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Ch.8 SOURCES OF BUSINESS FINANCE [BSt]

CHAPTER 8
SOURCES OF BUSINESS FINANCE

"Finance is the life blood of any business"

financial needs of a business are as follows:
(a) Fixed capital requirements.
(b) Working Capital requirements.

Q. Why is Fixed capital required for a business?
Ans. Fixed capital required by a business because it is the first time capital contributed by the business man into the business.

For Ex:- Land, Building, Furniture, etc.

Q. Why  Working Capital required by  business?
Ans. Working Capital is required by a business because it is the day to day expenses which have to paid from capital.

For Ex:- Wages, Salary, Tax, etc.

 Classification of Sources of Funds

1. Retained Earnings:
 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 self-financing or ‘ploughing back of profits’.

Merits:
(i) Owned Fund:
Retained earnings is a permanent source of funds available to an organisation.

(ii) No Mortgage/Interest:
It does not involve any explicit cost in the form of interest, dividend or flotation cost.

(iii) Flexibility:
As the funds are generated internally, there is a greater degree of operational freedom and flexibility.

(iv) Risk Bearing:
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.

Limitations/Demerits of Retained Earning:
(i) Excessive ploughing back may cause dissatisfaction amongest 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 recognized by many firms. This may lead to sub-optimal use of the funds.

2. Trade Credit:
Trade credit is the credit extended by one trader to another for the purchase of goods and services is said to be trade credit.

Merits:
(i) Readly Available:
Trade credit is a convenient and continuous source of funds.
Trade credit may be readily available in case the credit worthiness of the customers.

(ii) Mortgage:
It does not create any charge on the assets of the firm while providing funds.

(iii) Increase or promote sales:
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.

Limitations/Demerit:
(i) Financial Risk:
Availability of easy and flexible trade credit facilities may induce a firm to indulge in over-trading, which may add to the risks of the firm.

(ii) Limitation of Fund:
Only limited amount of funds can be generated through trade credit.

(iii) Interest on fund:
It is generally a costly source of funds as hidden interest is present.

 3. Public Deposits:
 The deposits that are raised by organisations directly from the public are known as public deposits.

Merits:
(i) Easy to obtain:
The procedure of obtaining deposits is simple and does not contain restrictive conditions as are generally there in a loan agreement.

(ii) High Interest:
Cost of public deposits is generally lower than the cost of borrowings from banks and financial institutions.

(iii) No Mortgage:
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) Control:
As the depositors do not have voting rights, the control of the company is not diluted.

Limitations:
(i) Difficult to formulate deposits:
New companies generally find it difficult to raise funds through public deposits.

(ii) Fair weather friend:
It is an unreliable source of finance as the public may not respond when the company needs money.

(iii) Limited fund:
Collection of public deposits may prove difficult, particularly when the size of deposits required is large.

Q. What do you mean by sharing capital?
Ans. It is a fund or capital which is generated after the selling of share.

Q. Who are the owner of the company?.
Ans. Share holder are the owners of the business.

Q. Name two types of share?
Ans. a) Equity Share.
         b) Preference Share.

Q. What are equity share? Give its merit and demerits?
Ans.  Equity shares represent the ownership of a company. Due to there fluctuating earnings, equity share holder are called risk  bearers of the company.

Merits:
(i) High Dividend:
Equity shares are suitable for investors who are willing to assume risk for higher returns.

(ii) Uncertainty of return:
Payment of dividend to the equity shareholders is not compulsory. Therefore, there is no burden on the company in this respect.

(iii) No Mortgage:
Funds can be raised through equity issue without creating any charge on the assets of the company.

(iv)Voting-rights to shareholders:
Democratic control over management of the company is assured due to voting rights of equity shareholders.

Limitations:
(i) High cost of share:
The cost of equity shares is generally more as compared to the cost of raising funds through other sources.

(ii) Unstable Dividend:
Investors who want steady income may not prefer equity shares as equity shares get fluctuating returns.

(iii) Formalities:
More formalities and procedural delays are involved while raising funds through issue of equity share.

Q. Give two preference rights of preference shares over equity share?
Ans.  The preferential rights enjoyed by preference share are:
(i) Receiving a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders.

(ii) They receive their capital after the claims of the company’s creditors have been settled, at the time of liquidation of the company.

Merits:3
(i) Fixed dividend:
Preference shares provide reasonably steady income in the form of fixed rate of return and safety of investment.
(ii) Less risk:
Preference shares are useful for those investors who want fixed rate of return with comparatively low risk.

(iii) Repayment of capital:
Preference shareholders have a preferential right of repayment over equity shareholders in the event of liquidation of a company.

Limitations:
(i) Not having voting rights:
Preference shares holder are not having voting rights.

(ii) Preference capital dilutes the claims of equity shareholders over assets of the company.

(iii) The rate of dividend on preference shares is generally higher than the rate of interest on debentures.

Types of Preference Shares
1. Cumulative and Non-Cumulative:
The preference shares which enjoy the right to accumulate unpaid dividends in the future years, in case the same is not paid during a year are known as cumulative preference shares. On the other hand, on non-cumulative shares, dividend is not accumulated if it is not paid in a particular year.

2. Participating and Non-Participating:
Preference shares which have a right to participate in the further surplus of a company shares which after dividend at a certain rate has been paid on equity shares are called participating preference shares. The non-participating preference are such which do not enjoy such rights of participation in the profits of the company.
3. Convertible and Non-Convertible:
Preference shares that can be converted into equity shares within a specified period of time are known as convertible preference shares. On the other hand, non-convertible shares are such that cannot be converted into equity shares.

Types of Debentures
1. Secured and Unsecured:
Secured debentures are such which create a charge on the assets of the company, thereby mortgaging the assets of the company. Unsecured debentures on the other hand do not carry any charge or security on the assets of the company.

2. Registered and Bearer:
Registered debentures are those which are duly recorded in the register of debenture holders maintained by the company. These can be transferred only through a regular instrument of transfer. In contrast, the debentures which are transferable by mere delivery are called bearer debentures.

3. Convertible and Non-Convertible:
Convertible debentures are those debentures that can be converted into equity shares after the expiry of a specified period. On the other hand, non-convertible debentures are those which cannot be converted into equity shares.

4. First and Second:
Debentures that are repaid before other debentures are repaid are known as first debentures. The second debentures are those which are paid after the first debentures have been paid back.


INTERNATIONAL FINANCING
It gives Indian companies have an access to funds in global capital market.

Various international sources from where funds may be generated include:
(a) Global Depository Receipts (GDR’s):
The local currency shares of a company are delivered to the depository bank. The depository bank issues depository receipts against these shares. Such depository receipts denominated in US dollars are known as Global Depository Receipts (GDR).

(b) American Depository Receipts (ADR’s):
The depository receipts issued by a company in the USA are known as American Depository Receipts. ADRs are bought and sold in American markets like regular stocks.

(c)  International Agencies and Development Banks:
These bodies provide long and medium term loans and grants to promote the development of economically backward areas in the world.
Example: 1. World Bank.
2. ADB (Asian Development Bank).
3. IMF (International Monetary Fund).
4. EXIM Bank (Export Import Bank).
5. IBRD (International bank for reconstruction development).

FACTORS AFFECTING THE CHOICE OF THE SOURCE OF FUNDS
 The factors that affect the choice of source of finance are briefly discussed below:
(i) Cost:
There are two types of cost viz., the cost of procurement of funds and cost of utilizing the funds. Both these costs should be taken into account.

(ii) Financial strength and stability of operations:
When the earnings of the organisation are not stable, fixed charged funds like preference shares and debentures should be carefully selected.

(iii) Form of  organisation and legal status:
A partnership firm, for example, cannot raise money by issue of equity shares as these can be issued only by a joint stock company.

(iv) Purpose and time period:
A short-term need for example can be met through borrowing funds at low rate of interest through trade credit, commercial paper, etc.

(v) Control:
Issue of equity shares may mean dilution of the control.

(ix) Tax benefits:
Interest on debentures is deductible, While calculating tax. Therefore, it is preferred by organisations.


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Comments

  1. Really, informative post. Have you another blog or post about FD Capital (financial director). If have please share, I want to about it in details.
    Thanks

    ReplyDelete

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