Concept of Business Finance

The term finance means money or fund. The requirements of funds by business to carry out its various activities is called business finance. Finance is needed at every stage in the life of a business. A business cannot function unless adequate funds are made available to it.

Significance of Business Finance

• To purchase plant and machinery, land, buildings, and other fixed assets.

• Smooth functioning of day-to-day operations of the business.

• Expansion.

Need of Business Finance

(a) Fixed Capital Requirement

In order to start a business, funds are needed to purchase fixed assets like land and building, plant and machinery. The funds required for fixed assets remain invested in the business for a long period of time.

(b) Working Capital Requirement

A business needs funds for its day-to-day operation, known as working capital requirements. Working capital is required for purchase of raw materials, paying salaries, wages, rent, and taxes.

(c) Diversification

A company needs more funds to diversify its operation to become a multi-product company (e.g., ITC).

(d) Technology Upgradation

Finance is needed to adopt modern technology, such as the use of computers in business.

(e) Growth and Expansion

Higher growth of a business enterprise requires higher investment in fixed assets. Thus, finance is needed for growth and expansion.

Sources of Finance on the basis of Ownership
A. Owners' Funds

Funds provided by the owners of the organization are known as Owners' Funds. It includes profits that are reinvested into the business.Important sources of Owners' Funds:

1. Equity shares

2. Preference shares

3. Retained earnings

4. Global Depository Receipts (GDR)

5. American Depository Receipts (ADR)

6. Indian Depository Receipts (IDR)

B. Borrowed Funds

These are the funds raised through loans and borrowings. This source includes:

1. Debentures

2. Loans from financial institutions

3. Loans from commercial banks

4. Public deposits

5. Trade credit

6. Inter-Corporate Deposits (ICD)

Issue of Share (Owner’s Fund - Long-term Source of Finance)

The capital obtained by issue of shares is known as share capital. The capital of a company is divided into small units called shares. For example, if a company issues 10,000 shares at ₹ 10 each, then the share capital of the company is ₹ 1,00,000. The person holding the share is known as the shareholder.

1. Equity Share

Equity shares represent the ownership of a company. They have the right to vote and participate in management. An amendment in the Companies Act in 2000 permitted companies to issue two categories of equity shares:

• (i) Equity shares with equal rights.

• (ii) Equity shares with differential rights as to dividend.

Merits:

• Permanent capital

• No charge on assets

• Higher returns

• Control (can vote)

• No burden on company

Limitations:

• Risk

• Higher cost

• Delays

• Market condition dependency

2. Preference Share (Owner’s Fund - Long-term Source of Finance)

Preference shares are considered safer in investment (compared to equity shares). They receive dividends at a fixed rate and are like creditors. They have no voting rights.

Merits:

• Investment is safe

• No charge on assets

• Control not affected (bc they cant vote)

• Fixed dividend

• Hybrid security

Limitations:

• Costly source of funds

• No tax saving

• Not suitable for risk-takers

• Dividend dependency on profit

Difference Between Equity Shares and Preference Shares

3. Retained Earnings (Owner’s Fund - Long-term Source of Finance)

When a company earns profit, a certain amount or percentage of those profits is retained within the business for future use, known as retained earnings. Financing through this source is called ploughing back of profits or internal financing.

Merits:

• Permanent source of funds

• No explicit cost

• Greater operational flexibility

• Enhances loss absorption capacity

• May increase market price of equity shares

Limitations:

• Excess retention may lead to shareholder dissatisfaction

• Profits fluctuate, making it uncertain

• Opportunity cost remains unrecognized

Borrowed Funds

1. Debentures/Bonds (Borrowed Fund - Long-term Source of Finance)

This is an important source of raising long-term debt capital with a fixed interest rate, where debenture holders are creditors of the company.

Merits:

• Investment is safe

• No control for debenture holders

• Less costly than preference shares

• Tax saving through deductibility of interest

Limitations:

• Fixed obligation makes it riskier during losses

• Company mortgages assets for secured debentures

• New issues reduce company credibility for further borrowing

Difference Between Shares and Debentures

2. Loan from Financial Institutions (Borrowed Fund - Long-term Source of Finance)

Development banks established by the state and central government provide finance to companies. Examples include IFCI, ICICI, IDBI, LIC, and UTI.

Merits:

• Provides long-term finance

• Offers managerial advice

• Loans can be made in easy installments

• Availability even during depression

Limitations:

• Time-consuming loan approval process

• Restrictions imposed on the board of Directors

3. Loan from Commercial Banks (Borrowed Fund - Short & Medium-term Finance)

Commercial banks grant loans and advances as cash credit, overdraft loans, and bill discounting, typically at a fixed interest rate.

Merits:

• Timely financial assistance

• Secrecy maintained about loans

• Easier source of funds without prospectus

Limitations:
Short or medium-term finance

• Requires asset security before loan approval

4. Public Deposits (Borrowed Fund - Medium-term Finance)

Deposits raised directly from the public, regulated by the RBI, with a maximum of 25% of share capital and reserves.

Merits:

• No charge on assets

• Tax-saving through interest deductible

• Simple procedure for obtaining deposits

• Control not diluted as no voting rights

Limitations:

• Short maturity period

• Limited funds due to legal restrictions

• New companies face difficulties raising public deposits

5. Trade Credit (Borrowed Fund - Short-term Finance)

Extension of credit by one trader to another for goods or services without on-the-spot payment, typically used for short-term financing.

Merits:

• Continuous and convenient source of funds

• Readily available based on credit worthiness

• Helps increase inventory levels during sales increase

• No charge on firm’s assets

Limitations:

• Possibility of over-trading

• Limited financial needs met

• Costlier compared to other sources

6. Inter-Corporate Deposits (ICD) (Borrowed Fund - Short-term Finance)

Unsecured short-term deposits made by one company to another, usually brokered. Higher rate of interest than bankers. Free from legal hassles

Types of ICDs:
(i) Three Months Deposits

• (ii) Six Months Deposits

• (iii) Call Deposits

Features of ICDs:

• Transactions between two companies

• Short-term deposits

• Unsecured deposits

• Brokered transactions

• No organized market

• No legal formalities

• Risky from lender's perspective

Factors Affecting the Choice of the Source of Funds

The choice of source of funds depends on various factors:

1. Cost of Finance: Analyzing procurement and utilization costs.

2. Financial Position: The ability of the business to repay borrowed funds.

3. Form of Business Organization: Certain forms cannot issue equity shares.

4. Time Period: Matching funds requirement with time needed.

5. Risk Factors: Choosing sources with lower risks.

6. Dilution of Control: Considering willingness to dilute control among shareholders.

7. Credit Worthiness: Choosing sources that support market credibility.

8. Ease of Issuance of Finance: The simplicity of procurement affects choice.

9. Tax Advantages: Seeking tax-deductible sources when possible.