Notes: Sources of Business Finance | Business Studies (BST) Class 11 - Commerce PDF Download

Introduction

This chapter gives an overview of the various sources from which funds can be obtained to start and run a business. It discusses the benefits and drawbacks of these sources and highlights the factors that influence the choice of a suitable finance source. It is essential for anyone wanting to start a business to understand the different ways to raise money, as well as the relative advantages and disadvantages of these methods, to make an informed choice.

Learning Objectives

After studying this chapter, you should be able to:

• explain the meaning, nature, and importance of business finance;
• categorise the various sources of business finance;
• assess the advantages and disadvantages of different finance sources;
• identify international finance sources; and
• analyse the factors that influence the selection of an appropriate finance source.

Meaning, Nature, and Significance of Business Finance

Business involves the production and distribution of goods and services to meet society's needs. To carry out its activities, a business needs money. Thus, finance is often referred to as the lifeblood of any business. The need for funds in business is essential for...

Classification of the Sources of Funds

For sole proprietorships and partnerships, funds can be sourced from personal means or loans from banks, friends, etc. In the case of companies, the different sources of business finance can be classified as shown in Table 8.1.

Table 8.1 Classification of Sources of Funds

As illustrated in the table, sources of funds can be classified based on the following criteria:

• On the basis of ownership: Equity share capital, Preference shares
• On the basis of source of generation: Internal Sources (Retained earnings), External Sources (Loans from banks, Debentures, Public deposits)
• On the basis of period: Long-term (Equity shares, Debentures), Short-term (Commercial papers, Trade credit)

In summary, understanding the various sources of business finance is crucial for making informed decisions regarding funding options for business operations and expansion.

Sources of Finance

A business can obtain funds from various sources, each with its own features. It's important to understand these options to choose the best one for raising funds. There isn't a single best source of finance for all organisations. The choice depends on factors like the situation, purpose, cost, and risk. For instance, if a business needs funds for long-term fixed assets, it may require long-term financing, which can be either owned or borrowed funds.

Retained Earnings

Companies usually do not share all their profits with shareholders as dividends. Instead, they often keep a portion of their earnings for future use, known as retained earnings. This serves as a source of internal financing or self-financing, often referred to as 'ploughing back of profits'.

• Retained earnings provide a permanent source of funds for an organisation.
• There are no direct costs like interest, dividends, or flotation costs.
• As the funds are generated internally, there is greater operational freedom and flexibility.
• It increases the business's ability to handle unexpected losses.
• It can lead to a rise in the market price of a company's equity shares.

External Sources of Finance

External finance sources include trade credit, factoring, lease financing, public deposits, commercial paper, and loans from financial institutions. These methods usually come at a higher cost compared to internal sources. Common external financing options include:

• Issuing debentures
• Borrowing from commercial banks
• Accepting public deposits

Short-Term Sources of Finance

Short-term finance provides funds for a period not exceeding one year, crucial for meeting day-to-day operational needs. Examples include:

• Trade credit
• Bank loans

International Financing

In addition to the sources mentioned earlier, there are several ways for organisations to secure funds globally. As economies open up and businesses operate on a global scale, Indian companies can access funds from the international capital market. Some of the international sources for raising funds include:

• Commercial Banks: Commercial banks worldwide provide foreign currency loans for business needs. They are a crucial source for financing non-trade international activities. The types of loans and services differ across countries. For instance, Standard Chartered has become a significant provider of foreign currency loans to Indian industries.
• International Agencies and Development Banks: Various international agencies and development banks have developed over the years to support international trade financing.

Factors Affecting the Choice of the Source of Funds

Businesses have different financial needs—long-term, short-term, fixed, and variable. Consequently, they turn to various sources for raising funds. Short-term borrowing can reduce costs by lowering idle capital, while long-term borrowing is often essential. Several factors influence the choice of funding sources, making this decision complex. These factors include:

Cost

There are two main costs to consider: the cost of obtaining funds and the cost of using those funds. Both should be evaluated when deciding which funding source to utilise.

Financial Strength and Stability of Operations

The financial health of a business is a crucial factor. A company must be in a stable financial position to repay the principal and interest on borrowed funds. If the organisation's earnings are unstable, it should be cautious about using fixed-cost funds like preference shares and debentures, as these can increase financial strain.

Purpose and Time Period

Businesses must consider the duration for which funds are needed. Short-term needs can often be met through low-interest trade credit or commercial paper. For long-term needs, issuing shares or debentures is usually more suitable. Additionally, the specific purpose of the funds should influence the choice of source.

Form of Organisation and Legal Status

The type of business structure and its legal status affect the options available for raising funds. Different organisations may have varying access to funding based on their legal framework.

Risk Profile

It is essential for businesses to assess each funding source regarding the associated risks. Understanding these risks is vital for making informed financial decisions.