **Cost** | Lower cost, no explicit interest | Higher cost with interest/floatation costs |

| **Control Dilution** | None | May dilute depending on type (equity dilutes) |

| **Availability** | Limited but certain | Large amounts but conditional |

| **Flexibility** | High flexibility | Regulated by terms and conditions |

| **Repayment Obligation** | None in case of retained earnings | Fixed obligation to repay |

| **Time for Acquisition** | Quick process | Time-consuming process |

| **Documentation** | Minimal documentation | Extensive documentation required |

KEY DIFFERENCES TABLE: OWNER'S FUNDS VS BORROWED FUNDS

| **Parameter** | **Owner's Funds** | **Borrowed Funds** |

|---|---|---|

| **Provider** | Owners/shareholders | External lenders/creditors |

| **Repayment** | Not required to be repaid | Must be repaid after specified period |

| **Interest** | No mandatory interest; dividends optional | Fixed interest rate mandatory |

| **Period of Stay** | Remains in business indefinitely | For specified period only |

| **Control Implications** | Provides right to control management | Does not provide control rights |

| **Cost to Business** | Lower explicit cost but opportunity cost exists | Higher explicit cost (interest) |

| **Risk in Loss Period** | No payment obligation during losses | Must pay interest even during losses |

| **Security Requirements** | Generally no security required | Usually requires asset security |

| **Examples** | Equity shares, retained earnings | Debentures, bank loans, trade credit |

EXAM-IMPORTANT POINTS

**1. Business Finance Definition:** Funds required by business to carry out activities for production and distribution of goods and services.

**2. Fixed vs Working Capital:**

**Fixed Capital:** For long-term asset acquisition, remains invested long-term

**Working Capital:** For day-to-day operations, current assets and expenses

**3. Three Classification Bases:**

**Period:** Long-term (>5 yrs), Medium-term (1-5 yrs), Short-term (<1 yr)

**Ownership:** Owner's funds (equity) vs Borrowed funds (debt)

**Source:** Internal sources vs External sources

**4. Retained Earnings:** Company's profits not distributed as dividends; permanent, low-cost but uncertain source.

**5. Trade Credit:** Short-term financing from suppliers; convenient but can encourage overtrading.

**6. Factoring:** Selling receivables to factor at discount; faster cash flow but expensive option.

**7. Lease Financing:** Renting asset instead of buying; avoids obsolescence risk, no ownership.

**8. Choice Factors:** Purpose, duration, cost, business size, risk, amount, control needs, security, profitability, industry norms.

**9. Life Blood of Business:** Finance is called the life blood because business cannot function without adequate funds.

**10. No Single Best Source:** Choice depends on specific circumstances, making situational analysis crucial for financial decisions.