Sources of Business Finance

Business Finance — Meaning:

Business finance refers to the money required by a business to establish, operate, and expand its activities. It encompasses all the funds needed to carry out various business operations smoothly.

Why do businesses need funds?

Businesses need funds for the following purposes:

(i) Fixed Capital Requirements:
Funds are needed to purchase fixed/long-term assets such as land, building, plant and machinery, furniture, etc. These assets form the foundation of business operations.

(ii) Working Capital Requirements:
Funds are required for day-to-day operations of the business, such as purchasing raw materials, paying wages and salaries, meeting utility bills, and other routine expenses.

(iii) Growth and Expansion:
Businesses need funds to undertake expansion plans, modernise existing facilities, diversify into new product lines, or enter new markets.

(iv) Meeting Contingencies:
Unforeseen circumstances such as natural disasters, economic downturns, or sudden market changes require businesses to maintain reserve funds.

(v) Research and Development:
Funds are needed for innovation, development of new products, and improvement of existing processes.

Conclusion: Without adequate finance, no business can function efficiently. Finance is thus rightly called the 'lifeblood' of business.

Sources of Long-Term Finance:

Long-term sources provide funds for a period exceeding 5 years. These include:

1. Issue of Equity Shares
2. Issue of Preference Shares
3. Issue of Debentures/Bonds
4. Retained Earnings (Ploughing back of profits)
5. Loans from Financial Institutions (e.g., IDBI, SIDBI, NABARD)
6. Lease Financing (long-term leases)
7. International Sources — GDRs, ADRs, FCCBs

Sources of Short-Term Finance:

Short-term sources provide funds for a period not exceeding one year. These include:

1. Trade Credit
2. Commercial Paper (CP)
3. Factoring
4. Public Deposits (short-term)
5. Loans from Commercial Banks (cash credit, overdraft, short-term loans)
6. Bill Discounting / Accounts Receivable Financing
7. Inter-Corporate Deposits (ICD)

Note: Medium-term sources (1–5 years) include public deposits, loans from commercial banks, and lease financing.

Internal Sources of Funds:

Internal sources are those sources of finance that are generated from within the business itself, without approaching any outside party.

Examples: Retained earnings (ploughing back of profits), depreciation funds, sale of surplus assets.

Features of Internal Sources:
- No obligation to repay
- No interest or dividend payment required
- Strengthens the financial position of the firm
- Limited in amount — depends on profitability
- Not available to new or loss-making firms

External Sources of Funds:

External sources are those sources of finance that are raised from outside the business — from individuals, institutions, or the market.

Examples: Issue of shares and debentures, loans from banks and financial institutions, trade credit, public deposits, commercial paper, factoring, international sources.

Features of External Sources:
- Involves obligation to repay (in case of borrowings)
- Interest or dividend may be payable
- Can raise large amounts of funds
- May involve restrictive conditions
- Available to both new and existing firms

Key Differences:

| Basis | Internal Sources | External Sources |
|---|---|---|
| Origin | Within the business | Outside the business |
| Cost | Generally no explicit cost | Involves interest/dividend |
| Availability | Limited to profits earned | Can be large amounts |
| Obligation | No repayment obligation | Repayment usually required |
| Example | Retained earnings | Bank loans, share issue |

Preference Shareholders — Preferential Rights:

Preference shares are those shares that carry certain preferential rights over equity shares. These rights are as follows:

(i) Preferential Right to Dividend:
Preference shareholders have the right to receive dividends before any dividend is paid to equity shareholders. The dividend rate is fixed and specified at the time of issue.

(ii) Preferential Right to Repayment of Capital:
At the time of winding up or liquidation of the company, preference shareholders are entitled to get their capital repaid before equity shareholders receive anything.

(iii) Cumulative Dividend Right (in Cumulative Preference Shares):
If dividends are not paid in any year due to insufficient profits, the unpaid dividends accumulate and are carried forward. These arrears must be paid before any dividend is declared for equity shareholders.

(iv) Participation in Surplus Profits (in Participating Preference Shares):
Some preference shareholders have the right to participate in the surplus profits of the company after a fixed dividend has been paid to equity shareholders.

(v) Convertibility Right (in Convertible Preference Shares):
Holders of convertible preference shares have the right to get their preference shares converted into equity shares after a specified period.

Conclusion: These preferential rights make preference shares attractive to investors who seek steady income with relatively lower risk compared to equity shares.

Three Special Financial Institutions and Their Objectives:

(i) Industrial Development Bank of India (IDBI):
- Established in 1964 as the apex development bank.
- Objectives:
- To provide long-term finance to large industrial enterprises.
- To coordinate the activities of other financial institutions.
- To promote and develop industries in India.
- To provide technical and administrative assistance to industrial enterprises.

(ii) Small Industries Development Bank of India (SIDBI):
- Established in 1990 as a subsidiary of IDBI.
- Objectives:
- To provide financial assistance to small-scale industries.
- To promote, finance, and develop small-scale industries.
- To coordinate the functions of institutions engaged in financing small industries.
- To provide refinance to banks and financial institutions lending to small enterprises.

(iii) National Bank for Agriculture and Rural Development (NABARD):
- Established in 1982.
- Objectives:
- To provide credit for the promotion of agriculture, cottage industries, and rural crafts.
- To provide refinance to cooperative banks and regional rural banks.
- To coordinate rural financing activities.
- To promote integrated rural development and secure prosperity of rural areas.

Note: Other examples include IFCI (Industrial Finance Corporation of India) and State Financial Corporations (SFCs).

GDR (Global Depository Receipt):

A GDR is a financial instrument issued by a company in more than one foreign country to raise funds from international markets. It is a negotiable instrument denominated in some freely convertible currency (usually US dollars or Euros).

- Issued in multiple countries simultaneously.
- Listed on international stock exchanges such as London Stock Exchange or Luxembourg Stock Exchange.
- Allows companies to raise funds from investors across the globe.
- Each GDR represents a fixed number of shares of the issuing company.

ADR (American Depository Receipt):

An ADR is a financial instrument issued by a company specifically in the United States of America to raise funds from American investors. It is denominated in US dollars.

- Issued only in the USA.
- Listed on American stock exchanges such as NYSE (New York Stock Exchange) or NASDAQ.
- Allows foreign companies to raise funds from American investors.
- Each ADR represents a fixed number of shares of the issuing company.

Key Differences:

| Basis | GDR | ADR |
|---|---|---|
| Market | Global (multiple countries) | Only USA |
| Stock Exchange | London, Luxembourg, etc. | NYSE, NASDAQ |
| Currency | US Dollar, Euro, etc. | US Dollar only |
| Investors | International investors | American investors |
| Scope | Broader geographical reach | Limited to USA |

Conclusion: Both GDR and ADR are instruments used by Indian companies to raise funds from foreign markets, but GDR has a wider geographical reach while ADR is specifically targeted at the US market.

A. Trade Credit as a Source of Short-Term Finance:

Meaning:
Trade credit refers to the credit extended by one trader (seller) to another trader (buyer) for the purchase of goods and services. It allows the buyer to purchase goods on credit and pay for them at a later date.

Features:
- It is a spontaneous source of finance — arises automatically with business transactions.
- Terms are specified on the invoice (e.g., 2/10, net 30 — meaning 2% discount if paid within 10 days, otherwise full payment in 30 days).
- No formal security is required.
- Small and new firms are more dependent on trade credit.

Merits of Trade Credit:
1. Easy Availability: It is easily available to firms with good business relationships.
2. No Security Required: No collateral or security needs to be pledged.
3. Flexibility: The amount of credit increases as business expands.
4. Promotes Sales: Sellers offer trade credit to boost their sales.
5. No Explicit Cost: If payment is made within the credit period, there is no interest cost.

Demerits of Trade Credit:
1. Limited Amount: The amount of credit is limited to the creditworthiness of the buyer.
2. Short Duration: Available only for a short period.
3. Risk of Overtrading: Easy availability may lead to excessive purchasing beyond needs.

---

B. Bank Credit as a Source of Short-Term Finance:

Meaning:
Commercial banks provide short-term and medium-term loans to business enterprises. Banks offer various forms of credit to meet the working capital needs of businesses.

Forms of Bank Credit:

(i) Loans:
A lump sum amount is sanctioned and credited to the borrower's account. Interest is charged on the entire amount. Repayment is made either in instalments or as a lump sum.

(ii) Cash Credit:
The bank allows the borrower to withdraw funds up to a specified limit (called cash credit limit) against security of stock or other assets. Interest is charged only on the amount actually withdrawn.

(iii) Overdraft:
The bank allows the current account holder to withdraw more than the balance in the account up to a specified limit. Interest is charged on the overdrawn amount.

(iv) Discounting of Bills:
The bank purchases trade bills before their maturity date and pays the amount after deducting a discount. On maturity, the bank collects the full amount from the drawee.

Merits of Bank Credit:
1. Timely Assistance: Banks provide funds quickly when needed.
2. Flexible: The amount can be adjusted according to business needs.
3. Confidentiality: Business secrets are maintained as banks keep information confidential.
4. Various Forms: Banks offer credit in multiple forms to suit different needs.

Demerits of Bank Credit:
1. Security Required: Banks generally require collateral security.
2. Restrictive Conditions: Banks may impose conditions on the use of funds.
3. Short-Term Nature: Bank loans are primarily short to medium-term.
4. Cumbersome Process: Documentation and formalities can be time-consuming.

Conclusion: Both trade credit and bank credit are important short-term sources of finance. Trade credit is more informal and spontaneous, while bank credit is more formal and flexible in terms of amount.

Sources of Finance for Modernisation and Expansion of a Large Industrial Enterprise:

A large industrial enterprise requires substantial funds for modernisation and expansion. The following sources are suitable:

1. Retained Earnings (Internal Accruals):
- Profits retained in the business after paying dividends.
- No cost of raising funds; no dilution of ownership.
- Suitable for gradual expansion without external obligations.

2. Issue of Equity Shares:
- New equity shares are issued to the public through a fresh public issue or rights issue.
- Funds raised are permanent — no repayment obligation.
- Shareholders become part-owners and share in profits.
- Suitable for large-scale expansion as large amounts can be raised.

3. Issue of Preference Shares:
- Preference shares carry a fixed dividend and preferential rights.
- No voting rights, so management control is not diluted.
- Suitable for investors seeking steady income.

4. Issue of Debentures/Bonds:
- Debentures represent borrowed capital with a fixed rate of interest.
- Interest is tax-deductible, reducing the cost of capital.
- Suitable when the company has stable earnings and can service debt.
- Does not dilute ownership.

5. Loans from Financial Institutions:
- Development banks like IDBI, IFCI, SIDBI, and SFCs provide long-term loans.
- They also provide technical and managerial assistance.
- Suitable for large-scale modernisation and expansion projects.
- Repayment is in instalments over a long period.

6. Loans from Commercial Banks:
- Banks provide term loans for medium to long-term needs.
- Repayment schedule is flexible.
- Suitable for financing specific assets like machinery.

7. Lease Financing:
- Instead of purchasing assets, the company can lease them.
- Preserves capital for other uses.
- Lease rent is tax-deductible.
- Suitable for acquiring expensive machinery and equipment.

8. International Sources:

(a) GDRs (Global Depository Receipts):
- Issued in international markets to raise foreign currency funds.
- Listed on international stock exchanges.

(b) ADRs (American Depository Receipts):
- Issued specifically in the US market.
- Helps raise funds from American investors.

(c) FCCBs (Foreign Currency Convertible Bonds):
- Bonds issued in foreign currency that can be converted into equity shares.
- Carry lower interest rates than regular bonds.

(d) ECBs (External Commercial Borrowings):
- Loans raised from foreign banks and financial institutions.
- Available at lower interest rates compared to domestic borrowings.

Conclusion: A large industrial enterprise has access to a wide variety of sources for financing modernisation and expansion. The choice of source depends on the cost of funds, the company's financial position, market conditions, and the nature of the expansion project.

Advantages of Issue of Debentures over Issue of Equity Shares:

1. No Dilution of Ownership and Control:
- Debenture holders are creditors, not owners. They do not have voting rights.
- Issuing debentures does not dilute the ownership or management control of existing shareholders.
- In contrast, issuing equity shares brings in new owners who have voting rights.

2. Fixed Interest Obligation — Beneficial in Prosperity:
- Debentures carry a fixed rate of interest.
- When the company earns higher profits, the surplus after paying fixed interest goes to equity shareholders, increasing their returns (financial leverage).
- Equity shareholders benefit more when debentures are used for financing.

3. Tax Benefit:
- Interest paid on debentures is a tax-deductible expense, reducing the company's tax liability.
- Dividends paid on equity shares are paid out of after-tax profits — no tax benefit.

4. Suitable for Stable Earnings Companies:
- Companies with stable and predictable earnings can comfortably service fixed interest payments.
- Debentures are a cost-effective source for such companies.

5. No Profit Sharing:
- Debenture holders receive only the fixed interest regardless of how high the profits are.
- Equity shareholders are entitled to share in all profits, which can be costly for the company.

6. Investor Confidence:
- Debentures are secured against the assets of the company (in case of secured debentures), making them attractive to risk-averse investors.
- This broadens the investor base of the company.

7. Redemption Flexibility:
- Companies can redeem debentures when they have surplus funds.
- Equity shares are permanent capital and cannot be easily returned (except through buyback).

8. Lower Cost of Capital:
- Due to the tax deductibility of interest, the effective cost of debenture capital is lower than equity capital.

Limitations of Debentures (for balance):
- Fixed interest must be paid even during losses.
- Creates a charge on assets.
- Not suitable for companies with fluctuating earnings.

Conclusion: Debentures are a cost-effective, non-dilutive source of long-term finance that provides tax benefits and financial leverage. They are preferred over equity shares when the company has stable earnings and does not want to dilute ownership.

A. Public Deposits:

Meaning:
Public deposits are deposits accepted by companies directly from the public (members of the public, shareholders, and employees) for a fixed period at a specified rate of interest. They are governed by the Companies Act and RBI guidelines.

Merits of Public Deposits:

1. Simple Procedure: The procedure for raising public deposits is simple and does not involve complex legal formalities compared to issue of shares or debentures.

2. Lower Cost: The rate of interest on public deposits is generally lower than the rate charged by banks, making it a relatively cheaper source of finance.

3. No Charge on Assets: Public deposits do not require the company to mortgage or pledge its assets as security.

4. No Dilution of Control: Since depositors are not shareholders, accepting public deposits does not dilute the ownership or control of existing shareholders.

5. Flexible: Companies can raise funds as and when needed by inviting deposits from the public.

6. Higher Returns for Depositors: The rate of interest offered is usually higher than bank deposits, making it attractive to investors.

Demerits of Public Deposits:

1. Uncertain and Unreliable: Public deposits may not be available when needed, especially during economic downturns when people prefer to keep savings in banks.

2. Limited Amount: The amount that can be raised through public deposits is limited by law (a specified percentage of paid-up capital and reserves).

3. Short-Term Nature: Public deposits are generally for a short to medium period (6 months to 3 years), making them unsuitable for long-term financing.

4. Repayment Pressure: If a large number of depositors withdraw simultaneously, it can create a financial crisis for the company.

5. Not Available to New Companies: New companies without an established reputation find it difficult to attract public deposits.

---

B. Retained Earnings:

Meaning:
Retained earnings refer to that portion of the net profits of a company that is not distributed as dividends but is retained and reinvested in the business. It is also called 'ploughing back of profits' or 'self-financing.'

Merits of Retained Earnings:

1. No Explicit Cost: There is no interest or dividend to be paid on retained earnings, making it a cost-free source of finance.

2. No Repayment Obligation: Unlike loans or debentures, retained earnings do not need to be repaid.

3. No Dilution of Control: Since no new shares are issued, the ownership and control of existing shareholders remain undiluted.

4. Increases Creditworthiness: A company with large retained earnings has a stronger financial base, which improves its credit rating and borrowing capacity.

5. Flexibility: The company has complete freedom in using retained earnings without any restrictions from external parties.

6. Tax Advantage: Retained earnings avoid the double taxation that occurs when profits are distributed as dividends (taxed at company level and again at shareholder level in some cases).

Demerits of Retained Earnings:

1. Limited Availability: Retained earnings depend entirely on the profitability of the company. Loss-making or low-profit companies cannot rely on this source.

2. Opportunity Cost: Retaining profits means shareholders are denied dividends. This may lead to dissatisfaction among shareholders.

3. Misuse of Funds: Excessive retention of profits may lead to misuse or inefficient deployment of funds by management.

4. Not Suitable for New Companies: New companies have no past profits to retain, so this source is unavailable to them.

5. Leads to Overcapitalisation: Excessive ploughing back of profits may result in overcapitalisation if the funds are not deployed productively.

Conclusion: Both public deposits and retained earnings are important sources of business finance. Retained earnings are more reliable and cost-free but limited in amount, while public deposits can raise larger amounts but are uncertain and carry repayment obligations.

Note: This is a project-based assignment. The following is a model answer framework.

Companies that have issued Debentures in Recent Years (Examples):

| Company | Type of Debenture | Purpose |
|---|---|---|
| Reliance Industries Ltd. | Non-Convertible Debentures (NCDs) | Expansion and capital expenditure |
| Tata Motors Ltd. | NCDs | Working capital and debt refinancing |
| HDFC Ltd. | NCDs | Housing finance operations |
| Mahindra & Mahindra | NCDs | Business expansion |
| Power Finance Corporation | Bonds/Debentures | Infrastructure financing |

Suggestions to Make Debentures More Popular:

1. Higher Interest Rates: Companies should offer competitive interest rates to attract investors, especially retail investors.

2. Tax Benefits to Investors: The government should provide tax exemptions on interest income from debentures (similar to infrastructure bonds) to make them more attractive.

3. Simplified Procedures: The process of issuing and investing in debentures should be simplified through online platforms and digital processes.

4. Better Credit Rating System: A transparent and reliable credit rating system will help investors assess the risk of debentures and invest with confidence.

5. Liquidity Enhancement: Debentures should be listed on stock exchanges to provide liquidity, allowing investors to sell them before maturity.

6. Investor Awareness: Companies and SEBI should conduct investor education programmes to make people aware of debentures as an investment option.

7. Flexible Tenure Options: Companies should offer debentures with varying maturity periods to cater to different investor preferences.

8. Secured Debentures: Issuing secured debentures (backed by company assets) will increase investor confidence.

Conclusion: Debentures are a cost-effective source of long-term finance for companies. With the right incentives and awareness, they can become a more popular investment instrument in India.

Note: This is a scrapbook/project assignment. The following is a model answer framework with information about key financial institutions.

Major Financial Institutions Providing Finance to Indian Companies:

1. Industrial Development Bank of India (IDBI Bank):
- Established: 1964 (as apex development bank); converted to a commercial bank in 2004.
- Provides long-term loans to large industrial enterprises.
- Offers project finance, equipment finance, and working capital loans.

2. Small Industries Development Bank of India (SIDBI):
- Established: 1990
- Provides financial assistance to small and medium enterprises (SMEs).
- Offers direct lending, refinance, and development support.

3. National Bank for Agriculture and Rural Development (NABARD):
- Established: 1982
- Provides credit for agriculture, rural industries, and rural development.
- Refinances cooperative banks and regional rural banks.

4. Industrial Finance Corporation of India (IFCI):
- Established: 1948 (first development finance institution in India).
- Provides long-term finance to industrial enterprises.
- Focuses on infrastructure, healthcare, tourism, and education sectors.

5. Export-Import Bank of India (EXIM Bank):
- Established: 1982
- Provides finance for export and import of goods and services.
- Supports Indian companies in international trade and investment.

6. State Financial Corporations (SFCs):
- Established at the state level to provide finance to small and medium industries.
- Examples: Delhi Financial Corporation, Maharashtra State Financial Corporation.

7. National Housing Bank (NHB):
- Established: 1988
- Provides refinance to housing finance companies and banks.
- Promotes housing finance in India.

Conclusion: These institutions play a vital role in channelling funds to various sectors of the Indian economy, promoting industrial growth, agricultural development, and export promotion.

Note: This question refers to a case study of a restaurant owner mentioned in the chapter. The following is a model answer based on the context of a small business owner needing funds.

Assumed Situation: A restaurant owner needs funds for:
- Day-to-day operations (working capital)
- Expansion or renovation of the restaurant
- Purchase of new equipment

Suggested Sources of Finance:

For Short-Term/Working Capital Needs:

1. Trade Credit:
- The restaurant owner can purchase raw materials (vegetables, groceries, beverages) on credit from suppliers.
- This reduces the immediate cash requirement for day-to-day operations.

2. Bank Overdraft/Cash Credit:
- The owner can approach a commercial bank for an overdraft facility or cash credit limit.
- This provides flexibility to meet short-term cash needs.

3. Loans from Commercial Banks:
- Short-term loans can be taken from banks for meeting working capital requirements.

For Medium/Long-Term Needs (Expansion and Equipment):

4. Term Loans from Commercial Banks:
- Banks provide term loans for purchasing equipment and renovation.
- Repayment can be made in monthly instalments.

5. Loans from Small Industries Development Bank of India (SIDBI):
- If the restaurant qualifies as a small enterprise, SIDBI can provide financial assistance at concessional rates.

6. Lease Financing:
- Instead of purchasing expensive equipment (refrigerators, ovens, etc.), the owner can lease them.
- This reduces the initial capital outlay.

7. Retained Earnings:
- The owner should reinvest a portion of profits back into the business for gradual expansion.

8. Microfinance Institutions:
- If the restaurant is a small establishment, microfinance institutions can provide small loans.

Conclusion: The restaurant owner should use a combination of trade credit and bank loans for short-term needs, and lease financing or term loans for long-term expansion. Retaining profits for reinvestment is also advisable for sustainable growth.

Comparative Chart of Sources of Finance:

| Source of Finance | Type | Duration | Cost | Security Required | Control Dilution | Suitable For |
|---|---|---|---|---|---|---|
| Retained Earnings | Internal, Owned | Long-term | Nil (no explicit cost) | No | No | Expansion, modernisation |
| Equity Shares | External, Owned | Permanent | Dividend (variable) | No | Yes (voting rights) | Long-term capital needs |
| Preference Shares | External, Owned | Long-term | Fixed dividend | No | No (generally) | Investors seeking steady income |
| Debentures | External, Borrowed | Long-term | Fixed interest (tax deductible) | Yes (usually) | No | Stable earnings companies |
| Commercial Banks | External, Borrowed | Short to Medium | Interest | Yes | No | Working capital, equipment |
| Financial Institutions | External, Borrowed | Long-term | Interest (concessional) | Yes | No | Large expansion projects |
| Trade Credit | External, Borrowed | Short-term | Nil (if paid on time) | No | No | Day-to-day purchases |
| Public Deposits | External, Borrowed | Short to Medium | Fixed interest | No | No | Working capital, expansion |
| Commercial Paper | External, Borrowed | Short-term (90–364 days) | Discount rate | No | No | Large creditworthy companies |
| Factoring | External, Borrowed | Short-term | Commission/fee | Receivables | No | Managing debtors |
| Lease Financing | External, Borrowed | Medium to Long | Lease rent | Asset itself | No | Acquiring fixed assets |
| GDRs | External, Owned | Long-term | Dividend | No | Partial | Large companies, global markets |
| ADRs | External, Owned | Long-term | Dividend | No | Partial | Companies targeting US investors |
| FCCBs | External, Borrowed | Long-term | Low interest | No | Potential (on conversion) | Companies needing foreign currency |

Classification Summary:

$$\text{Sources of Finance} \begin{cases} \text{By Period} \begin{cases} \text{Long-term: Shares, Debentures, FIs, Retained Earnings} \\ \text{Medium-term: Public Deposits, Bank Loans, Lease} \\ \text{Short-term: Trade Credit, CP, Factoring, Overdraft} \end{cases} \\ \text{By Ownership} \begin{cases} \text{Owned: Equity, Preference Shares, Retained Earnings} \\ \text{Borrowed: Debentures, Bank Loans, Public Deposits} \end{cases} \\ \text{By Source} \begin{cases} \text{Internal: Retained Earnings, Depreciation} \\ \text{External: All other sources} \end{cases} \end{cases}$$

Conclusion: Different sources of finance have different characteristics in terms of cost, duration, risk, and suitability. A business should choose an appropriate mix of sources (known as the capital structure) based on its specific needs, financial position, and long-term objectives.